The Financial Times reports that the investment banks are in talks with the financial guarantors to commute—that is, terminate—their credit default swap agreements related to Collateralized Debt Obligations (CDOs).

In normal times, neither side of those trades would consider such a commutation. But these aren’t normal times. In the current environment, both sides figure to gain from deals to terminate. I expect them to happen, and relatively soon.

As I see it, though, there’s a big difference between CDOs the guarantors have backed that are expected to produce no loss (the vast majority, by the way) and the ones that will generate a loss, and that the guarantors have already established a reserve against.

The healthy CDOs first.  In these cases, investment banks pay the guarantors an installment fee in return for a credit guarantee. This ensured a triple-A for the CDOs, which in turn gave capital relief to the investment bank. But the guarantors have since been downgraded, which means no triple-A on the CDOs and no credit relief for the banks. The banks are paying, in essence, for nothing.

You can understand, then, why the banks would like to commute the contracts. For their part, the guarantors have an interest in commutation as well, even though it would mean giving up a profitable revenue stream. Why are they so eager? Capital. If the guarantors can commute their CDO CDS agreements, they can free up some capital, since they’d no longer have to support the insurance in force.  If the rating agencies hadn’t gone so crazy with their incessant and arbitrary moving of goalposts, the guarantors wouldn’t be interested in a commutation.  But in times like this, the more capital the guarantors can show the agencies counts for more than future revenue. It would also demonstrate a lot more financial flexibility than the rating agencies have given them credit for.

So both sides would benefit from commutation.

In the case of troubled CDOs, meanwhile, the investment banks have already written them down--and will have to write them down further in view of the ratings downgrade of certain financial guarantors.  For their part, the guarantors have already recognized impairments on their CDSs, in the amount of the net present value of likely future payouts. (Remember, most of these principal payments would not take place until the maturity of the CDO, some 20-40 years out.)

So if both sides can agree on the net present value of those payouts, they can come to an agreement on commutation that would provide investment banks with early cash payments, and capital relief for the guarantors.

Thus, because of the credit rating agencies’ recent downgrade of certain financial guarantors, both the investment banks and the guarantors have incentive to commutate selected CDS on CDOs.

It’s a rare win/win in a bad situation.  Look for some deals to take place.

What do you think? Let me know!