Here’s an irony: one of the very instruments the bears have been using to beat up the financial guarantors, credit defaults swaps on the companies themselves, could provide the guarantors with a surprise tool they can use to help commute certain CDS on CDO  agreements with investment banks on very favorable terms.

In particular, the ballooning prices of the CDSs on the guarantors have some very interesting, and lucrative, effects on the economics of commutation. Let me walk you through a hypothetical example, and you’ll see how:

Step 1:  A financial guarantor (FG) writes a CDS on the super-senior tranche of a CDO composed largely of residential mortgage back securities (RMBS). Its counterparty: an investment bank (IB) that owns the super-senior tranche.

Step 2:  The CDO blows up, and its market value sinks. Initially for the IB, this market value decline is offset by a rise in the value of its CDS contract with the FG. So far, the credit enhancement has worked as planned. The FG, meanwhile, estimates the net present value of the impairment of the CDO it wrote at, say, $1 billion. (All numbers are illustrative.)

Step 3:  The rating agencies downgrade the FG amid a relentless negative commentary by certain high-profile bears. The price of CDS on the FG zoom, to the point that their prices imply a 60% chance the FG will default.

Step 4:  The quarter ends. The IB reports a positive mark of $1 billion on the CDS it owns, but by accounting rules has to net that against $600 million to reflect the wild market on CDS on the FG. So it can only show a $400 million positive mark, against the $1 billion it’s lost on the CDO. IB not happy now with enhancement!

Step 5:  FG also reports earnings. It recognizes an impairment of $1 billion (the net present value of expected loss) on the CDS it wrote on the CDO. But the FG will make cash payouts against that loss only gradually, in the form of principal and interest payments over the life of the defaulted bonds. The payouts will last for as much as 40 years, with principal payment at the end. In tallying the NPV of the CDO loss, the FG assumes a discount rate of 5%, to reflect the yield of its investment portfolio. Also, the FG, which intends to regain its triple-A rating, holds $1.3 billion in capital against the impairment, in line with the agencies’ requirement for triple-A.

Step 6: The FG approaches the IB with a proposal to commute the contract. Suggested deal: FG will pay $500 million in a single payment if IB terminates agreement. Benefits to IB: it gets $500 million up front rather than waiting for a dribble of cash that will last for decades; in addition, it no longer has to worry about the financial health of the FG, which the CDS market says is sinking fast. Best of all, remember that the IB has only been able to show a $400 million positive mark on its CDS on the CDO, since it had to net it against the sky-high market value of the CDS of the FG. Five hundred million dollars is more than $400 million. A good deal!  Also, the IB can earn 15% (or whatever its ROE is) on the $500 million it gets from the FG, rather than the 5% discount rate the $1 billion was returning as a liability of the FG.

Benefits to the FG, meanwhile: In return for its $500 million cash payout, it recognizes a $500 million reduction in impairments, and frees up the $800 million in capital it had set aside under the rating agency model!

Would it make sense to commute every CDS agreement? Of course not. It only works for agreements between selected guarantors and selected investment banks. But as you can see, a big driver of the benefit is the high price of CDS on the guarantors, which, ironically, the bears on the guarantors and those wacko rating agencies have helped bring about. In this case, both the guarantor and the investment bank have strong economic incentives to come to some sort of agreement. It’s been made possible largely by the excessive fear and panic about the health of financial guarantors led by Bill Ackman.

I certainly hope commutation agreements are announced soon, before Bill Ackman covers his short and CDS positions with respect to the financial guarantors.

What do you think? Let me know!