Our view of the US banking and credit sectors is that the credit adjustment process was nearing half way at the end of Q3 2008. The first portion of the crisis started from the collapse of New Century Financial early in 2007, was about loss recognition. The headlines concerning insurers such as MBIA (NYSE:MBI) and lenders such as Countrwide Financial, now owned by BA, were dominated by mark-to-market losses, largely as a result of the implementation of the new rule regarding “fair value” accounting. Neither Paulson nor Bernanke foresaw nor understood the impact of imposing fair value accounting on a speculative market bubble.

The second phase of the crisis is unfolding now and is more focused on loss realization, that is, the sale of distressed assets and the charge-off of bad or doubtful credits.
Loss rates reported by banks in Q3 2008 continue to climb rapidly and new provisions are flowing into reserves at more than 2x current charge-off rates. Based on our estimates, these loss rates could force large banks such as JPMorgan Chase (NYSE:JPM) into the arms of the government when additional equity injections are required, perhaps as early as Q4 2008.

The third phase of the crisis involves a broadening of losses from asset classes such as mortgages and financials into a more general credit loss peak cycle affecting entire economy. There will be continuing need for government support of large banks as on- and notional off-balance sheet obligations become very real and must be funded. Indeed, the political rhetoric of getting banks to “start lending again” is entirely at odds with the economic situation inside the banks.

In 2009 and beyond, the funding needs for financial institutions are going to be dominated by first loss absorption, then reserve/capital replacement, and finally balance sheet expansion via new lending. The full weight of the funding required to liquefy/subsidize the $55 trillion OTC credit default and other derivatives still not recognized by Fed, G-7 central banks. Indeed, the OTC derivative market encouraged and fostered by Chairman Greenspan, the BIS and other global regulators may now be a dead weight that drags down the global economy for years to come.

Consider the ongoing discontinuity in the dollar LIBOR in Europe. Regulators such as Paulson and Bernanke publicly stated that their efforts at providing liquidity to the markets will restore credit availability to private markets. But what neither the regulators nor the media understand is that the bad effect of the CDS market comes not merely from when there is market dysfunction and an individual counterparty fails. That happens often enough and the prime broker-dealers like C and JPM clean up the mess quietly so as not to roil the markets. Remember, the dealer already owns the counterparty's collateral through the credit agreement, so there is no point forcing the issue with a messy and noisy bankruptcy. Right? This is why the media rarely hears of failed trades in CDS.

No, as with the repatriation of the Structured Investment Vehicles onto the balance sheets of C and other money center banks, the true significance of CDS comes when the markets function smoothly, as after a default event like Lehman. The trigger event putting a single name CDS contract in the money results in a liquidity-raising event for the seller of protection, who must fund the purchase of the debt at par less recovery value - whether or not the other party actually owns the debt!

This process of funding the CDS is reportedly a factor behind the high rates of dollar LIBOR in London and illustrates how cash settlement derivatives actually multiply risk without limit. Through the wonders of cash settlement, the derivative-happy squirrels at the Fed, BIS and ISDA created a liquidity-sucking monster in OTC derivatives that multiplies risk many times, for example, above the amount of underlying debt of Lehman Brothers.

In October, my firm reported that there are more than a few EU banks which wrote CDS on Lehman over the past several years, CDS which were written at relatively tight spreads. These banks did have chosen to take delivery on the Lehman debt, forcing them to fund a nearly 100% payout on the collateral. A certain German Landesbank, for example, took delivery on $1 billion in Lehman bonds that are now worth $30 million, and had to fund same. Does this example perhaps suggest a reason why the bid side of dollar LIBOR in London has been so strong?

As one veteran CDS trader told me in October: "It's not that people can't fund, it is that people have got to fund these CDS positions. These banks don't have access to sufficient liquidity internally to fund, so they hit the London markets... The Fed and the other central banks must start to deal with the huge overhang of currently hidden funding needs from the CDS and other derivatives." Another market observer suggests this is precisely why the Fed and other central banks have been furiously putting reciprocal currently swap lines in place.

As consumer and commercial default rates in the US rise, the normal operation of the OTC derivatives markets is creating a cash position that must be funded in the real world and is thus distorting these benchmark cash markets such as LIBOR. This distortion is magnified by the dearth of liquidity due to the breakdown in the rules regarding valuation and price. So far, the Fed and other central banks have addressed the on-balance sheet liquidity needs of global banks.

But as default rates rise in the US in 2009 and beyond, funding the trillions of dollars in notional off-balance sheet speculative positions in CDS, which become very real and require funding when a default occurs, could prolong the economic crisis and siphon resources away from the global economy. That, at the end of the day, may be the bitter legacy that Alan Greenspan, Hank Paulson and Ben Bernake may leave behind.