Selling not just actual debt but bets on debt is the essence of the derivatives market, where the aim is to create more shit for the banks to sell by magically creating loanlike products out of thin air. "Synthetic lending," is how one market analyst put it. Imagine a Foot Locker floor manager sticking a new set of Nikes in front of a three-way mirror and selling off each of the images as a new pair of sneakers, and you get an idea of what we're dealing with here. According to Moody's, there are a hell of a lot of these doppelgänger BP bets in circulation. "We reviewed our entire universe of outstanding CSOs," the firm reported, "and determined that exposure to BP and its rated subsidiaries appears in 117 (excluding CSOs backed by CSOs) transactions, which represents approximately 18 percent of global Moody's-rated CSOs."
In other words, a full 18 percent of these complex bets in circulation are tied in some way to BP's future. And note the frightening parenthetical comment, which reveals that the Moody's analysis conveniently excludes "CSOs backed by CSOs." Wrap your head around this: If a CSO is a basket full of bets on loans, then a CSO backed by a CSO (a thing called a "CSO squared") is just what it sounds like: a basket full of baskets filled with bets. When I called Moody's to ask how many of these mutant debt-clones are out there in circulation, the firm said it didn't have that data.
This sort of uncertainty about the potential impact following the collapse of a major firm like BP is the heart of the problem. AIG went down because of a vicious cycle of variables: A downgrade in the company's credit triggered collateral clauses in some CDS deals that forced the company to post so much cash to pay off bettors that its credit got downgraded again — triggering still more collateral clauses, leading to more cash losses, leading to the death spiral of September 2008. The disaster took even AIG's top management by surprise, because almost nobody knew about those collateral clauses; the markets simply had no idea who was going to have to pay, or how much, if the company defaulted. And fear of that unknown is a big part of what drove the panic on Wall Street in the weeks before Lehman and AIG started circling the drain.
Now a similar, if perhaps less dramatic, fear exists with BP, which has already seen its credit downgraded multiple times as a result of the spill: On the day of Obama's speech, the Fitch agency sliced the firm's credit rating all the way down to BBB, just above junk status. In the months and years to come, BP will no doubt have to produce large sums of cash to pay for cleanup costs and lawsuits and penalties — and each time its cash situation deteriorates, its credit rating may worsen, which in turn could mean big betting losses in derivatives like CDSs and CSOs and CSO squareds.
The lack of transparency in the derivatives market means that nobody has any idea what will happen or who will be affected if BP goes under. Nobody knows whether a BP credit downgrade will trigger losses in any of those 117 CSOs, or whether losses would only come in the event of a bankruptcy. ("It depends on a lot of factors," says Moody's spokesman Thomas Lemmon. "Every one of them can have different characteristics.") Nobody knows who's taking those billions and billions of dollars of CDS bets against BP, meaning that nobody knows which federally insured banks will be fucked if BP defaults. (Asked if the identities of the CDS sellers is knowable, market analyst Casey had a blunt answer: "No.")
It's not even possible to more than vaguely quantify the dollar amount of losses that might ensue if BP goes under. We know, because the Depository Trust and Clearing Corporation posts these statistics, that at this writing BP is listed as a "reference entity" on some 3,413 derivative contracts worth somewhere in the vicinity of $18 billion — meaning that roughly that many derivative bets hinge on the question of whether or not BP defaults. But we don't know who those bettors are, and we don't know how many CSO-like side bets are pegged to those bets.
In short, nobody knows what might happen if BP goes down. The general consensus is that the company probably isn't at the center of as many economic webs as Wall Street firms like Lehman Brothers or AIG — but that doesn't mean it couldn't touch off a financial tempest of global proportions. "It would be huge," says Peter Kaufman, president of the investment bank Gordian Group. "I don't believe it would have the interconnectivity of an AIG or Lehman, but it would be big."
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