Who wins when banks die?

Imagine you're recently divorced and your ex-wife is still the beneficiary of a
$1,000,000 life insurance policy.  The local police chief holds a press
conference and announces, "Murders are way up this year.  Due to limited
resources, we will now only investigate cop killings.  Please stay honest and
have a good day."  You have to hope your ex-wife was an honorable person.
Either that, or increase alimony payments so you're worth more alive.

If a story on msnbc.com is true, this is the position the weaker American banks
are in.  MSNBC.com quoted TCW Group analyst Jeff Gundlach as stating, "The
credit crisis has obviously entered into a new phase - the government has one
bailout left in them and [Fannie/Freddie] is it...One consequence of Freddie and
Fannie is that other firms are allowed to go under.  If you couldn't get your
act together after four months of unprecedented financing terms, maybe you don't
deserve to be thrown another lifeline."  Aside from allowing IndyMac to fail,
news concerning the government 'bailout' of Fannie and Freddie does not
immediately lead me to this conclusion.  However, Mr. Gundlach has a corporate
biography infinitely more impressive than mine so I'll take him at face value:
American banks will be allowed to fail.

A failing bank - a popular example of which is Washington Mutual - has a life
insurance policy called a Credit Default Swap (CDS).  In it's original form, a
CDS was an insurance policy against an economic events including corporate
failures.  An investment group could buy Washington Mutual debt and a CDS; if
Washington Mutual fails to pay the CDS insures them against a loss.  The
counterparty, or insurance company, accepts the credit risk in exchange for a
premium.  If both the investment group and counterparty understood the risk,
then it benefited both parties.  With a CDS in play, if Washington Mutual
defaults on debt obligations, someone gets paid big.

To be fair, a CDS is more like homeowner's insurance than life insurance; in so
much as a house fire is unlikely to occur while death is inevitable.  In recent
years the CDS market has ballooned from nothing in 1995 to an estimated $45
TRILLION in 2007, as reported by the New York Times.  This does not mean $45
trillion will change hands; the figure is akin to the insurance payout if every
house in America simultaneously burned.  So to trigger a $45 trillion pay out,
every business in the world would have to go under.  But, like homeowner's
insurance, the CDS payout can change previously held incentives for the
corporation and its investors.

This leaves troubled businesses - like Washington Mutual - in a position
dissimilar to history.  The company faces traditional short-selling pressures
but, unlike the past, there are many CDS owners who also want the bank to fail.
Many of them are speculators and don't even own and Washington Mutual debt.
It's my opinion that once an institution gets into the crosshairs of short
sellers and CDS speculators, it will be difficult for them to survive in today's
environment.  The popular victims are currently Washington Mutual, National
City, Lehman Brothers, Fannie Mae, Freddie Mac, and Wachovia.  Much like Bears
Sterns, they are not resigned to failure or takeover, but they're facing
tremendous headwinds to survive because there are now multiple beneficiaries
from their failure.  The SEC's initiative to limit short selling only addresses
part of them problem.