Weak Markets: Bernanke Not Total Reason (Hedged Exposure)

If you are wondering why the markets are weak, you cannot blame it all on Mr. Bernanke's somewhat downbeat testimony. The initial comments from Bernanke, on top of a very poor Philly Fed, down 20.1, the lowest since October 2001, set the tone early on.

But Wall Street is once again worried about subprime, but there is a new wrinkle now: while financial firms like Merrill have been aggressively writing down UNHEDGED exposure to subprime CDOs, there is a whole other area--HEDGED exposure, that has not been touched to a great extent.

Look at Merrill. Merrill went out and bought credit default swaps on about $20 billion worth of CDOs (collateralized debt obligations)—this is where most of the subprime problem is. This is basically a put option; if the CDOs turn south, Merrill is (theoretically) protected.

Here's the problem: the counterparty on most of these credit default swaps are the monoline insurers--Ambac and the others. It's a small group. Last night Moody's came out and said they have placed Ambak under review for a possible ratings cut. Any cut to something below a AAA rating would be disastrous for the company.

Ambac now says they probably won't be able to raise capital in the manner in which they expected.

What happens to firms like Merrill who bought protection from, say, Ambac and other monoline insurers? If Ambac and MBI go under, they are obviously not able to take on the exposure from Merrill or anyone else. This means that all this supposed protection that financial firms bought may be worthless and they may have a lot more exposure than they thought.

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