Will Puerto Rico Cause An Inadvertent “Black Swan” Derivatives Melt-Down?

I really had not been paying much attention to the Puerto Rico debt situation.  After all, $72 billion in debt that might go bad – big deal.  The Fed can print up $72 billion in credit lines with the push of a button.

But a friend of mine happened to mention to me today (Monday) that MBIA’s stock was down over 23% and Assured Guaranty’s stock was down over 13%.  That woke me up.

MBIAMBI guarantees $4.5 billion in par amount of Puerto Rico muni paper.  As of it’s latest 10-Q (March 31, 2015), MBI showed a book value of $3.9 billion. Puerto Rico alone could more than wipe out MBI’s net worth.  But that’s only a portion of the story. The bigger part of the story is buried off-balance sheet in the footnotes in opaque financial structures called Variable Interest Entities (VIE’s). Remember those from 2008?  I remember them vividly.

The VIEs are the off-balance sheet vehicles that triggered the massive chain of counterparty defaults which de facto collapsed the U.S. financial system in 2008.  The VIEs are where the credit default swaps and other nebulous forms of OTC derivatives bet slither around.

Companies like MBI and AMBAC underwrite  credit “enhancement” guarantees on these massive cesspools of debt – and the associated derivatives that are “wrapped around” the debt structures – and stick them in VIEs.  MBI’s 10-K has several pages of footnotes which vaguely describe the contents of its VIEs.   The problem is that MBI and its ilk are thinly capitalized relative to the potential size of the liabilities they face if the credit markets become volatile to the downside.


Toxicity plus toxicity does not equal purification.  But VIEs that contain off-balance sheet debt and derivative guaranteed equals toxicity cubed, at least.   In other words, whatever MBI lists as its “net” credit exposure in its financials, take that number and, at the very least, triple it.

But wait, the story gets even better.  As it turns out Warburg Pincus, one of the loftiest private equity firms on Wall Street,  is by far MBI’s largest shareholder.  Warburg announced a little over five weeks ago that it was going to unload 60% of its stake via over the counter negotiated sales – LINK.   The firm has been unloading these shares since May 18th.  We won’t know how successful this effort has been until the selling is completed.

Does Warburg Pincus sound recently familiar?   It’s the firm that hired “Turbo Tax” Tim Geithner shortly after he left his post as Treasury Secretary.   Remember, Geithner was head of the NY Fed at the time of the 2008 financial collapse.  In other words, he knows where a lot of the bodies in the financial system are buried.  I have no doubt that Geithner has played a significant role in advising Warburg on the need to unload its exposure to MBIA.  Anyone who takes the other side of this trade is a complete idiot.  

But this story isn’t just about MBI.  It’s about the companies that, along with MBIA, provide “insurance” for bonds and derivatives.  These firms have assumed potential liabilities that dwarf their ability to cover them.  Not just in the worst case scenario.  I believe Puerto Rico’s financial demise could trigger the dreaded financial nuclear daisy chain of counterparty defaults.

The problem with creating “actuarial” payout models for insurance guarantees on financial assets, and this especially true for derivatives, is that the outcome is pretty much binomial.  Either the assets pay off or they become worthless or near worthless.  Furthermore, with the extreme degree of Central Bank intervention, which has enabled literal financial zombies to continue living and has enveloped the entire financial system with opacity, it’s impossible to model in expectations on, and potential sources of, counterparty default risk.  It’s like lightening.  It can unexpectedly strike anywhere – just ask Hank Paulson and Goldman Sachs…

This is exactly what occurred in 2008.  Only this time around the problem is significantly greater than it was in 2008.  Global debt and gross derivatives outstanding are much bigger than in 2008.   And, except for the Plan B hyperinflation of the money supply, Central Banks are out of bullets.

I believe it is highly probable that the crashing stocks of MBIA, AMBAC and AGO are the alarm bells of a black swan landing.  And, of course, no one has been talking about them until today.  Although these firms are somewhat obscure and small compared to the size of the majority of financial companies, they are highly leveraged with massive off-balance-sheet liabilities for which they have zero hope of covering in the event of even relatively small bond defaults.   In other words, these firms are the ones most likely to set off the next financial collapse triggered by their counterparty defaults.

17 thoughts on “Will Puerto Rico Cause An Inadvertent “Black Swan” Derivatives Melt-Down?

  1. i hope you are wrong. really no winners. however, my gut feeling tells me you might be right … especially that Warburg Pincus few weeks warning kind of thing, it is a big red flag … not so sure those guys need little Timmy to “advise” them … they are the advisors, timmy got lucky in life and is along for the ride

  2. Dave,

    Wolf Richter picked up on this today as well. His commentary dovetails nicely with yours.


    As far as I’m concerned, Puerto Rico is as big of a threat to the system as Greece (if not bigger). Governments have been watching the slow motion Greek train wreck for years – they’ve had plenty of time to prepare contingency plans. Puerto Rico? As of a couple days ago, most people probably didn’t know it was a U.S. territory.

  3. More support for PM’s ownership right there Dave, a proportionately perfect black swan shapely flying under the radar screens of complacent, self-absorbed oligarchs, tyrants, czars, lobbyists, and political, social and economic leeches everywhere.

    There could be light at the end of default,
    Markets could breathe after a halt.
    Chickens always come home to roost,
    Will they lay golden eggs as a boost?
    Contracts should settle one by one,
    Their counterparties out in the sun.
    TPTB are bold with their scam,
    So, soon will end this flim-flam.
    How far can the fallout hurl,
    As force-fed markets unfurl?

    http://www.gata.org/node/15500 – EXCERPT:

    “OCC derivatives report suggests U.S. govt. has seized all commodity markets
    Submitted by cpowell on Tue, 2015-06-30 03:13. Section: Daily Dispatches
    10:56p ET Monday, June 25, 2015

    Dear Friend of GATA and Gold:

    Citing the latest quarterly report of the U.S. Office of the Comptroller of the Currency, Zero Hedge concludes tonight that JPMorganChase has “cornered the commodity derivative market,” the notional value of the investment bank’s commodity derivative position having just exploded from around $200 billion to nearly $4 trillion…”

  4. Great column, Dave! Wow, mention of MBIA and AMBAC sure brought back memories of fall 2008! Keep on the trail, man!

    1. Thanks JG. The market has such a short memory – especially when it’s been subjected to the heavy dosage of QE narcotics.

  5. Or as they say..the FED will Bail them all out…and NOT allow them to fail or give ‘funny money to their minions to ‘purchase the shares that are being sold as to soften the loss to said firms…the fed sends trillions around the world to lesson the carnage and keep the shitboat afloat….just saying….

  6. Monday June 29, 2015:


    Obama signes TPP Fast-track “bill”

    Tuesday June 30, 2015:


    Jerry Brown (California governor) signs mandatory vaccination “bill” for ALL public & private school enrollments in California


    Coming soon, new “Federal” “bill”:

    Mandatory consumption of Monsanto’s GMO corn in each American household, with the mandatory amount per person in each household to be decided by Michelle Obama.

  7. Wow. Great article Dave.

    De JaVu all over again. I had No idea that those companies were tied tied into the PR bond guaranty markets. WoW. MBIA & AMBAC all over – Again? This is going to be horrendous and you know that little stinkin tax evader forewarned Warburg just as you said. Those slimy dirt balls.

  8. Around $72 billion is a drop in the bucket for the money printers. No big deal…they will keep this thing afloat as long as THEY want to. It will be “them” who decide when to collapse it all…but only after they move as much wealth unto themselves as reasonable. Fundamentals mean nothing in controlled markets. Get used to it.

    The common human being could do it (collapse) if they’d all stop going to work…but unification amongst the people won’t happen. They know it and I know it. Participation in the game (going to work, etc) keeps it going. They are too afraid to do otherwise.

  9. Dave, this is a bit off-topic, however I think you and many of your readers will enjoy this bit of comic relief…

    …oh and being part English (WW II vintage) AND part Jewish, personally I find this piss-take of the Germans hilariously side-splitting, but that’s just me. ANYway…:

  10. PS to my above comment…

    …and I think of THIS, as Jean Claude Juncker (weirdly, a Gothic Prussian freak with a French first name) singing to himself in a mirror:


    Lyrics translated into English (although the Gothic freakiness sounds better in German):

    If the friends are nice to me
    the white fairy will stretch her bow
    she’ll shoot into the face of my worries
    and out of the two halves will break
    the father of all mirrors

    He waves for me and I bend
    he whispers quietly in my ear

    You are the most beautiful child of all
    I hold you like my own blood
    you are the most beautiful child
    even the bad is good, in me

    The curiosity lengthens my dream
    the white fairy sings and laughs
    she has violently made me pregnant
    and tortures me pregnant through the night
    the father of all mirrors

    He waves for me and I bend
    he whispers quietly in my ear

    You are the most beautiful child of all
    I hold you like my own blood
    you are the most beautiful child
    even the bad is good, in me

    And how I defend myself against the pains of birth
    in the cradle yet still whoring
    I see at the same time how I give birth
    and devour the afterbirth

  11. DAVE!
    You always amaze me with the dirt you dig up! Keep it up! Your the man!
    Question….. are you planning on shorting or buying puts on MBI and/or AMBC? I’m curious when the Puerto Rico debt problem will hit the news. Also pondering what Puerto Rico’s next move will be. I’m thinking about dipping my toe in the water and testing it out with a few put options on AMBC (I’m talking about chump change here. Don’t trust this controlled market to make big options bets and I don’t have a whole lot of capital anyways so I don’t feel comfortable rolling the dice putting up a few grand on puts) I feel like that one has some more downside to catch up with MBI. MBI got cut in half almost with a 40 percent drop in 2 days basically while AMBC has only dropped 28% in the same time frame……
    I feel that luck isn’t on my side. I played GLD calls a few times in the past month when gold was in the 1170 range then both times gold went up and my options were in the money but that didn’t last long. Both times it was immediately slammed back down.

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