For far too long, Counterparty risk was ignored throughout the world’s fixed income and structured credit instruments. The markets expanded on this underlying concept of insurance where there were no limits to what could be created (or how much of it) so long as we could say that risk was mitigated. The CDO market could expand exponentially because of the false belief that the risks of default in the subprime tranche were compensated by the higher cash flows and the supposed certainty and smoothing provided by the Alt-A and prime tranches. And even if they were wrong, the bigger failsafe was said to be the monoline insurance that would make good on any payment disruptions in the underlying CDO. After all, the monoline had AAA ratings that would all but crush any hint of counterparty risk. We are paying the price for that ignorance now.

But that is not the only example. Just consider the counterparty effects on the municipal bond market. Additionally, there are elements of counterparty risk in the Asset Backed Commercial Paper market when the assumption that liquidity from investors would continue forever and that the big banks providing backup commercial paper lines of credit would soak up the volume if it ever would be needed. In a sense, those banks and their AAA ratings and backup facility were providing the role of counterparty that kept yields low and volume high. Can ABCP issuers still count on them being there? Can ABCP investors feel confident that they will be there to cover the rollover risk?

The biggest example that is still being ignored is the entire Credit Default Swap market. Every once in a while we see hints of the losses that will eventually hit, but they are always downplayed. Never mind that it is the embodiment of counterparty risk and has a notional amount of approximately $45 trillion. Somehow the lovers of CDS feel it is immune to loss simply because it is designed to counter counterparty risk. Eventually we will suffer from that ignorance.

There are multiple tiers where moral hazard meets counterparty ignorance. The higher it goes, the bigger the consequences. The ultimate counterparty? The United States Government.

Look at our currency. To me, the decline in the dollar reflects investor confidence in our government and that it will be able to make good on its promises when needed. More and more, our government is either called upon or volunteers to provide the ultimate insurance. When it comes to banks needing liquidity, the Fed makes sure they get as much as they need. Is there any reason to believe they will not continue to do so? After all, it is the lender of last resort. And if a bank fails? The FDIC supposedly insures that depositors will get their money back. Is there any reason to believe they won’t? If mortgages fail and foreclosures mount, we now have the Dems putting together a proposal for the government to create a new HOLC and provide the ultimate backstop. There may be no limit to what a government can do to prop up an economy but there are consequences for it.

When I see the problems with GSE debt now getting publicity, it really rests on the Ultimate Counterparty. If investors are losing their appetite for agency debt and need an assurance that they have the full faith and credit of our government before they will hold them, we are facing the Ultimate Counterparty risk.