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The market rallied hard into the close on Friday on the news [rumour] that a group of Banks were going to provide an infusion of capital to AMBAC, thus ostensibly preserving their AAA credit.

Why would the Banks do such a thing?

Obviously the Banks have something to gain. They are not charities.

The most obvious gain for the Banks is to maintain, at least for the moment the ratings that currently exist on existing CDO’s. If Ambac were to go under, or be broken in two, the ratings on the CDO’s must fall, as their rating is based on the underwriting insurance from Ambac.

This would result in further losses to the Banks on a number of potential area’s.

*CDO’s

*CDO’s squared [derivatives of CDO's where the CDO is collateral for the squared]

*CDS contracts.

The losses on the CDO’s would damage any Banks that still held existing CDO’s which can be easily determined simply from examining the list of rescue Banks; Citi [always in trouble every cycle] Royal Bank of Scotland [shame on you] UBS, Wachovia Corp (WB), Barclays (BCS), Societe Generale SA, BNP Paribas SA, Dresdner Bank AG

CDO^ are derivatives of CDO’s and seemingly haven’t been in the news much yet. Who actually hold them? Who knows. The problem is that being a derivative, they are even more leveraged than a CDO, thus will accelerate gains/losses.

CDS are insurance contracts that were supposed to provide a hedge for the Banks, who hold some $45 Trillion in notional value.

The dissolution of AMBAC would as stated trigger downgrades on CDO’s due to the loss of the underwritten insurance that provided the AAA rating in the first place. As thay lose this, and are downgraded this will trigger movement, and very significant movement in the CDS contracts.

CDS contracts can be triggered by; Default in the underlying, Downgrades in the underlying, Widening credit spreads in the underlying.

The Banks put in place hedges, to try and protect themselves. So if UBS held say $10 Billion in CDO’s that they didn’t want exposure to, they would PURCHASE a CDS contract, typically from another Bank, say Citi, to insure their exposure.

Citi however may no longer hold that liability. They may have sold it to a Hedge Fund, that thought selling a PUT, was easy alpha.

The problem now is this. UBS may have already approached Citi and said, hey guy’s, get ready to pay out, our exposure is $XX, Citi reponding, sorry guy’s, Hedge Fund XXX hold the contract now as we sold last year.

UBS contact Hedge Fund XXX, who say, sorry guy’s, we can’t pay, we don’t have the capital, and have no way to raise it.

This is counterparty risk.

The writedowns that we have seen to date are most likely the UNHEDGED components that the Banks were holding as an *investment* or couldn’t hedge, and couldn’t sell in time.

The writedowns that the Banks are trying to avoid by saving AMBAC could very well be the start of the *hedged* book, that possibly has become un-hedged due to counterparty risk. This is far, far larger than the straight directional exposure [huge though it was] and will threaten the viability of the financial system, as failure in one [or more] Banks on that list will have a huge domino effect within the financial system.

Thus the proposed bailout will have to take place, even though the Balance Sheets of the Banks CANNOT support such an undertaking. Their Balance Sheets are so badly damaged from the losses already sustained, that it is almost suicide to try and provide capital to Ambac. That they are attempting to do so, really tells you just how bad it is yet to be.