I still don't hear the dog barking.
Me neither. I'm reminded of the Brent 15 day market with loads of open contracts but net exposure relatively minimal.
Bringing in a Central Counterparty is one way of netting out such open bilateral (OTC) contracts, but at the price of concentrating all the residual market risk in one Single Point of Failure.
Alternatively, a neutral custodian could hold the contract data, and clearing agent software like Ripple could net contracts out wherever possible.
Ripplepay.com - About Ripple
And that's how Ripple works. You create a profile on the system and indicate who you know and how much you trust them by connecting to people by email address and giving them credit limits. Then whenever you want to make a payment to another Ripple user using only friendly obligations, the system finds a chain of intermediaries connecting you to the person you want to pay, and records the payment in each intermediary's account all the way down the chain. You end up owing one of your "neighbours" on the system, and the payment recipient ends up being owed by one of her neighbours.
AIG was the nexus here. They were fools taking all bets with no capacity to take a hit. But if their largest counterparties only had $10 billion ish of exposure (much of it already margined), how much more can be out there?
now on the CDO's there's still big problems if real estate continues to melt down. But from what I see, real estate is getting cleared at about 60 cts on the dollar for the most part (some real disaster auctions in the central valley of CA). So there's a floor under them much higher than the trading price of the paper. Some bright sparks will make a killing off of the big banks puking this paper.
As for how to prevent this, I've no great idea other than requiring huge margining such that no one player can get too big to fail. Your system has elements of the system that just failed us. AIG was AAA with open credit all around. Until suddenly they weren't and didn't.
I've heard some interesting tales of how the major oilcos simply shut down all credit with the wall streeters last fall. Nearly brought physical trade to a halt. Ugly.
Some bright sparks will make a killing off of the big banks puking this paper.
According to news reports - so take with appropriate amounts of salt - some bright sparks already are. Reportedly a company in California is picking-up the paper for 22 cents on the dollar.
