Two More Positives? Time To Slightly Boost Equity Allocation If You're Far Below Target

(1) European countries may be close to agreeing to recapitalizing some of their banks.

(2) Exposure on credit default swaps may not be as bad as "$55 trillion."

One of the major reasons banks won't lend to one another, is that they're hoarding cash to prepare to make big payouts for the bond insurance (CDS) they've written, and they don't trust that other banks haven't written the same type of insurance. But "$55 trillion" in outstanding CDS may be far more than the amount of actual liability. A NakedCapitalism post this afternoon explains:

• Reader Tim sent us a link to a press release from The Depository Trust and Clearing Corporation which says that the net payout on Lehman credit default swaps will be comparatively minor, a mere $6 billion, versus the gross exposure, which has been widely reported as in excess of $400 billion. If this proves correct, that will be the best news we have heard for some time, since one of the unknowns hanging over the market has been the prospect of further bank failures resulting from Lehman payouts.
• DTCC's report, if accurate, is consistent with the industry's claim that protection writers hedged their exposures, and in this market, the only effective way to do so was by entering into an offsetting swap).
• The problem is that even if many of the trades were hedged, for any dealer, the quality of its hedges depends on the quality of its counterparties. Even though CDS protection-writing was concentrated among a short list of names (all big suspects), hedge funds were also writing protection. So way BigBank had $30 billion of Lehman CDS exposures, $15 billion each way. Let's say 15% of the protection was written by hedge funds that can't make good. That leaves a $2.25 billion failure, which multiplied by the payout, is a $2 billion loss. In this environment, any meaningful losses would be a source of worry.

Why only make a slight boost to equity allocations, and then only because we're way underweight? Because the tsunami of crisis has yet to roll across most U.S. and European banks, and the Asian and the Middle Eastern banks and economies. Also, there will be fresh opportunities for the banking system to freeze up further; for example, payment on Lehman CDS paper aren't due until October 21.