CDS: What If There Was a Crack-Up and Nobody Came?

There is no stopping the CDS crackup chatter. While credit default swaps could do with a great deal more transparency, one data point we all need to deal with is the non-world-ending consequences of the Lehman bankruptcy.

Today is the last day for money to change hands as a result of default swaps being triggered related to the Lehman filing, and it looks like the market handled it in a surprisingly orderly fashion. Collateral was adjusted and traded on a regular basis from the bankruptcy filing date forward, and, as a result, while a great deal of money still changed hands -- somewhere between $6- and $60-billion, depending on who you ask -- it currently doesn't look like any counterparty was made insolvent by its CDS-writing actions.

Does that make credit default swaps a non-issue? Far from it. But in my never-ending search for disconfirming data, the Lehman non-event -- so far, anyway -- is a useful data point to keep in mind the next time a default event triggers an unwinding.

Comments

[Moon Kil Woong:]

Yes the SEC did a good job letting banks hide their CDS value by allowing them to make up whatever value they want. That's why banks don't trust each other. $42 trillion in potential losses hidden away among financial institutions will do that. It's like hunting for rotten eggs on Easter.

2008 Oct 21 01:01 PM

[Stimpy:]

"surprisingly orderly?"

Sure, as long as the Gov't was there to lend AIG 80+ Billion and you don't count the meltdown in the money markets after Reserve Fund 'broke the buck" on bad Lehman CP because CDS conterparties were sucking on the bons of the Company BEFORE they filed, things went just great.

2008 Oct 21 01:20 PM

[J-Ro:]

There is a reason the govt. didn't let Bear fail but let Lehman. Bear was so intertwined in the CDS market that it would have destroyed it in one fail swoop. Banks are allowed to choose how they want their CDS' valued, either in-house or via independent valuations. This is an obvious problem that they will not want regulated. The whole CDS industry has a wild west feel to it and easily manipulated by both sides of the trade. Valuation models need to be standardized as well as spread sources, as there isn't enough liquidity to truly value these assets. Going forward there will be much talk about regulation and a lot of push back by banks using ISDA as a transparency shield. If counterparty risk would have been used to value these we may not have seen the govt bail out Bear since risk departments would have taken care of it themselves.

2008 Oct 21 08:37 PM

[Moon Kil Woong:]

The fact is, #1 all CDS and other derivatives should require at least a minimum 2-5% reserve the needs adjusting when the equity drops to negative similar to calls and puts. As pointed out if you put $1% reserve requirements on CDS you need at least 400 billion that no one has and if you put 1% down on the 600+ trillion other derivatives (besides options that already require reserves) you need $6 trillion. Considering all CDS are under water already this is a scary thought. So I guess the answer is to keep lying about the risk and values. After all banks can't even raise $5 billion let along $100 of billions to clean up the mess.

Someone needs to put in place the firewalls between insurance, banks, and brokerages again. So far the Fed and Treasury is only exacerbating the situation by letting them merge. If you look at the derivatives market. It is not shrinking, it is still growing. An estimated $40 trillion CDS contracts at the beginning of the year are now estimated at $55 trillion. So apparently banks keep issuing more of them even as the house burns down. After all, no one will buy mortgages without insurance anymore. Even if the insurance is written by people who can't pay the claim.

2008 Oct 21 10:24 PM