Impact of Lehman Failure on CDS Market Less Than Feared

The credit default swaps market fared batter than expected in the wake of the failure of Lehman Brothers (LEHMQ.PK), according to a survey by Moody’s. However, Moody’s still sees the possible failure or failures of other large CDS market participants as a continuing source of systemic risk.

The bankruptcy of Lehman Brothers has put the CDS market to an unprecedented test and has resulted in losses in the hundreds of millions dollars for a number of Moody’s-rated firms, but these CDS market disruptions have not, in and of themselves, resulted in the downgrade of any rated company to date, Moody’s said.

In Moody’s opinion, it is highly unlikely that the CDS market would have been able to deal effectively with a simultaneous default by AIG — probably the largest net seller of CDS protection.

The survey of the major Moody’s-rated banks and insurance firms active in the CDS market suggests that the overall market has fared better than many observers had anticipated.

Lehman’s bankruptcy, although resulting in sizable losses for a number of market participants, did not lead to the unraveling of the CDS market.

Nonetheless, the emergency unwinding of Lehman’s CDS book by major dealers and hedge funds though the “Risk Reduction Trading Session” on the weekend preceding Lehman’s anticipated bankruptcy filing demonstrates that the structure of the over-the-counter CDS market is ill-equipped to reliably deal with such events, Moody’s said.

Moody’s noted that major dealers also did not suffer losses in excess of their ratings-tolerance on CDS contracts referencing Lehman Brothers as an obligor, despite the low auction-determined settlement price of 8.625 cents on the dollar for Lehman’s senior bonds.

The report also discusses what Moody’s characterizes as “encouraging progress” among market participants and regulators to move the CDS market, or at least a portion of it, to a central counterparty model. If implemented effectively, a central clearinghouse could substantially reduce, although not completely eliminate, counterparty and trade replacement risks. It could also impose economic limits on effective leverage and excessive credit exposure by requiring protection sellers to post appropriate initial margin.

For details see: “Credit Default Swaps: Market, Systemic, and Individual Firm Risks in Practice.

Meanwhile, CreditSights has updated its Q & A on the regulatory options for the CDS market with a comparison of two leading alternatives. CreditSights sees the ICE/Clearing Corp proposal - known as the ICE TCC - as the likely frontrunner.  “The ICE TCC is designed in a unique way, offering exchange-like features of standardized contracts without the actual listing of exchange contracts.”

The other big factor that makes the ICE TCC a likely frontrunner is the fact that it comes with a “built in” regulator via the Federal Reserve.

According to testimony before the House and Senate last week, the ICE will, in cooperation with its partners - Markit, RiskMetrics, and Clearing Corp - form a limited purpose bank which will be a New York trust company that is a member of the Federal Reserve system and the New York Banking Department (the state level banking regulator in New York). 

CreditSights also critiques the competing CME/Citadel proposal, which includes many features of an exchange mechanism, with all counterparties having the ability to face the CCP, and standard margin bonds posted, not on the basis of credit quality from the participant, but rather on the undulations and volatility of the instrument itself - in this case, CDS.

Comments

[N.John Joseph:]

The present global financial crisis was precipitated by the failure to bail
out Lehman Brothers. Lehman Brothers should withdraw bankruptcy
petition and pass their bad paper to the TARP. This will restore the investor
confidence and stabilize the markets. Implement new regulatory
measures to secure financial growth.

Joseph
An investor and a father of two about to loose job.

2008 Oct 30 09:11 PM

[who:]

LEH's missed bailout was the biggest mistake in handling this crisis, probably created more problems then solved. Too late to save the company now part of other organisations, but saving some of the bond and creditors would be worth doing.

2008 Oct 31 06:41 AM