How do CDS contracts get settled after a credit event? We've had several recently, which means upcoming auctions (see also here). Fannie Mae (FNM) and Freddie Mac (FRE) auctions were October 6 (yesterday), Lehman is October 10, and Washington Mutual is scheduled for October 23.
Since Treasury is guaranteeing the GSE debt, October 6 was probably not as much of a problem as the Lehman auction will be in a few days. Many firms are scrambling for or hoarding cash because they don't know what they are on the hook for. At the auction, one first has to determine the value of the bonds before deciding the value of each CDS contract. That means first an auction of Lehman debt, presumably worth only a fraction of its face value (but exactly how much?), and then a settlement of contracts. If most of the contracts are offsetting they can be canceled then and there, but the suspicion is that many CDS counterparties (perhaps, especially, hedge funds?) were writing naked contracts, which means they would have to come up with the money on the spot. For detailed discussion see here. Related post at naked capitalism.
If Treasury wants to stabilize markets and perhaps avoid more collapses, it could start on 10/10 by buying up some of Lehman's debt with its $700B war chest. Will they make an appearance? It's estimated that Lehman was involved in hundreds of billions in CDS contracts (notional). This is a very delicate moment since no one is going to want Lehman debt and therefore the market value will be very low. I can imagine a lot of smart guys hedged their Lehman exposure against some other (imperfectly but highly) correlated index or debt. Since those entities used in the hedge will not be simultaneously marked to market on 10/10, what was, at the time, a reasonable hedge will turn into a disaster. Note, I think the auction only covers contracts that reference Lehman -- that is, which protect one of the counterparties from a Lehman default on its debt. The auction won't resolve the problem that arises in other contracts if Lehman was actually one of the counterparties. To the extent that these exposures are canceled they would be "glued" together at the appropriate reference auction, but it's possible Lehman had some naked exposure as well.
Thinking about this more broadly, freezing of credit markets means that the effective money supply is shrinking even as central banks cut interest rates. 'Helicopter Ben' Bernanke has always said that in an emergency the Fed had numerous tools available to inject liquidity into the markets, and today it was announced they would enter the paralyzed short term commercial paper market which is crucial to the functioning of ordinary businesses.
Helicopter speech: ...The financial distress of debtors can, in turn, increase the fragility of the nation's financial system--for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. Japan in recent years has certainly faced the problem of "debt-deflation"--the deflation-induced, ever-increasing real value of debts. Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33 -- a period in which (as I mentioned) the U.S. price level fell about 10 percent per year.
Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern -- the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate -- the overnight federal funds rate in the United States -- and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.
Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition" -- that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. ...
However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.