To CDS or not to CDS
Kim Asger Olsen
Posted Oct 21, 2008
Tomorrow, 21 October 2008, will be the first really interesting
day in the financial markets. since the day last week when US
Treasury Secretary Paulson partially nationalised the nine largest
US banks. Tomorrow there will be settlement of the CDSs
issued on Lehman debt.
First the facts. A CDS or a Credit Default Swap is essentially
an insurance against losses if an issuer of debt goes bankrupt
and cannot honour its obligations. Those who have sold the protection
will then compensate the loss to those who have bought the protection.
Estimates say that Lehman debt amounts to some $150bn. Other
estimates say that tomorrow will see settlement of about $360bn
worth of nominal CDS contracts.
$360bn of debt insured while the total outstanding of Lehman
debt amounts to only $150bn? Sounds fishy, doesn't it? The explanation
is a simple one, that the CDSs are not necessarily linked
to the buyer of the credit insurance in fact holding any Lehman
debt. To put it in different terms: CDS is the financial market
equivalent of being able to take out an insurance that will pay
out money to you in case your neighbour's house burns down.
This situation is indicative of something that ought to have
everybody hold their breath for a second. CDSs were originally
meant as insurance for holders of debt. But in absence of rules,
oversight, and regulation CDSs became instruments of speculation,
where the buyer and the seller took bets on Lehman's future.
If the above estimates are true, and if we make the friendly
assumption that $150bn worth of nominal contracts are indeed
bought by the actual holders of Lehman's debt, no less than $210bn
worth of speculative bets will have to be settled tomorrow.
If the recent prices [of] Lehman debt is anything to go by (between
8 and 9 cents in the dollar), this settlement will lead to some
$190bn changing hands - from sellers to buyers of "default
protection".
In order to get the order of magnitude right, the amount
changing hands corresponds to nearly three months of US current
account deficit.
A gain of 91 cents or so for each underlying of 1$ is not a bad
return on a few minutes work. In other words, those who speculated
in Lehman's collapse are looking forward to a huge pay day.
Or are they?
Certainly, some of the biggest players, i.e. fully nationalised
AIG and the nine partly nationalised banks are big players in
this game. It is inconceivable that some of them are not on the
"underwriting" side and have sold the "protection",
irrespective of whether the buyer actually held Lehman debt or
was just another gambler in the market. Now an interesting new
dilemma is appearing: will the US Treasury accept that potentially
huge sums of taxpayer money are used to pay speculators who were
right that the US Treasury would allow Lehman to fail.
It is known in the market that AIG have asked the US Treasury
for some $20bn+ extra on top of the bailout package of $85bn
agreed 3 weeks ago. And it is widely guessed in the market that
those $20bn are earmarked to meet AIG's obligations related to
Lehman debt. We have not started to talk about other defunct
debt issuers yet - Bear Stearns or WaMu,
Being among those who have to shell out $190bn is enough to give
other institutions a powerful push in the direction of insolvency.
For this reason alone the US Treasury is facing a serious choice:
Using taxpayer money to reward speculators or try to limit the
damage. One possible avenue would be to demand that those who
have bought protection actually prove that they held Lehman debt,
and pay them, but refusing to pay those who had speculated. This
could be a politically attractive way out of an interesting moral
dilemma.
Morals are always interesting to discuss. For our purposes it
is, however, more relevant to look at the potential impact on
the CDS market. It is estimated that CDSs have been sold,
covering $55,000bn or $55tn of corporate debt. Given that the
CDS market is unregulated, it is at this point in unknown how
many of those "protection" contracts are purely speculative
as about 2/3 of the Lehman contracts. It is unknown who issued
them and we do not know the buyers. What we do know is that the
settlement of the Lehman CDSs will be an important indicator
for whether this market will be the next to melt down as the
Subprime market has already done.
Probably, most of the CDSs are issued on non-financial
companies, and some even on sovereign issuers. This could indicate
that we are not heading for a total meltdown as the rate of corporate
bankruptcies obviously will not go through the roof (unless we
really are heading for a depression ... interesting thought,
isn't it). But it is almost certain that hedge funds are among
the big holders of speculative default protection. If the settlement
of Lehman CDSs gives rise to any glitches, the huge CDS
market will be shaken and it is likely we will see a scramble
for the exit as holders of "protection" realise that
they may not be protected at all.
I remind the readers of the ancient Chinese curse: May you live
in interesting times! Sometimes I believe that a bit of boredom
should be welcomed.
Oct 20, 2008
Kim Asger Olsen
email: kim.a.olsen@sakam.eu
Kim Asger Olsen
is trained as an economist in Denmark, Italy, and France. He
has worked as an investment strategist, CIO and a managing director
in the European financial sector for more than 20 years. He writes
about the important crossfield between politics and economics.
321gold Ltd
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