A great deal of nonsense has been written about credit default swaps and their role in the recent financial crises, mostly by journalists. My friend Bob Cunningham tells you all you need to know about a financial catastrophe that didn’t happen:
Amidst all the blathering nonsense from the ignorant about the role of credit default swaps in the financial crisis is today’s news about the huge Lehman Bros. debt issues covered by CDS contracts. When Lehman filed for bankruptcy on September 15, sparking the crisis, payment obligations from sellers of protection to buyers of protection were triggered. There was a certain amount of weeping and gnashing of teeth about the impact of this credit event and a fear that a cascade of interlocking failures of CDS protection SELLERS would trigger a catastrophic financial meltdown.
It didn’t happen. And there is very important reason why, completely overlooked by most of the uninformed commenters on the current situation. Sellers of CDS protection are required to “mark-to-market” EVERY DAY…and if a contract is in the money for the buyer the seller must post cash collateral to cover the prospective obligation if a default event should ensue. So it is very difficult to have a big surprise all at once…the CDS market is very responsive and forward looking to potential default events, as well as highly liquid…. and swap spreads had already been ticking up before the Lehman bankruptcy…and with them the cash collateral margining.
The hand-wringers were also concerned about the “overhang” in the CDS market — the fact that you do not actually have to own the bond or loan that defaults and is the subject of the CDS contract…in effect it can be a side bet. (There are plenty of reasons to do this, but that discussion is beside the point here.) In the case of Lehman it was estimated that about $ 400 billion of notional contracts were written!!
So what happened?…well…first there was an “auction” on October 10…to determine the payout to buyers of protection. The auction determined payout was about 91Â¢ on the dollar of bond face value –pretty high, but not surprising since Lehman’s assets became worthless, so only about 9Â¢ on the dollar is available for recovery. Then, part 2 took place today. The sellers of the CDS settled with the buyers. And NOTHING happened…or, rather, the sellers shelled out about $6 billion or so to the buyers and everyone went home. No CDS counterparty failed to perform! The cash collateral margining mechanism worked just fine. A handful of small hedge funds might fail…because they typically borrow to meet their CDS collateral margin calls…so lenders to those funds may have a problem, but NOT the CDS counterparty. But so far none has.
And the overhang?…well almost all of it is HEDGED, i.e., offsets other obligations…when these were all netted….the actual required payout was LESS THAN 2% of the notional amount of the CDS contracts.
I’ll be waiting for the big news report on this in the MSM and their informed observers.
There you have it.
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