What’s Next?

Tuesday, October 21, 2008 is likely to be a decisive day in the credit crunch. That day is when credit default swaps (CDS) on Lehman Brothers debt will be settled.

Credit default swaps are sort of like insurance. One party offers, for a fee, to guarantee a certain bond against a “credit event,” usually something like a default, missed interest payment, restructuring, etc. If that happens, the insurer (seller) pays the difference between the bond’s face value and what it is worth after the event. In the case of Lehman Brothers, the company’s bankruptcy means that the sellers of the CDS will have to pay about $91 for every $100 of par value insured, since those bonds were selling for $8.65 per $100 par value at auction on October 10. Because there is no central market or clearing house for CDS trading, no one has a complete story on who will be paying and who will be trying to collect. The gross notional amount of credit default swaps on Lehman Brothers debt is believed to be approximately $300 billion to $400 billion. One hopes that the net amount is a lot less, maybe less than $10 billion after offsetting positions are netted out. One hopes, but one does not know.

(Update 10/19/2008: SEC Chairman Christopher Cox has a piece on the CDS issue in the New York Times.)

Some of the big net sellers of insurance on Lehman’s debt include AIG, which has already been taken over by the federal government, and also MBIA and AMBAC. You may recall that these latter two companies were involved early in the crisis because they were in effect guarantors of other companies’ debt, and they had their own credit ratings reduced by S&P and Moody’s in January 2008. Will they have the money? They have been trying to reduce or offset their exposure, and soon we will see how well they succeeded. In the case of AIG, where the government has sunk $123 billion into the company, how will the public react if large portions of that taxpayer money are dealt out to politically unpopular CDS holders like hedge funds and foreign investors?

If we get through 10/21, we can look forward to a similar but smaller situation on 11/7, when Washington Mutual’s credit default swaps settle. Then we can start to deal with the credit default swaps on asset-backed securities, including the huge amount related to Fannie Mae and Freddie Mac. Somehow, I don’t think the $58 trillion credit default swap market (a little more than the annual gross world product) is going to stay unregulated much longer.

Some predictions:

  • Credit default swaps will soon be regulated similarly to futures. They will be traded on exchanges, instead of in private contracts, and traders will have to meet capital requirements and margin restrictions. The EU and the SEC are already working on proposals.
  • Financial regulation is probably going to have its most comprehensive restructuring since 1934. The SEC has been late in recognizing and reacting to problems in the financial sector, and of limited help in solving them. They are likely to be merged with the Commodity Futures Trading Commission, and not likely to assume much of the authority that Treasury and the Federal Reserve have exercised.
  • If the Lehman Brothers settlements go smoothly, the worst of the credit crunch will likely be over. The economy is probably already in a recession, but we cannot get out of it without fixing the credit markets.
  • The US and the UK are probably going to lead the recovery, but it’s not going to start soon. The north-south split in the Euro zone will worsen. Oil producers still have some pain in store for them, which may in turn cause them some domestic political problems. Hugo Chavez, you are about to get the world’s worst margin call.
  • The wild card is what Congress will do with Fannie Mae and Freddie Mac. Weigh the damage these entities can do to the economy against the campaign contributions and great jobs they offer to politicians, and you can see where there could be a problem. It’s bigger than just Barney Frank and Chris Dodd.

Sources (some require registration):
Seeking Alpha
Roubini Global Economics
Wall Street Journal
Financial Times

7 thoughts on “What’s Next?”

  1. One problem here is that CDS are probably insurance contracts. To the extent that the sellers are not licensed insurers, or the buyers do not own the defaulted bonds, the CDS contracts may be void. If I were a CDS seller, I might start a law suit rather than paying off.

  2. Robert, you are absolutely right about the insurance aspect of these contracts. Dealers in CDSs go to great lengths to call them anything but insurance, since insurance is something regulated by the states. But if one of the parties decided to abrogate the contract, saying they were shocked, SHOCKED! to find that insurance had been committed, the courts would probably have a good laugh at their expense (assuming they did not refer the lawyers to the state bar for disciplinary procedures). Both parties knew what they were getting into, including any touchy regulatory issues, and the courts would likely uphold the contract. IANAL, but a contract has to be in pretty serious violation of law before a court would void it on those grounds. Knowingly entering into a contract that you believe you legally cannot does not give you an automatic mulligan, assuming the other party performs his part. In particular, if the seller of the “insurance” contract were to say “Oops, we weren’t legally able to sell you that contract, so we’re not going to pay you,” the courts would be very much amused but not very convinced. The buyer might get a little more sympathy, but not much better results. The violations of insurance law might mean that other penalties would be considered, but would not necessarily void the contract.

    Anyway, watch what happens on Tuesday. If nothing happens, then I’m an uninformed alarmist but a happy one.

  3. Mitch,

    My compliments on a nice piece. I’ve looked for an 8-K from AIG after the auction and haven’t found one disclosing severe losses. If the losses were very large they would have had to have been disclosed per SEC regulation. Are you using ‘trade’ journal references for the $300-$400 billion number? I ask because this OCC report (pages 21 and 26) indicates somewhat less. It certainly doesn’t cover what are called synthetic CDS and that’s where the truly fantastic notional numbers seem to be coming from.

    I would also note that ‘insurance’ used as you are doing could also be applied to put options. I tend to think of CDS as out of the money puts. I’m not sure where they belong within the regulatory apparatus but I sure wish the Feds would give them a home – and make the unregistered synthetics unenforceable. Right now it appears that many of these ‘insurance’ policies have been sold to arsonists.

  4. Hi Rick

    The OCC numbers are only for banks under OCC supervision. Among banks, that leaves out the ones subject to OTS and the dwindling number of state-only institutions. More importantly, it leaves out investment banks, hedge funds, mutual funds, foreign banks, and single managed accounts like pension funds and endowments.

    I was using industry numbers, but they are likely to be out of date. There is an emergency effort behind the scenes to get things closed or offset, and they may have succeeded to some degree. For example, the night before Lehman filed for bankruptcy, their holders met and tried to trade, offset, or somehow deal with the issue and at least reduce the uncertainty, if not the loss. That effort has continued and probably will for quite some time.

  5. I’ll try the long winded answer. I will refer to New York Law because I am, a not yet disbarred but semi-retired, member of the bar of the Appellate Division of the First Department of the New York Supreme Court. Besides the Wench was in Manhattan.

    The starting place for this discussion is that gambling is illegal in New York (unless the bookie is the State itself), and a contract that requires one party to pay the other upon the occurrence of a contingent event is void, gambling debts are unenforceable, and bets must be returned to the bettor. (NY GOL Sec 5-401 et. seq.).

    An insurance contract is one which requires the insurer to transfer value to the the insured, upon the occurrence of an event that is beyond the control of either party and which adversely affects an economic interest (“insurable interest”) of the insured. (NY Ins L Sec. 1101 & 3401).

    What then distinguishes a void wager from a valid insurance contract? The insurable interest of the insured. If the insured does not have the insurable interest the contract is void and may be unwound at the request of the insurer.

    It is illegal to sell insurance without a license, but I do not know if there has ever been a case where illegality was presented as a defense by the insurer. Certainly commercial interest alone would push real insurers away from that claim.

    What about option contracts. One answer is that an option is a simple contract of purchase and sale, where the closing and payment are deferred at the option of one of the parties. There is no event that is beyond the control of either party in an option contract. So there is neither an insurance contract, nor a wager.

    We can see that economically an option can act as insurance, and, if neither party owns the property subject to the option, it may act as a wager. There has been a great deal of attention to this issue in the chartering of the commodities business and in the swap market.

    CDS, depending on the details, might fit into the option paradigm. I think the most important fact would be whether it requires the claimant to tender the defaulted security.

    Whatever CDS is, I think the model needs to be rebuilt, if it going to survive. I would go for the exchange traded option route, with the ability to use custom insurance policies by regulated insurers.

  6. Dodged a bullet! The S&P was down 3% today, so I guess we caught a brick instead. I’m very glad to be wrong.

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