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.
- 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.