Have the markets finally caught a break?
Fears that Lehman’s Credit Default Swaps (CDS) settlement would lead to more bankruptcies might be unfounded.
The net fund transfers from CDS protection sellers to CDS protection buyers is expected to be in the $6 billion range, according to a release issued yesterday by the Depository Trust and Clearing Corporation (DTCC). With $400 billion of outstanding CDS on Lehman’s debt, $6 billion of actual losses is far smaller than many had feared. How could the losses have been so well-contained? It appears financial firms may have done something right for a change, hedging their exposures to Lehman CDS appropriately.
CDS are a type of Over-The-Counter (OTC) Derivative that act like insurance on debt. Like the rest of the OTC derivatives market, the CDS trade is unregulated, but that is likely to change soon (See SEC and New York Department of Insurance). And a CDS settlement is what happens when those that have bought CDS insurance file a claim and find out how much their insurer is going to pay.
On Friday, the market found out that CDS sellers would pay a little more than 90 cents for every dollar of Lehman debt they insured. The CDS market had never before been faced with settling such significant claims for a company with so much debt.
The big worry, with the Lehman settlement and with CDS generally, is the size of the market. It is estimated to be in the tens of trillions of dollars (most up to date number I’ve seen is $34.8 trillion, but nobody really knows because there are no mandated reporting requirements).
When CDS were invented during the early nineties they were considered innovative because of the manner in which they allowed risk to be spread. Trading desks across the globe could accept a fee for taking on the downside risk that a given credit obligation could not be met. Those desks could offset that risk by turning around and buying CDS insurance from another trading desk for nearly the same amount.
Instead of huge insurers and reinsures centralizing massive amounts of risk, CDS contracts allowed risks to be traded and therefore to be spread thinly across huge portions of the market. This was supposed to lower the price of taking on risk by allowing more participants access to the market.
Potentially huge pools of money get transferred when CDS contracts settle. For years, smart people on Wall Street have wondered what might happen if one of the trading desks in the chain failed to pay up. The answer seemed straightforward: if the chain of payments broke, those firms closest to the end would bear the largest liabilities. Friday’s Lehman Bros. settlement was the biggest test of the market yet.
According to the DTCC, the CDS market passed that test, with only $6 billion changing hands. What’s the DTCC? It’s basically the most important financial institution nobody has ever heard of. It provides back office and settlement services to pretty much everyone. If you own any kind of stock or bond, chances are a trust run by the DTCC holds it for you.
What’s more, the DTCC is claiming that it is the “central registry” for CDS trading:
“The idea that the industry lacks a central registry for over-the-counter (OTC) credit default swaps (CDS) is grossly misleading and has resulted in inaccurate speculation on a number of matters, including the overall size of the market, its role in the mortgage crisis, and the size of potential payment obligations under credit default swaps relating to Lehman Brothers. The extent to which such speculation has fueled last week’s market turmoil is difficult to determine.”
For Wall Street firms whose balance sheets account for hundreds of billions of dollars, $6 billion is nothing. If the DTCC is right, this is the best news the market has had in weeks. It means that most of the fears regarding the Lehman CDS settlement, perhaps the CDS market in general are unfounded. It means the system works.
But, before I break into song, I think there are a few questions that need to be answered: 1) Why is this the first time we have heard anything regarding CDS from the DTCC? 2) Why have regulators, including the Federal Reserve Bank of New York, been working to create a central registry for CDS if one already existed (a registry is not the same thing as a clearinghouse, but it certainly gets the system closer and it seems odd that the DTCC would not be mentioned in clearinghouse discussions)? 3) What are the chances that the DTCC doesn’t know what it is talking about?
I’ll be looking into this over the next few days. If any of you have answers please post them in the comments. No matter what happens going forward, this is big news.
(To better understand CDS, read this post)