Until now, it hasn’t been entirely clear how much damage will result from the Lehman bankruptcy. An auction taking place today will be an important step in assessing which financial institutions stand to take a hit. Today’s auction involves a type of security that many people know little about or have only heard of recently: credit default swaps.
What are credit default swaps?
Generally, an “investment swap” involves trading one security for another. However, another kind of investment swap is a contract: one in which two parties agree to enter into transactions with each other on the basis of changes in some defined security. These contracts, in turn, become a kind of security themselves, and are sometimes called derivative securities.
Suppose that an investor – Party A – purchases a bond issued by General Motors. Party A is nervous about the risk of a default by GM, so he enters into a credit default swap (CDS) with Party B. In this contract, Party B promises that if General Motors defaults on the bond or goes bankrupt, he will (in effect) pay Party A the amount lost on his bond as a result of the default. In return for this promise, Party A pays Party B a regular premium for the duration of their agreement. The premium will vary and will be affected by factors such as the perceived likelihood of a default and the creditworthiness of Party B. Party B might even put up some collateral so that Party A can be assured of collecting at least the value of the collateral in the event that the bond defaults.
What Party A is doing is transferring a risk: the CDS is really just an insurance policy. Party A wants to be sure that if GM defaults, he will get his expected return on the GM debt that he owns. Note however, that what Party A is doing is transferring his risk from the creditworthiness of General Motors to the creditworthiness of Party B. The contract is only worth anything if Party B has the ability to pay the promised amount (Party B in this transaction is called the “counterparty,” and the risk that Party B does not pay up according to the terms of the contract is called “counterparty risk”).
These contracts can have other elements, too. I mentioned that Party B might be required to put up some collateral to assure that the contract will be paid out. Sometimes this type of contract includes a clause which requires that if Party B’s creditworthiness (as determined by a credit rating agency like Moody’s or Standard and Poor’s) goes down, Party B must put up some additional collateral. It’s easy to understand why Party A might require this, as his risk is now based on Party B’s credit strength. But these clauses can cause problems for Party B, because if it does get downgraded, it must set aside more of its capital as collateral. This may make it look even weaker financially to the ratings agencies, sparking a downward rating spiral. This is partly what led to the demise of insurer AIG. David Merkel has argued that this type of clause should be illegal, and I agree with him. There will undoubtedly be calls to regulate the derivatives markets, and this should be part of the fix.
Something that’s critical to understand is that Party A does not actually have to own a GM bond to enter into this contract; Party A may simply believe that GM is going to default, in which case the premium paid is simply the cost of a bet against GM’s solvency. The credit default swap (CDS) itself is a security: Party A can subsequently sell his contract to someone else if he can find a buyer and they agree on a price. If GM’s outlook gets worse, for example, the contract becomes more valuable, because the probability of the payout increases: if there is a default and the GM bond in question only pays out half its face value, the CDS holder receives 50% of the bond’s face value from the counterparty; if the bond’s value drops to zero, the contract holder receives 100% under the contract. David Merkel has an excellent post today in which he argues that only parties who have some sort of direct interest in the financial health of the company underlying the contract should be able to buy a CDS on that company. In other words, it should not be permissible to use CDS as “bets;” they should function only as insurance.
Given that one doesn’t have to hold the debt of a company to buy a CDS on the company’s debt, the total face value of CDS on a company’s debt can greatly exceed the actual amount of debt that the company has outstanding. According to Dwight Cass at breakingviews.com, Lehman has about $113 billion of bonds outstanding. The value of CDS on the debt could be several times that amount; MarketBeat estimates that it could be as high as $400 billion.
Today’s auction will determine the payout of the Lehman CDS. Since there are two sides to the contracts, the net financial effect is zero, but some investors will have losses and others will have gains. The entities that were functioning as “Party B” for Lehman’s debt will have to pay some amount out, depending on what the payout rate is. Other entities are in a position to get paid. Banks, hedge funds, and other financial entities that participated in the market for Lehman’s credit default swaps may or may not have been hedging actual bond holdings.
If I’m reading the available information correctly, participants in today’s Lehman CDS auction will settle up next Wednesday. It will probably take another week for all the winners and losers to be identified. It may be that some of the guarantors (Party B’s) of the Lehman debt will have to pay out enormous sums of money. If some of the counterparties aren’t able to pay up, that affects not only them, but also the “Party A’s” hoping to get paid.
There are undoubtedly a lot of people on Wall Street anxiously waiting to see who the guarantors are, what they owe, and whether they have sufficient funds to pay off their contracts. This is probably also one reason that banks are holding on to their cash; they’re waiting to know the outcome of the Lehman bankruptcy.
Postscript added Oct. 11, 2008: Portfolio.com reported the Lehman auction results: counterparties of CDS on Lehman’s debt will have to pay 91.375 of the insured values. It will actually take a couple of weeks (they estimate Oct. 21) for the parties to settle up.
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