Unregulated Market Faces Test as Corporate Defaults Pile Up

Eric Dinallo, New York state's chief insurance regulator.
Eric Dinallo, New York state's chief insurance regulator. (Jay Mallin - Bloomberg News)
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By Heather Landy
Special to The Washington Post
Monday, October 20, 2008

The unregulated market where protection against financial defaults is bought and sold will be tested in the coming weeks as never before, as countless claims are settled on a series of expensive corporate casualties at the heart of the credit crisis.

Potentially, hundreds of billions of dollars of these contracts are coming due.

But it's unclear which firms are on the hook, how much they're on for, and whether they can pay. Firms do not have to disclose whether they hold these contracts, called credit-default swaps. So there's no way to know whether the contracts will be settled smoothly, or whether they will set off a cascade of losses in markets that already have been pushed to the brink.

That uncertainty is making investors anxious.

Banks, hedge funds, insurance firms and other investors are unwinding an unprecedented number of the contracts following the recent failure of Wall Street investment bank Lehman Brothers, savings-and-loan giant Washington Mutual and three Icelandic lenders. Tomorrow is the deadline for settling the contracts on Lehman.

The amount of money that actually changes hands between buyers and sellers of these insurance-like contracts could be much smaller than the amount of protection written on the failed companies. A portion of what's owed may already have been supplied in the form of cash collateral. And big dealers of credit-default swaps regularly offset their exposures by both buying and selling protection.

An auction process earlier this month determined that investors who held protection against a default by Lehman Brothers will get paid about 91.375 cents for each dollar of protection purchased. But with no concrete data on how many Lehman contracts there are or how many of them are offsetting, estimates for the total payout range wildly, from $6 billion to 60 times that amount.

"The world is waiting to see how many of these settlements clear," said New York state's chief insurance regulator, Eric Dinallo, who has called for greater government oversight of CDS trading.

The Depository Trust and Clearing Corp., which electronically stores CDS contracts for more than 1,200 customers, including all the major dealers, said it's warehousing $72 billion of CDS contracts on Lehman. But the figures shrink to $6 billion after adjusting for offsetting trades and netting out trades among groups of investors.

Even the size of the total market is in dispute. DTCC reports that its customers have registered about $35 trillion of contracts. An industry group representing firms that deal in financial derivatives pegs the market at $55 trillion.

"There is complete uncertainty as to how much there is, and we accept kind of blithely $10 trillion swings in the estimates for this stuff," Dinallo said.

The CDS market, barely a decade old, began as a novel way for bond investors to insure themselves against losses. It ballooned as investors started trading the contracts without ever owning the corresponding bonds, turning the market into a fragile, intricate web of obligations between the biggest financial companies in the world.

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