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Unregulated Market Faces Test as Corporate Defaults Pile Up

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.

A better picture of those obligations may emerge after Tuesday's deadline for contracts on Lehman. But there will still be little way to learn whether protection holders get paid in full.

After the Lehman settlement, traders will move on to the Washington Mutual settlement -- an auction to determine the payout rate is scheduled for Thursday -- and then to the settlement for the failed Icelandic banks.

The credit crisis has made financial markets more vulnerable than ever to a conflagration of credit-default swaps. For instance, a hedge fund might have a harder time settling its bad bets if it is already losing customers because of slumping returns. And if this hedge fund can't make good, those who are owed money might not be able to meet their own obligations in turn.

Unprecedented government action has helped neutralize the biggest known threats to the credit-default swaps market. An $85 billion federal loan last month helped insurance giant American International Group meet collateral calls on trades in which it offered default protection.

And the Treasury Department's plan to pump billions of dollars into big banks should reduce any likelihood that these firms would not be able to pay off their contracts.

"If there are other large concentrations of CDS outstanding, we don't know about it," said Robert Bliss, a finance professor at Wake Forest University and a former economic adviser to the Federal Reserve Bank of Chicago. "But who would have thought AIG, a plain-vanilla insurance company, suddenly was going to get blown up by CDS?"

AIG had written nearly half a trillion dollars of CDS contracts, Dinallo testified last week at a Senate hearing on the role of the derivatives market in the financial crisis. When AIG's credit ratings got downgraded because of investment losses tied to the subprime mortgage meltdown, that triggered clauses in AIG's contracts requiring the firm to post billions of dollars in collateral.

Had AIG failed, this could have brought down other parties that were relying on the company for protection against losses arising from Lehman's default. An AIG failure also would have been costly for those firms that, in turn, had sold CDS contracts to protect against a default by AIG.

If there is another threat of similar magnitude looming over the CDS market, it probably is not from the insurance industry, according to Dinallo and experts in derivatives markets. A quirk in regulatory requirements allowed AIG to build up a free-wheeling investment arm, while most of AIG's big rivals come more fully under the purview of insurance regulators.

The International Swaps and Derivatives Association, which represents 850 firms that deal in derivatives, estimates that 65 percent of CDS exposure is covered by collateral. But that figure is based on a membership survey in which fewer than an eighth of the group's members responded. Notably absent from the survey was AIG.

Brian Yelvington, a strategist at independent credit research firm CreditSights, said protection buyers that used to request 2 percent in upfront collateral now demand double-digit percentages. And the collateral requirements are recalculated as the CDS contract changes in value.

"Is there a possibility that one person didn't post enough collateral or didn't have collateral? Yes, but you're going to expect that the banks would have been fairly on top of that," Yelvington said. "They haven't always been that great at scrutinizing their own books, but they've been superb at scrutinizing other peoples' books."

Vigilance will continue to be key. Moody's Investors Service expects the annual rate of default by corporate borrowers to continue climbing over the next year.

"We're going to have a tsunami of corporate defaults, and the effects on the CDS market are going to be really severe," Nouriel Roubini, an economics professor at New York University's Stern School of Business, said last week at a forum on the financial crisis.

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