Pre Opening Nightmare
Oct 8, 2008
Posted by Jody Eisenman | Filed under crisis
Overnight, the Japanese Nikkei index fell 9.3%, it’s worst day in over 20 years. In order to quell fears, the US cut the Fed Funds rate to 1.5%. This was part of a coordinated strategy to cut rates in order to arrest the slide. The futures, which were down dramatically, rallied on the news. However, in another almost unprecedented development, the futures have now turned dramatically negative again. It used to be that the market would open higher on good news, and then sell off. Today, we sell off even before the opening!
Now we have had TARP, a commercial paper guarantee, and a rate cut. The Fed is throwing every piece of ammunition at the credit crisis, and nothing is working. Earnings season has started, and they are mostly disappointing so far. We are now in almost a complete meltdown scenario.
In addition, tomorrow and Friday are very key days on Wall Street. First of all, the ban on short selling ends tonight. Secondly, and perhaps more importantly, the first of the Credit Default Swaps (CDS) on Lehman Brothers come due. These are insurance policies issued to pay off lenders in case of corporate defaults. In other words, they are insurance policies on bonds. Here is an article from the Financial Times of London:
Derivatives market faces biggest test
By Aline van Duyn in New York
Published: September 30 2008 16:17 | Last updated: September 30 2008 22:38
The $54,000bn credit derivatives market faces its biggest test in October as billions of dollars worth of contracts on now-defaulted derivatives on Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual are settled.
Highlighting the opacity of this market, it is still not clear how many contracts have to be settled, and whether payouts on the defaulted contracts, which could reach billions of dollars, are concentrated with any particular institutions.
According to dealers, insurance companies and investors such as sovereign wealth funds, which are widely believed to have written large amounts of credit protection through credit default swaps on financial institutions, could have to pay out huge amounts.
“There is a lot at stake,” said an executive at one big dealer. “This is a crisis time, and if these auctions do not go well, or if the amounts investors and dealers have to pay is seen as not being fair, it could have further negative repercussions on the CDS market.”
The “auction season” starts on Thursday, when the International Swaps and Derivatives Association has scheduled an auction for Tembec, a Canadian forest products company.
”This is a tried and tested process that we expect to run as seamlessly for these larger scale events as it did for the last nine credit events ISDA helped settle smoothly,” said Robert Pickel, chief executive officer of the International Swaps and Derivatives Association.
This is followed by Fannie Mae and Freddie Mac auctions on October 6. Then, Lehman is settled on October 10, and Washington Mutual is scheduled for October 23.
Even though it is possible that some participants in the credit derivatives market will have to make large pay-outs, the flipside is there could also be big winners. For every loss in credit derivatives, there is a gain.
The amount of credit derivatives contracts outstanding that reference Fannie Mae and Freddie Mac alone are estimated to be up to $500bn. The default was triggered under the terms of derivatives contracts by the US government’s seizure of the mortgage groups, even though the underlying debt is strong after the explicit guarantee from the US government.
The CDS contract settlement could result in billions of dollars of losses for insurance companies and banks who offered credit insurance in recent months. The recovery value will be set by an auction process. Usually, the bond that is eligible for the auction that trades at the lowest price – the so-called cheapest-to-deliver – is the one that sets the overall recovery value for the credit derivatives.
In the Lehman case, numerous banks and investors have already made losses due to exposure to Lehman as a counterparty on numerous derivatives trades. The auctions next week are for credit derivatives which have Lehman as a reference entity. There are likely to be fewer contracts outstanding than for Fannie Mae and Freddie Mac because Lehman was not included in many of the benchmark credit derivatives. However, exposure remains unclear, which is one concern that regulators now have about the credit derivatives market.
Lehman’s bonds have been trading between 15 and 19 cents on the dollar, meaning that investors who wrote protection on a Lehman default will have to pay out between 81 and 85 cents on the dollar, a relatively high payout.
The previous biggest default in credit derivatives was for Delphi, the US car parts maker that went bankrupt in 2005 and which had about $25bn of CDS.
Copyright The Financial Times Limited 2008
The CDS market has been largely unregulated. Any potential hiccup in the eventual payoffs could be disastorous.
