Lehman Brothers: a primer on Credit Default Swaps

Given the historic nature of the Lehman Brothers bankruptcy, it bears explaining how the credit default swaps market work and why it matters.

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The bankruptcy of Lehman Brothers was a credit event which triggered a massive liability to participants in the large and potentially dangerous Credit Default Swaps (CDS) market. This is a market that represents the “weapons of financial mass destruction” label which Warren Buffett gave to the derivatives.

Below, I will attempt to explain, with much help from Wikipedia, what Credit Default Swaps are, how the market functions and why it is THE derivatives market that needs to be regulated before systemic risk threatens the global financial system.

This is how Wikipedia describes a Credit Default Swap:

A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the “buyer” makes periodic payments to the “seller” in exchange for the right to a payoff if there is a default[2] or credit event in respect of a third party or “reference entity”.

In the event of default in the reference entity:

  • the buyer typically delivers the defaulted asset to the seller for a payment of the par value. This is known as “physical settlement”.
  • Or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation. This is known as “cash settlement”.

While little known to most individual investors, credit default swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults — a buyer doesn’t necessarily have to own a bond to buy the credit default swap that insures it.

Banks and other institutions have used credit default swaps to cover the risk of default in mortgage and other debt securities they hold.

Wikipedia

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In essence, a CDS is an insurance contract against corporate default, much like auto insurance or home owner’s insurance. But it is also a derivative, which is a financial instrument that derives its value not from its own intrinsic worth, but from the underlying value of another asset. The best simple example of a derivative is a equity call option. Here the buyer of the option retains the right but not the obligation to buy a publicly-traded stock at a specific price. The value of this option to buy the stock at the specified price is derived from the price of the underlying stock, how long the option is valid and how likely the stock is to reach that price.

Now, a CDS is a more complicated instrument, as you can see from the definition above. Moreover, the CDS contract is over-the-counter i.e. it is not regulated by a formal exchange like equity options are. This means that no one knows what the exposures of specific financial institutions to specific credit defaults are. Only those institutions themselves know, there is no mandatory disclosure law, and it is not in the institutions’ best interest to disclose. Moreover, this market is not very liquid because the contracts are not standardized as they would be if traded on an exchange. The contracts are two-party negotiations, often with very specific terms and are, therefore, illiquid — not interchangeable with other contracts, even for the same company and debt issuance.

The CDS market is enormous, one reason for its enormous implications or the health of global finance. Again from Wikipedia:

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Credit default swaps are the most widely traded credit derivative product.[3] The Bank for International Settlements reported the notional amount on outstanding OTC credit default swaps to be $42.6 trillion[4] in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005). By the end of 2007 there were an estimated $45 trillion [5] to $62.2 trillion [6] worth of credit default swap contracts outstanding worldwide. On September 23, 2008, Christopher Cox, Chairman of the U.S. Securities and Exchange Commission, placed the worldwide CDS market at $58 trillion, and stated it was “completely lacking in transparency and completely unregulated.”[7] The U.S. Office of the Comptroller of the Currency reported the notional amount on outstanding credit derivatives from reporting banks to be $16.4 trillion at the end of March 2008. (For reference and perspective, the U.S. GDP for 2007 was $13.8 trillion[8], while the world’s GDP for 2007 was estimated at $54.3 trillion [9])
Wikipedia

These are enormous sums of money, an order of magnitude bigger than the underlying securities that the CDS market serves to insure. Therefore, large credit events in the CDS market can have very bad implications for the health of our global financial system. Lehman Brothers’ bankruptcy presented us with the first test case of what kind of implications this market could have.

When Lehman Brothers declared bankruptcy, it triggered the transfer of large sums in the CDS market to insure buyers of Lehman credit default risk protection against all losses from that event. The sellers of these contracts received the Lehman debt and in return they were obligated to pay the contract buyers (the insured parties) enough money to make the buyers “whole” i.e. to give them their full investment in the bonds back as if they had never bought the Lehman bonds.

The auction for Lehman’s debt occurred on Friday afternoon and the final auction price was $8.625. This means that for each $100 initial par value, the debt is only worth $8.625. The sellers of Lehman CDSs are obligated to pay the insured counterparties 91.375% of the bonds’ face value and, in return, they will receive the bonds.

Because Lehman has hundreds of billions of dollars of debt outstanding, this had been a large worry for the market. In fact, it as because of large exposure to the CDS market
that the U.S. authorities did not allow AIG to fail. In the end, we seemed to get through his one just fine so far. However, the Lehman process demonstrates the potentially devastating problems the CDS market can create for sellers of CDS insurance like AIG.

In the future, the monetary authorities like the SEC cannot let a large derivatives market like this go unregulated. These contracts must be disclosed, standardized and controlled via an exchange like the Chicago Board Options Exchange. My hope is this will be a lesson that U.S. and G-7 policy makers take on board in order to prevent crises of this nature in the future.

Related post
Initial results of Lehman CDS auction

Sources
Credit default swap – Wikipedia
Lehman Brothers auction results – Credit Fixings

Related articles
Credit Default Swaps: The Next Crisis? – Time

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