Systemic Risk Haunts Credit-Default Swaps

Holders of credit-default swaps may look for collateral now that they have seen a big issuer fail.

The credit-default swap has been called both “the most important instrument in finance” by former Federal Reserve Chairman Alan Greenspan and a financial “weapon of mass destruction” by Warren Buffett. This week’s bankruptcy of Lehman Brothers and bailout of the insurer AIG may have proved both men right, while testing the limits of the $62 trillion market for such financial derivatives.

The rising costs of a company’s credit-default swaps tend to correlate with a slump in its stock price, and the case with Lehman was no different. Fearing moral hazard if it attempted to bail out the investment bank, the Fed allowed Lehman to slip into bankruptcy.

But since AIG had issued credit-default swaps covering more than $440 billion in bonds—far more than it could afford to cover—what was designed to be tool for hedging became a risk to the entire financial system. And while the Fed’s statement of its loan of up to $85 billion to the ailing insurer didn’t specifically mention the systemic risk associated with the swaps, its remark that “a disorderly failure of AIG could add to already significant levels of financial market fragility” could be interpreted to include that risk.

One likely result from the current financial crisis, is an increase in lawsuits related to credit-default swaps, as some holders try to change their existing contracts with issuers. Holders of swaps issued by Lehman that were backed by collateral will be able to keep the collateral, says Kevin LaCroix, a director of OakBridge Insurance Services. If the default hasn’t occurred, they can get out of those contracts and replace Lehman with other counterparties.

The extent of CDS losses, however, remains unclear. Timothy Mungovan and Jonathan Sablone, writing in a client alert for the law firm Nixon Peabody, warn that parties who have sold protection on Lehman bonds will be obligated to pay their counterparties. With such a massive default, they say, a “domino effect” could result as many of those counterparties default on their own obligations.

Another question is the role of Lehman as a CDS issuer itself. Now that it has declared bankruptcy, what are its responsibilities for insuring against the default of other bonds?”Because Lehman is a counterparty in the CDS market, its bankruptcy disrupts the functioning of that unregulated market,” write Mungovan and Sablone. “In those contracts where Lehman sold protection via CDS, there is substantial risk that Lehman will be unable to satisfy its obligations to its counterparties.”

The authors warn that the entire CDS market will see increased volatility as the prices to insure against default spike. On Wednesday morning the U.S. CDX index of investment grade corporate debt jumped by 23 basis points to a record 217.5 basis points. That number indicates that it costs $217,500 a year to insure $10 million of corporate debt over five years. Although regulators judged that Lehman was not “too big to fail”, Mungovan and Sablone argue that if another major player crashes, the “CDS market may cease functioning with parties dishonoring obligations.”

CDS contracts are further complicated because the market is unregulated and every agreement is different. In some cases the definition of an “event” can be unclear and lead to litigation. Earlier this year UBS, a Swiss bank, sued Paramax Capital International for failing to make good on its agreement in a CDS contract when several notes held by the bank declined in value.

“More lawsuits involving credit default swaps are likely to be initiated in the near future, as the current trend has the potential for huge losses resulting from defaults on “high-yield” or ‘junk’ bonds in connection with the general market failure,” John P. Doherty and Richard F. Hans of the law firm Thacher Proffitt & Wood, wrote earlier this year.

In the case of an issuer defaulting, however, counterparties have little recourse to recover their losses if their arrangements were not backed by collateral. Lehman Brothers, notes LaCroix, was the type of “blue chip” issuer that would not usually need to offer collateral.

“There were structures built on structures, all to guard against default,” says LaCroix. “No one would have thought it would be Lehman that would default.”

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