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October 16, 2008 3:00 am

Lehman shows that CDSs work

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Credit derivatives

Many blame the recent market plunges on the bankruptcy of Lehman Brothers, which unleashed investor paranoia about counterparty risk. But one fear, at least, proved unfounded last Friday. A New York auction successfully settled a price for credit default swaps on the insolvent investment bank, calming concerns that the $55,000bn (£32,000bn, €40,000bn) market would implode when a major company actually defaulted.

CDSs were originally conceived to insure bond holders against the default of a counterparty, but they quickly became yet another way for investors to bet on the financial health of a company. Now the value of the CDS market far exceeds the volume of the bonds they reference.

This created certain anomalies. When the UK rail company Railtrack defaulted in 2001, the value of its bonds paradoxically rose, as CDS holders scrambled to ensure that they could cash in their insurance policies.

Now, however, a mechanism for cash settlement has evolved. Investors can still get their insurance money in exchange for the bond - a process known as physical settlement. But alternatively, they can simply trade their CDS for cash. The auction on Friday set the value of a Lehman bond at 8.625 cents on the dollar. Financial firms that wrote CDSs on Lehman Brothers now have to pay out the balance - 91.375 cents on the dollar.

This auction offers a credible alternative to physical settlement, meaning that there no longer needs to be one CDS holder for every bond bolder. "What Lehman shows is that the market does actually work quite well, which is reassuring," says Karl Bergqwali, co-head of fixed income at Gartmore Investment Management.

So is the way clear for CDSs to continue their upward trajectory? Two potential obstacles can be identified. First, the regulatory attack on short selling equities could spill over into fixed income markets. Buying a CDS on a company is, after all, a bet on its demise.

"If the regulators are going to start getting heavy handed about the short selling of equities then it will be surprising if they don't focus on the short selling of credit.

"Runs have been started on a number of banks by the CDS market, the Icelandic banks being a case in point. Spreads widened out very significantly, which contributed to the liquidity problems they had," says Mr Bergqwali.

Second, the CDS market has had its own liquidity issues. Blockages have arisen as investors have lost faith in each other's ability to complete on contracts.

"We are still encountering daily the situation where counterparties will not face each other to close CDS trades," says Stephen Thariyan, head of credit at Henderson Global Investors.

"The CDS market has become far less liquid than anyone imagined." This problem might be resolved by the creation of a central trading mechanism for CDSs, which are currently bought and sold over the counter. A number of exchanges have already put themselves forward as potential platforms, including the Chicago Mercantile Exchange, which last week announced a joint venture with the hedge fund Citadel.

"Opening a more centralised body would fit in perfectly with a brave new regulated and nationalised financial services world," says Mr Thariyan.

Stephen Wilmot is a features writer at Investment Adviser

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