After Meltdown Monday, Frightful Friday?

Naked Shorts, the blog not Elmer Fuld's Lehman excuse, alerted Guambat to some of the pre-Halloween frights loitering about this week.

It seems on Monday there was a showdown between the insureds and insurers who took/wrote cover in the event of a Fanny/Freddie credit default.

And on Friday there will be another shoot out of like kind when the Lehman default is dealt with.

Naked Shorts reckons they dodged the bullets after the smoke cleared on Monday, but there is concern and positioning to see if anyone is bullet-proof come Friday.

This is all about Credit Default Swaps, so let's back up a bit here and try again to understand this topic. A CDS is nominally an insurance contract. An insurance contract, of course, is a bet you make with someone else that some unfortuitous event may occur, and should it eventuate, they cover your loss.

Like life insurance. You bet the life insurance company that you will die this year; they bet you won't. In the event you die, you win, but if you don't die, you loose. Now if you understand how crazy that sh!t is, you will have no trouble with CDSs.

But there is a difference in the market structure of CDS insurance and most other insurance that makes the CDS insurance a bit more "gamey", or ludicrous, depending on your sense of containing or spreading systemic risk.

In most insurance you must have an "insurable interest" in the thing insured. The insurable interest rule is designed to mitigate what some call moral hazard. The idea is that if you buy life insurance, you won't kill yourself to collect the payoff, but if just anyone at all could buy insurance on your life, some of those folks will think nothing at all of killing you to collect the payoff, so the insurable interest rule says not just anyone can buy insurance on your life. It's to protect you against the hazard that others may not share your moral of self-preservation.

Lex, the Guru Collective at the Financial Times, describes the CDS market similarly:

A house insured for more than its value is always considered a fire risk. But home insurance is regulated and arson is a criminal offence. That keeps most people honest, most of the time. The same cannot be said of the credit default swap industry. The private, over-the-counter market allowing two parties to bet on the likelihood of a company defaulting on its debt had, by the end of 2007, grown to at least $62,000bn in notional amounts insured – more than all the credit outstanding worldwide.

Lex passes over the point that anyone can buy insurance on any company that pays in the event of the company's default, that is, that there is no insurable interest rule for CDSs, as one of the reasons the CDS market has been so central to the whole credit implosion.

Lex, rather, points to the idea that the CDS contagion was due to too many people of unknown wherewithal to do so who have underwritten too much CDS insurance at premiums too cheap to cover the risk.

the pressure to hedge has led the most liquid contracts to overshoot, in effect pricing in absurd default risks and recovery rates. These same prices are then used as supposedly objective indicators to value the securities the CDS contracts were designed to hedge – hence the spiral of over-hedging and overstated marked-to-market losses.

The priority, rather, should be to move trades on to already regulated exchanges. That would mean buyers and sellers of protection were matched more efficiently and transparently. A central clearing house would reduce counterparty risk and enforce bigger margin requirements. This would also price out some of the chancers.

Now no one would call Guambat a Guru, so far be it from Guambat to challenge Lex' diagnosis. Rather, Guambat will merely offer his thesis that the lack of insurable interests in CDSs is what caused the credit implosion as a non-exclusive alternative analysis to Lex' notion that wrong-headed pricing did it.

So, anyway, getting back to the Monday Meltdown, Frightful Friday theme, what happened on Monday was this, per the Financial Times:

The credit derivatives markets will on Monday set the price tag for settling up to $500bn of contracts related to Fannie Mae and Freddie Mac, the US mortgage lenders whose seizure by the US government had the unexpected knock-on effect of triggering defaults on derivatives deals.

This price – called the recovery value – will in turn determine the payouts that have to be made by insurers and banks that offered credit cover on the mortgage financiers in recent months.

The breakdown of large parts of the credit markets has raised concerns about the ability to settle the derivatives contracts, as pricing is determined by the bonds that are eligible for use in the derivatives settlement auctions.

The Fannie and Freddie derivatives default is unique because their underlying $1,600bn of debt is now explicitly guaranteed by the US government. However, the government’s move to place them into conservatorship triggered default, as defined by bankruptcy clauses in credit derivatives contracts.

Analysts have estimated the number of credit default swaps (CDS) – a kind of insurance against debt default – which reference Fannie and Freddie to be between $200bn and $500bn.

By some estimates, these payouts could amount to $75bn, assuming a recovery value of 85 cents in the dollar, but it is hard to pinpoint because the number of derivatives that reference Fannie and Freddie is not known.

And, in the event, as noted above, Naked Shorts said the market dodged that bullet:

The CDS market yesterday dodged the first of three big bullets headed its way when, undoubtedly aided by the tailwind of now explicit government guarantees, the auction of obligations related to the debt of Phoney and Fraudy produced recoveries from 91.5-99 per cent for protection sellers.

But the Lehman default showdown on Friday does not carry the same implicit US government bail out as Fanny and Freddie. The Financial Times again reports on that problem, hinting at the possibility that the Fed will help fashion some kind of clearing house by then to help deal with the issue.

Banks are hoarding cash in expectation of pay-outs on up to $400bn of defaulted credit derivatives linked to Lehman Brothers and other institutions, according to analysts and ­dealers.

“The New York Fed will hold a meeting Tuesday with a small number of banks and buyside firms to discuss the progress being made toward the creation of a central counterparty for credit default swaps,” said a Fed official, adding that this would “help reduce systemic risk associated with counterparty credit exposure and improve how the failure of a major participant would be addressed”.

Credit default swaps, a form of insurance against bond defaults, are the most common type of credit derivative. On Monday, the default of up to $500bn in derivative contracts linked to Fannie Mae and Freddie Mac was settled, the biggest such exercise ever carried out.

The next test will be the unwinding of CDS linked to Lehman, which filed for bankruptcy three weeks ago. Michael Hampden-Turner, a credit strategist at Citi, estimates that there could be $400bn of credit derivatives referenced to Lehman.

These contracts will be settled on Friday, and with the recovery value on Lehman bonds currently estimated at about 10 cents on the dollar, the pay-out by banks and other sellers of credit protection on Lehman could reach a gross $360bn.

Guambat notes that, inspite of the Meltdown Monday, the Fanny/Freddie default clearance went OK, so, to the extent its occurrence had anything to do with the meltdown, it has proven to be not too terribly horrible and the market on Tuesday is, to some extent, stabilized.

Hopefully, there will be enough holding of hands by Friday that the Lehman default fright might turn out to be one of those Disney frights where everyone screams then giggles.

But who knows? Maybe it'll turn out to make the chain-saw masacre look like a picnic. These are interesting times, and there are very real things more fearful than fear that lurk about.

Cue theme song from "The Adams Family".


PS: Did Guambat say "stabalized"? It WAS when he wrote that. Nothing is stable now.