No explosion, Turkish-style strangulation
Posted by Harry Stotle on October 22, 2008
Quite a lot was learnt yesterday from the settlement of Lehman’s credit default swaps. First of all, we were all relieved to see the process complete with no major incident. Simultaneously, the reasons to continue worrying were made clear: (i) the main losses had already been taken and gradually paid for over the last weeks, under the form of both margin calls or “stop loss” returned positions; (ii) payments were made using the recent giant bailout packages as well as the central banks’ new credit facilities; (iii) and such packages and facilities had precisely been precipitated in order to allow the settlement. We also learnt the exact amount of CDS contracts now registered in the Depositary Trust and Clearing Corporation’s clearing warehouse, totaling approximately $34.8 trillion at this time (as opposed to the previously estimated $ 60 trillion, which was based on surveys, and down from an actual $44 trillion in April).
The residual funds transfers that took place yesterday were only the last ones to complete an actual monster loss of about $400 billion. There was basically no difference between nominal and actual losses: margin calls are not a free ride, nor is returning one’s position (unless this can been done way before the event and in a none-volatile environment). Instead of one-day explosion, death took therefore the smoother form of a slower Turkish-like strangulation.
One has to remember that Lehman’s CDS were nothing but a first test of the process, representing a minute portion only of the total outstanding Credit Default Swaps. It is true that the percentage of loss was extremely high in this specific case due to an underlying bankruptcy. It is yet fair to say that very few net positions on all other CDS are winning, in a global situation when almost if not all credit ratings are crumbling down fast.
Regulators are of course scrambling to take some control over CDS. All they can do, however, is limit the creation of new ones and give them more transparency. They cannot reduce by 1 cent the present amounts of further losses to settle which should reflect in the quarterly reports to come, at least for listed companies.
This is not good news for the stock markets and yet
this is how the world goes.
