Abet Chichi2

[bob3]

Firms must now pay up credit swaps

By Jay Fitzgerald | Sunday, October 19, 2008 | http://www.bostonherald.com | Business & Markets

Another “day of reckoning” for battered markets may be coming later this week.

Financial experts are closely - and nervously - eyeing Tuesday as a major test of the strength of credit markets as major Wall Street firms are forced to pony up billions of dollars in payments for “credit default swaps” tied to the collapse last month of Lehman Brothers.

No one is quite sure how much money is owed by those who sold the complicated investment contracts, which basically are insurance agreements tied to Lehman’s bonds and Lehman’s ability to pay off those debts.

The contracts - which are part of a $54 trillion-dollar market for credit-default swaps - went into default after Lehman declared bankruptcy Sept. 15.

Now the payments are due on Tuesday - and it’s still a mystery exactly how much is owed by whom and to whom.

“Tuesday is a day of reckoning,” said Mark Williams, a specialist in capital risk management at Boston University. “Tuesday is going to be the next shock test to see how resilient the markets really are.”

The main problem is that credit-default swaps have been largely unregulated and extensively sold among major Wall Street firms behind closed doors.

Last week, Federal Reserve Chairman Ben Bernanke, echoing the sentiments of others, called for a new “clearinghouse” of data on credit-default swaps.

But future regulations won’t come in time for Tuesday’s big pay day.

Some have estimated that firms will have to cough up hundreds of billions of dollars - sums that could devastate already reeling Wall Street firms such as Morgan Stanley and Goldman Sachs.

Karel Gelen, a director at the International Swaps and Derivatives Association, says that those estimates are “clearly wrong.” Other estimates put the figure at a more affordable $6 billion, he said.

He noted that a recent industry auction set the price for Lehman’s bonds at about 9 cents per dollar - so the final bill for the Lehman debacle will only be a fraction of what some are fearing.

But Daniel Bergstresser, an assistant professor at Harvard Business School, said the problem remains: the market for the CDS contracts is too “opaque” and “we don’t really know the number of credit-default swaps written on Lehman’s debt.”

Bergstresser described Tuesday’s payment deadline as an “important event” that will indeed test nervous markets.

Some have blamed the exotic credit-default market for exacerbating Wall Street’s woes.

Companies such as Bears Stearns and Lehman Brothers were ultimately brought down by their bad investments in subprime-mortgage securities.

But their collapses pulled other investment products down with them, such as credit-default swaps.

American Internationl Group almost went under because of its own insurance commitments, before the Treasury took it over and pumped billions into its coffers to keep AIG propped up.

Fannie Mae, Freddie Mac, Washington Mutual and three key banks in Iceland have also had their own credit-default scares.

Gerard Cassidy, an analyst at RBC Capital Markets, agreed with the ISDA’s Gelen that past credit-default problems were “handled OK” via the industry “protocol” for handling settlement.

But he agreed Tuesday is still a “big day” for investors hoping for a sign markets are returning to normal.

Article URL: http://www.bostonherald.com/business/general/view.bg?articleid=1126383