Monday, 13 October 2008

And Now a Word from our Sponsor

Now for some good news about the market for credit default swaps (those insurance-like products that guarantee the value of corporate bonds and mortgage-backed securities). These details are by way of a clearinghouse for trades that goes by the name Depository Trust and Clearing Corporation (DTCC).

* Pleasant surprise #1: DTCC, which claims to handle the "vast majority" of trades on credit default swaps, says it has registered $34.8 trillion of such contracts. That would make the credit default swap market about half of earlier estimates of $60 trillion, thus reducing its "neutron bomb" capacity for widespread destruction.

* Pleasant surprise #2: Less than 1% of its credit default swaps are for mortgage-backed securities. So, presumably, even if these securities (whose value rests on the fortunes of the cratering U.S. home market) take a tumble, that won't trigger huge CDS claims.

* Pleasant surprise #3: The net payout in the Lehman bankruptcy, from the sellers of credit default insurance to the buyers, will be about $6 billion, not $365 billion or some other ghastly-high figure. This is because, apparently, the players in this market are well hedged. In other words, if A owes B $30 billion, he's mostly covered because C owes him $29 billion.

The DTCC corrected all these misperceptions in an October 11 press release in which it decried "inaccurate speculation." What's going on here, I think, are several things. DTCC is trying to (1) quiet investor fears about swaps, (2) show that the products aren't part of some crazy Wild West marketplace being run off Uncle Jed's back porch, and (3) position itself for the coming onslaught of Washington regulation.

This disclosure is useful, though it helps underscore why there's so much concern about credit default swaps in the first place. The market has been operating in too many dark, unregulated corners. The fact that the net payout from the Lehman bankruptcy could have been misestimated by a factor of 60 shows how little is known about how these swaps work and who has how many of them.