October to be a test of the credit default swap market

Posted by Tim Hope on 9/30/08 12:58 pm

Given the recent failures and takeovers within the financial sector, October may prove to be a significant test for the multi-trillion dollar credit default swap (CDS) market.  Insurance firms and other investors are believed to have created CDS contracts on a number of financial institutions that are now in default of the contract terms.  As a result, extremely large sums may need to be paid out in coming weeks which could be made more difficult given the tight credit conditions in the current market.  How much is at stake?  Consider that CDS contracts involving Fannie Mae and Freddie Mac are estimated to be about half a trillion dollars.  According to the Financial Times, the Fannie/Freddie settlement auction is scheduled for October 6th.  In the case of Lehman, consider that the bonds of the now defunct firm are currently trading in the range of roughly 15-19 cents on the dollar.  Investors who wrote CDS contracts on Lehman debt will likely have to pay out about 81 to 85 cents on the dollar.  Lehman CDS settlement auctions are reported to be scheduled for October 10th.  The impact of failed CDS contract settlements on the capital markets would be difficult to predict.  Click here to read more.

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