Structured settlements

“While CDS contracts did not cause the current financial crisis, they may have exacerbated the problems and complicated the process of dealing with the issues. CDS contracts can amplify losses in credit market. For example, when Lehman Brothers defaulted the firm had around $600 billion in debt. This would have resulted in a maximum loss to creditors of that amount. In addition, according to market estimates, there were CDS contracts of around $400-500 billion where Lehmans was the reference entity (the outstanding volume of CDS contracts is not known with certainty reflecting the lack of information about trading in the OTC market).

If the CDS contracts were used for hedging, then the CDS contracts would merely have resulted in the losses to creditors being transferred to the sellers of protection leaving the total loss unchanged. However, market estimates suggest that only around $150 billion of the CDS contracts were hedges. The remaining $250-350 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200-300 billion) are additional to the $600 billion. The CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by (up to) approximately 50%.

In addition, Lehman Brothers was included as a reference entity in other structured credit products, such as Collateralised Debt Obligations (“CDOs”) and credit indices, and additional losses would have resulted therein. Documentary asymmetries in the contracts may also increase the losses.”

“The derivative industry’s indefatigable support of the CDS market (motivated undoubtedly by the specter of regulation and greater scrutiny) centers on the fact that all the CDS contracts related to the high profile defaults have settled and the overall net settlement amounts were small. Strictly speaking, this is correct.

In practice, there are actually two settlements. The ‘real’ settlement where genuine hedgers and investors deliver bonds under the physical settlement rules (i.e. those who actually own bonds and were hedging). Then there is the parallel universe where the dealers and large hedge funds settled via the auction. Dealers tend to have small net positions (large sold and bought protection but overall reasonably matched).

For example in the case of Lehman Brothers, the net settlement figure of $6 billion that was quoted refers to the second process. Real CDS losses from Lehman CDS were higher, probably around $300-400 billion. Some banks and investors that had sold protection on Lehmans did not participate in the auction. They chose to take delivery of defaulted Lehman debt resulting in losses of almost the entire face value. For example, one German Landesbank reportedly took delivery of $1 billion of Lehman bonds that are now worth $30 million. read more