Credit Default thingies

Will Hutton\’s suitably apocalyptic today.

As recession deepens, there will be defaults on securitised bonds and the potential collapse of more banks outside the G7 ring-fence. Nobody knows what proportion of the $55 trillion of credit default contracts that have actually been written will be honoured and who might bear losses running into trillions of dollars.

Now I\’m not sure if I\’ve got this right, but can\’t the losses only be equal, in total, to the underlying losses? That while there may well be $55 trillion in nominal terms, most of those cancel out and so the total actual losses will be the underlying $1 or $2 trillion?

A lot of which has already been written off by the banks anyway?

On a slightly different point, about those CDS contracts. Does anyone know, would nationalisation of a bank be an "event" under them, one that would trigger a payout? Thus meaning that if, say RBOS were nationalised, then all of the contracts they\’ve written then become due?

5 thoughts on “Credit Default thingies”

  1. No one has gone bust over Lehman’s CDS but there was a huge scramble to get into cash on Friday.

    Tim adds: Settlement’s on the 21 st. That’s when we find out.

  2. “Tim adds: Settlement’s on the 21 st. That’s when we find out.”

    … whether it was a good idea or not to let Lehman go to the wall.

  3. No, CDS losses could exceed the nominal outstanding debt, if those selling protection can’t pay up.

    HOWEVER, CDS contracts usually involve margin, so in fact most of the payments owed to buyers of protection will have already been made. The exceptions are where the sellers were considered so secure as not to need to post margin, which includes AIG, but not the investment banks such as Morgan Stanley.

    Since the auction resulted in a lower price for LB bonds than was expected, the sellers of protection will need to cough up a bit more, but only by a few cents on the dollar.

  4. Tim, the answer to your question could be yes. When Railtrack (remember that?) was nationalised by Stephen Byers in the early ‘Noughties, something similar happened. The key is whether a lawyer can show that a bank or other entity being taken over was considered to be in default at the time or whether the action had the effect of putting the bank in default. That might be tricky.

  5. “Now I’m not sure if I’ve got this right, but can’t the losses only be equal, in total, to the underlying losses? That while there may well be $55 trillion in nominal terms, most of those cancel out and so the total actual losses will be the underlying $1 or $2 trillion?”

    I could be misremembering but I thought I read that people were selling CDSs to people who didn’t own the underlying debt.

    i.e. it was like me taking out a policy against the burning down of my neighbour’s house.

    Nice business for the “insurance company” in the good times but a rather effective way of multiplying losses if you got your pricing wrong…

    Also. it sounds like you’ve missed up your parties.

    If RBS were nationalised and if it were regarded as a default event, then surely it would be the parties who had *sold* CDSs on RBS debt that would have to pay up?

    I’m not sure I understand why RBS would need to pay anything on the CDSs they had written themselves. After all, who would buy insurance against an RBS default *by* RBS?!

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