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  • October 7, 2008 09:15 AM EDT by Elizabeth MacDonald

    Behind the Turmoil

    Massive positions are just starting to be unwound in the credit default swaps market as tens of billions of dollars worth of these contracts are now getting settled in the aftermath of several high-profile flops.

    Banks are hoarding cash in expectation of expected payouts on anywhere from $200bn to $1 tn--no one knows the amount, adding to volatility--for defaulted credit derivatives linked to the collapse of Lehman Brothers, the government's seizure of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE), the government's rescue of American International Group (AIG), and the failure of Washington Mutual (WM).

    The swaps on derivatives on these companies are now being settled.

    Banks, insurance companies, pension funds, hedge funds, you name it, even sovereign wealth funds have sold CDSs and may have to pay out big-time. The derivatives are roiling money market funds which supply funding to businesses who borrow in commercial paper markets. 

    The Reserve Primary Fund had invested in Lehman's debt securities, and when those investment went south, the fund broke the buck, leaving investors unlikely to get back all the cash they put in as the fund failed to keep assets of at least $1 for every dollar invested.  

    This unwinding is causing banks to hoard cash and the stock market to boomerang wildly. It's one of the reasons why the Federal Reserve is making historic moves to unclog the credit system with its recent bid to buy unsecured commercial paper from non-banks.

    And the tumultuous CDS auctions are behind the push I've been reporting to you since last spring to set up a central clearinghouse to take care of these trades, which occur now in the murky over-the-counter market (see my blogs "Can Wall Street's Clean Up Plan Work?" and "How Congress Can Fix the Crisis").

    The idea is to bring some transparency to this market with a centralized clearing mechanism, as the deals are currently conducted between traders over the counter.

    I have been reporting the CDS story with sources on Wall Street and government sources since last weekend.

    Investors can't ignore the severity of this issue. This massive unwinding of these derivatives is happening now and stands behind the market's plunge yesterday and the VIX volatility index hitting levels not seen in two decades.

    Why Now

    When the Federal Reserve decided to let one of its primary dealers, namely Lehman Bros. (breaking counterparty contracts), go bankrupt, when Fannie and Freddie were taken into conservatorship (breaking counterparty contracts), when AIG was effectively nationalized (breaking counterparty contracts), when WaMu went under, these collapses triggered a sequence of credit default swap events now being unwound.

    A credit default swap (CDS) is an insurance contract bought on a derivative to protect payouts in the event a company defaults on its debt. A buyer makes a series of insurance payments to a seller, and in exchange receives the contractual right to being made whole on the derivative if a credit instrument defaults or if a company goes bankrupt or restructures.

    So, CDSs are essentially a form of insurance against bad debts.

    An estimated $54 tn to $64 tn in CDSs now perambulate the globe, largely unregulated ever since Congress enacted the US Commodity Futures Modernization Act of 2000, which barred regulation of these trades.

    TO RECAP: A key driver behind the market plunge has been the tremendous demand for cash from counterparties related to the CDS (credit default swap) payouts on these recent major credit events.

    It's all happening now.

    The CDS Auction Schedule

    This past Monday: An estimated $200 bn to more than $1 tn in CDS written on Fannie and Freddie's debt, the two companies' senior and subordinated debt, were auctioned on Monday.

    Reports indicate that protection sellers on the mortgage giants' subordinated debt won big time here, with contracts on Fannie Mae's subordinated debt recovering 99.9% of the sum insured, and swaps on Freddie Mac's subordinated debt recovering 98%, reports auction administrators Creditex and Markit.

    However, CDSs on the senior debt got less, with Fannie Mae's senior swaps recovering 91.5% the sum insured and Freddie Mac's senior swaps recovering 94%. CDS sellers' losses less than expected being felt here, because  Fannie and Freddie debt have rallied since the two were placed under conservatorship;

    This Friday, October 10th: When the Lehman deals get unwound. Potentially $400 bn in payouts. Lehman debt now trading between 15 cents and 19 cents on the dollar, with imputed losses of 81 cents and 85 cents on the dollar;

    Oct. 23d: WaMu trades get unwound.

    The last two auctions are on a tentative basis, they may be rescheduled. No information yet on AIG CDS auctions.

    What Happens at CDS Auctions

    At these settlement auctions, defaulted bonds can be exchanged for the par value of the bond, or in cash, or the CDS insurance seller pays buyers of this protection the difference between the bonds' face value and the market value of the bonds.

    Also, traders begin to set the reference price for the underlying bonds to determine payout levels. Meaning, mortgage-backed and related bonds are being priced now, sending yet another ripple effect through financials' balance sheets as their holdings get reset-with potentially more writedowns.

    Murky Trades

    A big problem is the fact that CDSs are largely traded over the counter, which means it is hard to figure out who sits on the other side of the trade, not to mention the difficulty figuring out the health of their balance sheets.

    All of this uncertainty is feeding the level of mistrust that has led to a creeping shutdown in the money markets and commercial paper markets.

    Behind the Federal Reserve's Recent Actions

    It's behind the reason why the Federal Reserve and the Treasury are working on a plan to buy huge amounts of commercial paper in the hope of unclogging the credit pipeline.

    That would bring the Fed the closest it has ever been to directly lending not only to banks, but to other companies.

    The Fed yesterday pledged to "take additional measures as necessary" to fight the credit crisis.

    Also, on Monday the Fed said it will provide up to $900 bn in cash loans to banks facing trouble obtaining cash to try and unclog the credit markets.

    Freeze in Interbank Lending

    This unwinding is also the reason why interbank lending has ground to a halt, and why LIBOR rates have risen, as banks are charging each other more in the way of lending rates because they don't trust each others' balance sheets.

    Another problem: Companies may have protected themselves from one or two bankruptcies in the system but not failures on the level we've seen. As one of the best credit derivatives journalists out there, Felix Salmon of Portfolio.com, notes, if they bought a CDS from Lehman to protect them on AIG, they're not protected.

    So, with multiple bellyflops no one can hedge their risks perfectly.  

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Alex Jones' Prison Planet: The truth will set you free!

[...] Fox News puts it: Massive positions are just starting to be unwound in the credit default swaps market as tens of [...]

October 10, 2008 at 4:03 pm

John Kirby

Ms. MacDonald, this subject was broached Sunday night on 60 Minutes, and is the first I've seen mentioned of these Swaps.I am a regular citizen 54 years old that has minimal investments, other than my house, therefore I have not watched this or any other financial site on a regular basis. That has changed in the last three weeks as I have tried to figure out just what is going on in Washington and Wall Street. I have been opposed to the bailout based on the information that was fed to me, but had the gut feeling the citizenry was not being told the truth about the depth and breadth of this financial crisis. The first inkling of suspicion was a Fox News video of a phone interview with Warren Buffett that aired about Sept. 25th. His tone of voice seemed like the Cheshire Cat, amused but unwilling to divulge the real reasons and just saying it's ok and we should vote for it and get it into place. Followed by the 60 Minutes program on these CDSs and now your succinct article above. Makes sense now to this simpleton. All the markers are about to be called in and it will be a bloodbath. This should be on Fox's OrangeBanner Breaking News!!

October 7, 2008 at 5:46 pm

Arnold

Interesting... I believe I heard over the weekend that the total amount of CDS' is between 50-60 trillion. If 10% of CDS-backed mortgages fail, does that equate to 10% of total CDS amount that comes due?

October 7, 2008 at 4:31 pm

Greedom

Doesn't matter Won't be published anyway probably. Instead of 20 20 hindsight ? Try this on for size. Bank of America. With Paulson holding the catchers mit ? you can bet when BAC crashes ? General Tommy Franks - sr. military architect on War on Terror who NOW sits on the Bank of America Board of Directors ? Funny how Rumsfeld was an investment banker FIRST ... Connect the dots. Bank of America is the LAUNDERING VEHICLE. In the end ? Cash in on selling the bogus loan products, and cash in on the flip side too now that Paulson has the money to bail out Bank of America not IF, but WHEN the final part of Savings and Loan scandal part TWO come into play. you watch - in the end, BAC will have picked up firesale bargains - ALL in the end to be rescued by the Fed... Gee.. Franks - oh yeah, go figure, there is that OTHER sr. architect for war on terror MEDIA - LArry Di Rita - he's now sr. spokesperson of BAC - what ARE the odds so many pentagon folks end up at BAC eh ? Franks and Di Rita are BOTH about to get their promised reward. Hey, what would YOU do for 100 million dollars. You'll see. BAC is going to collapse, then get propped right back up. TOTAL cash in. Ask yourself, why did BAC announce it's halving it's dividends ? for Q3 ? Ask yourself. What ? Didn't they JUST go through acquisition process ? Didn't they JUST say 10 billion buyback ? And they're cutting dividends... Huge cut in profits ? Wow - I wouldn't rely on anything CEO of Bear Stearns says outside his Palm Beach home the night before we got the truth on THAT company. Most people in the US have been played, HAD - and looted. Not bad. I STILL Ask - who in their right mind could just 'sit there' during WTC... Let alone an alleged president. No one could just sit there. Our alleged president did. for 14 minutes. Ask yourself... Was it "Ok, we're going through with this" Bush bottom line failed this country to let fear and panic take over from hope and hard work. We went from MAYBE being locked out jobs to - oh my - terrorists will kill us all, we're doomed, it's End Days ! augh! I am going to go vomit now. Enjoy the company you keep

October 7, 2008 at 3:48 pm

Robert Meyers

Sell, sell , sell everything. Put all the cash you can accumulate under the matress. Then don't pay your mortgage or, credit card debt..and let U.S. (Uncle Sugar) pay for it. Then go ahead and vote for the Democrat's who have been in control of this mess for about 4+ years now. They'll raise the taxes of the rich...what does Barak Obama call rich..about $150K for a family of 4. At least he has a lot of exeriance in running big government, (has he ever run anything?)..sure go ahead and trust this mess to a first term Senator..he's sure to fix all our problems! Anyone want to by shares of the Brooklyn Bridge...cheap!

October 7, 2008 at 2:48 pm

Darryl

The financial problems that we are now experiencing began with the laws and regulations of Carter and Clinton administrations, but since they are gone we can’t boot them. We need to look at the current members of congress. We need to boot Sen Dodd, Congressman Franks and Congresswoman Pelosi because of their involvement in aiding and protecting the failed policies of Carter and Clinton that caused the problem. We need to boot Sen Obama too. We cannot stand to have more his big government that aids and protects socialism.

October 7, 2008 at 12:59 pm

Gisela

Thanks Elizabeth. Your article really was an eye opener. Wow, it isn't what we know, is it? It's what we don't know that is so scary right now.

October 7, 2008 at 11:29 am

Ron

Emac, thank you very much. Your in-depth, insightful analysis teaches me something new every day. You are exactly the type of person that has made Fox business so succesful, so fast.

October 7, 2008 at 10:56 am

Andy Kohlhofer

This is not only a crisis in confidence in the financial markets, this is also a crisis in confidence in the U.S. Government. The massive amount of debt accunulated (I think that it is now close to $11 Trillion, the sense that there is no urgency to reduce spending (the last piece of the budget submitted had $6 billion in earmarks) or spending obligations (Social Security, Medicare, Medicaid, Education, Iraq and Afghan wars, etc., amnd the failure to enact changes to government policieas that encourage sub-prime lending, have all added to the anxiety that within a few years it will all happen again. The charters for Fannie Mae and Freddie Mac have not been revoked and their legal obligation to increase the # of loans in their portfolios to those area and individulas that require a loosening of mortgage requirments is a major failure of this administration and Congress. I also read yesterday that FHA is still guarenteeing loans that require only 3 % down! Add to that the bothe Bush and Congress were completey unprepaired. Paulson should have had contingency plans drawn up a year ago in a way that minimized taxpayer involvement. Add to this the prospect that a high tax and spender may be elected, repeating the mistiahes of Hoover that led to the Depression and the complte incoherence regarding capitalism from the other side, we have problems.

October 7, 2008 at 10:48 am

NIck

EMac,assuming FoxBusiness has some debt on the books,and I've just possibly acquired that debt thanks to the US Treasury,I have to demand that you get back to work and quit posting these BLOGs.It's tying up company time,which I now have a vested interest in.(I'm gettin the hang of this Socialism stuff.) Signed, US Taxpayer/Owner of Bank and Commercial Debt P.S. Do you need all of those lights on in your office?It raises energy costs,which contributes to OUR company debt.Can't have that.

October 7, 2008 at 10:05 am

about this blog

  • Elizabeth MacDonald is the stocks editor for Fox Business Network. She is recognized as one of the top prize-winning business journalists in the country, and has received 14 awards, including the top prize in business journalism, the Gerald Loeb Award for Distinguished Business Journalism, and the Newswomen's Club of New York Front Page Award for Excellence in Investigative Journalism.

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