The collapse of Lehman Brothers is putting significant strain on the giant, opaque, market for credit default swaps, in which investors buy protection against the risk of corporate defaults, and reinvigorating longstanding calls for improved regulation of the markets.
The cost of insuring against corporate default surged yesterday on concerns about the safety of financial companies and about the potential unravelling of the $62trn ($34.6trn) market, in which Lehman had been a major counterparty.
Dealers were working furiously to gauge the effect of the winding down of Lehman's trading positions, and many agreed between themselves to honour the results of a shadow trading session, conducted on Sunday night, aimed at cutting Lehman out of many trades.
Lehman filed for Chapter 11 bankruptcy to protect it from its creditors after confidence in the bank was shattered and Barclays walked away from talks aimed at saving it.
Benchmark measures of corporate credit risk jumped by a record in Europe and were near record highs in North America, with the cost of insuring against debt defaults by Morgan Stanley and Goldman Sachs – the last remaining independent investment banks – among the most inflated.
It was fear about the effects on the credit derivatives market which prompted the Federal Reserve to backstop the takeover in March of Bear Stearns by JPMorgan Chase. Its refusal to do the same to rescue Lehman leaves the markets in uncharted territory. The unwinding of Lehman positions could affect the values of many kinds of derivatives held by financial companies all over the globe.
Willem Sels, head of credit strategy at Dresdner Kleinwort, said: "This accelerates the pain. It makes it deeper but it hopefully then means that we will reach a clearing level more quickly so that the bottom can be reached earlier. The more realistic banks are about the valuations they hold, the quicker they will start to lend again."
The US Treasury secretary Hank Paulson has been pushing hard for the creation of a formal mechanism for regulating and settling derivatives trades, which are currently conducted directly between banks. Addressing the crisis yesterday, he called for an overhaul of the US regulatory system to prevent future crises and to protect market stability.
"I'm committed to working with regulators here and abroad, as well as policymakers in Congress, to take additional necessary steps to maintain the stability and orderliness of our financial markets," he said.
Increased fears in the money markets have come at a bad time because banks traditionally conserve liquidity as they head for the end of the year to report a strong balance sheet. A freeze in the money markets would also be bad news for the wider economy if risk-averse banks rein in lending to companies and individuals.
Central banks sought to shore up confidence and bolster liquidity in the banking market. The Bank of England supplied £5bn of three-day money to the market in a deal that was four times oversubscribed at £24.1bn. The European Central Bank made €30bn (£24bn) of one-day liquidity available and attracted €90.3bn.
Those moves followed action by the Fed to accept a much wider range of assets as collateral for its borrowing facilities in an attempt to boost liquidity in the market. The Fed meets today to set interest rates.