The credit derivatives market, worth some $54 trillion (£31trn), began its biggest test yesterday as an unprecedented round of settlement operations on derivatives contracts began,including those covering the debt of Lehman Brothers, Fannie Mae and Freddie Mac.
At stake is how much will be paid out on credit default swaps (CDS) – a type of insurance contract against acompany defaulting on its debt which is sold by investment banks and major insurers such as AIG.
The "auctions" to decide the value of bonds in default and the amounts the derivative insurance will have to pay out on them are organised by theInternational Swaps and Derivatives Association (ISDA), based in New York. ISDA has held only nine auctions since 2005, but this month will see five that will include many of the former giants of the US financial scene. The CDS market is opaque because contracts are only registered between the buyer and seller of the insurance, with no central record of the value or whereabouts of outstanding contracts.
With massive debt defaults taking place, and more predicted as the economy slows, the lack of clarity has raised fears of mounting losses at issuers of CDS paper who may not have thecapital to pay out on their guarantees.
The auctions will also be a big test of investment banks' procedures when the authorities are scrutinising certain securities firms for lapses.
"It is significant because it is probably going to be a good opportunity for investment banks to prove to regulators that they have their house in order. Any big investment bank will want to make sure that nothing is dropped on the floor," said an analyst at oneinvestment bank.
A record 409 firms had alreadyregistered for the Fannie and Freddie auction yesterday, with 300 having signed up in the previous 24 hours and hundreds more in the pipeline. The value of derivatives contracts covering the two US mortgage finance agencies, which were effectively nationalised last month, is estimated at between $400bn and $600bn.
The size of the Fannie and Freddie auction dwarfs the previous biggestdefault in credit derivative markets, which was for Delphi, the US car-parts producer that went bankrupt in 2005.
The auction system was put in place seven years ago to centralise agreement of the recovery rate on company bonds in default.
ISDA calculates an average value for the underlying bonds from varioussubmissions by market makers. If the average is 40 per cent, for example, then the issuer of the protection pays the "lost" 60 per cent to the CDS buyer.
Before the system was brought in, the buyer of protection had to physically find some bonds and present them to the insurer in return for the payment. The insurer then had to get back as much as possible from the defaulting company. The system has become increasingly important because, as the CDS market has grown, for many companies the value of outstanding CDS contracts vastly exceeds the value of the actual bonds issued.
A spokesperson for ISDA said: "It is really a straightforward process. The only difference here is the volume, and we don't see any reason why itshouldn't go smoothly despite theanticipated high volumes of trade."
Freddie and Fannie will be settled on 6 October, with Lehman on 10 October and Washington Mutual on 23 October.
First up in the process yesterday was Tembec Industries, a US business of Tembec Inc, the Canadian paper and timber producer.
$: Size of credit default swap market.