Banks are hoarding cash to prepare for CDS pay-outs

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Banks prepare for CDS pay-outs

By Aline van Duyn in New York and Hal Weitzman in Chicago

Published: October 7 2008 03:00 | Last updated: October 7 2008 03:00

Banks are hoarding cash in expectation of pay-outs on up to $400bn (£230bn) of defaulted credit derivatives linked to Lehman Brothers and other institutions, according to analysts and -dealers.

This added pressure on the frozen financial system comes as officials prepare to meet participants in the so-far unregulated $54,000bn credit derivatives market to speed up plans for the creation of a central clearing house.

The Federal Reserve will meet dealers, investors and exchange executives in New York on Tuesday. Although big dealers had committed to setting up a central counterparty by the end of the year, urgency has increased in light of the collapse of banks around the world and as company bankruptcies loom.

"The New York Fed will hold a meeting [today] with a small number of banks and buyside firms to discuss the progress being made toward the creation of a central counterparty for credit default swaps," said a Fed official, adding that this would "help reduce systemic risk associated with counterparty credit exposure and improve how the failure of a major participant would be addressed".

Credit default swaps, a form of insurance against bond defaults, are the most common type of credit derivative. The default of up to $500bn in derivative contracts linked to Fannie Mae and Freddie Mac was settled on Monday, the biggest such exercise ever carried out.

The Fannie and Freddie CDS settled at between 91.5 and 99.9 cents on the dollar, reflecting the fact its underlying debt is not in default after the mortgage groups were seized by the US government. The seizure did trigger defaults on derivatives, however.

The next test will be the unwinding of CDS linked to Lehman, which filed for bankruptcy three weeks ago. Michael Hampden-Turner, a credit strategist at Citi, estimates that there could be $400bn of credit derivatives referenced to Lehman.

These contracts will be settled on Friday, and with the recovery value on Lehman bonds currently estimated at about 10 cents on the dollar, the pay-out by banks and other sellers of credit protection on Lehman could reach a gross $360bn.

The Fed meeting is expected to include executives from exchanges such as the CME Group and Intercontinental Exchange, which are vying with The Clearing Corporation, a consortium of investment banks and dealers that has vowed to establish a central counterparty clearing house by the end of the year.

The Financial Times Limited 2008

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