Halloween Costume Idea: Go as a Credit Default Swap

We are now entering a new roller coaster phase of the financial crisis. The G7 meeting this weekend produced little more than the illusion of a hint of group resolve. The communiqué that was issued contains fine-sounding principles but no plan of action. Markets will likely respond no more than if they had been slapped with a wet noodle.

The real news this week will be quietly going on behind the scenes: a scramble for cash to meet credit default swap obligations after the Lehman Brothers bankruptcy. That's a mouthful, and since I created this blog for curious people who aren't from the world of finance, I'll go slow here.

First, when you go bankrupt, your owners are wiped out. In Lehman's case, this means the stockholders. The bondholders, being creditors, are in a better position. They get to divvy what's left of the carcass, if you will. For every dollar they lent to Lehman, they may get 70 cents, 50 cents or even 10. Turns out, unfortunately, it's pretty close to 10 cents, as determined Friday.

So are the bondholders almost completely wiped out? Well, not so fast. If they owned credit default swaps, a sort of insurance on their bonds, they get to recover the remaining 90 percent. (Cue the rousing cheer sound effect.) So far, this sounds like a very savvy bit of Wall Street financial engineering, these credit default swaps, eh?

The problem, as with any insurance, is your insurer must have enough money to pay out the claim or the whole scheme falls apart. Large Wall Street banks and hedge funds have been happily writing credit default swaps and raking in the fat premiums for the last eight years. They don't have to show that they have sufficient funds to make good on the swaps because this market is COMPLETELY UNREGULATED. I could theoretically write one of these contracts from my bedroom, in my pajamas, with $26 in my savings account. And the CDS market has exploded in size to about $60 trillion. (That's the cost of about 100 Iraq wars).

Here's another wrinkle: you can buy these pseudo-insurance policies without even owning the underlying bond. In other words, it would be like taking out a fire insurance policy on Fred's house across town. You don't own the house, but you can collect when it burns down. That wrinkle matters hugely because it inflates the size of the CDS market. Lehman, I believe, had about $128 billion of bonds and an estimated $400 billion worth of credit default swap coverage on those bonds. This is where a CDS stops looking like insurance and more like a roulette wheel bet. Insurers write swaps for buyers who just want to take a flyer on whether or not Lehman will go belly up.

Now, to the heart of the matter: why this week could be especially turbulent in the markets. The insurers for the Lehman credit default swaps will have to start coughing up about $365 billion -- that's right, billion with a “b.” Now remember, the CDS market is totally unregulated, so no one is entirely clear who all these insurers are, or how much they’re on the hook for, or whether they'll be able to come up with the funds.

Two possible outcomes: 1. If some of the CDS insurers are cash-strapped hedge funds, they may have to sell off truckloads of stock to meet their obligations, driving down the Dow and S&P for yet another week. 2. If some of the CDS insurers are banks, the steep payouts could potentially bankrupt them. The second possibility is scarier, as it ushers in a death-spiral scenario: they go bankrupt, which triggers payouts on the credit default swaps on their own debt, which causes more bankruptcies, etc. etc.

This week and the next could be a major stress test for the credit default swap market. And then the whole thing starts anew with Washington Mutual's bankruptcy settlement at the end of this month. Better take some Dramamine.