The CDS market’s size has halved from $64 trillion to $31 trillion in three months. But finally, we’re told, the much-needed central clearinghouse for this market is being built:

 New York approved Intercontinental Exchange Inc.’s application to form a state-regulated trust to guarantee trades in the $31 trillion credit-default swap market, boosting the company’s bid to beat rival CME Group Inc. in running a clearinghouse for the trades.

The state Banking Department approved the application after a meeting today, Chairman Richard Neiman said in a statement. The approval paves the way for Intercontinental, the second-largest U.S. futures exchange also known as ICE, to raise capital to fund the clearinghouse, according to the statement. ICE U.S. Trust LLC, as the subsidiary is known, still needs regulatory approval from the Federal Reserve.

“We have worked closely with our counterparts at the Federal Reserve Bank of New York in overseeing this industry initiative,” Neiman said in the statement. A clearinghouse for CDS contracts will “reduce systemic risk” within the banking industry, he said.

The Fed has been pushing for a clearinghouse after Lehman Brothers Inc., one of the largest dealers in the CDS market, went bankrupt in September, threatening the stability of its trading partners. A clearinghouse, capitalized by its members, all but eliminates counterparty default risk by becoming the buyer for every seller and the seller for every buyer.

CME Group

Chicago-based CME Group, the world’s largest futures market, is seeking to use its existing clearinghouse to back CDS trades. It still requires regulatory approval from the Commodity Futures Trading Commission, as well as license agreements from Markit Group Ltd., which owns the most used CDS indexes and pricing systems.

A clearinghouse owner could earn between $100 million and $400 million a year in revenue from clearing CDS trades, according to estimates by Wachovia Capital Markets and Keefe Bruyette & Woods Inc.

NYSE Euronext and Eurex AG are also seeking to clear CDS trades. ICE earlier this year said it will buy the Clearing Corp., the clearinghouse owned by banks including Goldman Sachs Group Inc. and JPMorgan Chase & Co., to secure commitments from nine dealers in the CDS market to participate in its plan.

Corporate bonds, CDS, libor, commodities, are all in crisis mode at the moment. But the situation is not the same as in September, the financial system is already wrecked, and all that the investor has to do is waiting. A general pessimistic bet on the economy is likely to pay well for the next six months, even if angels descend to the Earth to save us all.

The cost of protecting corporate bonds from default surged to records around the world as the prospect of U.S. automakers filing for bankruptcy protection fueled concern of more bank losses and a deeper recession.

“Markets are back in crisis mode,” said Agnes Kitzmueller, a Munich-based credit strategist at UniCredit SpA, Italy’s biggest bank. “There is fear in the market.”

General Motors Corp., Ford Motor Co. and Chrysler LLC executives left Washington empty handed yesterday after two days of pleading with lawmakers for a $25 billion bailout. Credit markets have “significant” liabilities to the automakers, raising the prospect of “continued writedowns,” BNP Paribas SA analysts told investors today.

Credit-default swaps on the Markit CDX North America Investment-Grade index jumped 23 basis points to an all-time high 270, according to broker Phoenix Partners Group at 11:15 a.m. in New York. The Markit iTraxx Crossover Index of 50 European companies with mostly high-yield credit ratings rose 37 basis points to 927, having earlier traded at 933.

Stocks slumped worldwide as a Conference Board report of leading economic indicators fell for the third time in four months, signaling a deepening recession. U.K. retail sales dropped for a second month in October as rising unemployment and the financial crisis dissuaded shoppers from spending.

Treasury yields declined to record lows, with two-year notes dropping below 1 percent for the first time, as investors shunned all but the safest assets.

Credit-default swaps on New York-based Citigroup Inc. rose 40 basis points to 405, Phoenix prices show. Contracts on Goldman Sachs Group Inc increased 65 basis points to 400 and Morgan Stanley rose 60 to 515.

“Anything’s possible in this market,” said Mark Bayley, a director of credit at ABN Amro Holding NV in Sydney. “You’re seeing sellers of risk and very few buyers. The sellers are becoming more stressed and willing to accept very wide spread levels for corporate bonds.”

Investors also shunned high-risk, high-yield loans, driving the Markit iTraxx LevX index of CDS on leveraged buyouts down to a record low of 78.5, BNP Paribas prices show. The current series of the index began trading at 99 on Sept. 29. The benchmark falls as credit risk rises.

The US Treasuries keep outperforming everything else. But this may not remain so forever, if the Fed decides to activate its most outlandish contingency plans, so to speak. I believe that the Federal Reserve is soon going to engage in the most unprecedent reflationary effort of any government at any time, and we’ll together see the results of the experiment. Three month treasuries are yielding 2 basis points, that is 2 hundredths of one percent, at the moment.

Treasury yields declined to record lows, with two-year notes dropping below 1 percent for the first time, as global stocks slumped and a deepening recession drove investors to the safest assets.

Yields on two- and five-year notes and 30-year bonds dropped to the least since the Treasury began regular issuance of the securities. Ten-year note yields touched the lowest since 2003 after yesterday’s release of the minutes of last month’s Federal Reserve meeting showed policy makers expect the economy to contract through the middle of 2009 and more interest-rate cuts may be needed to counter deflation.

Investors turned to government debt as recessions in the U.S., Europe and Japan hurt corporate earnings and drove prices of shares, commodities and real estate lower. Stocks declined worldwide, with the MSCI World Index losing 2.4 percent.

Longer Maturities

The 30-year yield fell as much as 21 basis points to 3.70 percent, the lowest level since regular sales started in 1977. Yields on five-year notes declined to 1.93 percent, not seen since 1954, according to data compiled by Bloomberg and the Fed.

Treasury Bill Rates

Two-year notes returned 6.5 percent in 2008, compared with 7.5 percent last year, according to indexes compiled by Merrill Lynch & Co. The yield declined from 3.11 percent on June 13, the highest level this year.

Rates on three-month bills dropped to 0.02 percent. That equals the level reached after the collapse of Lehman Brothers Holdings Inc. on Sept. 17, the lowest since the start of World War II.

Fed officials lowered their economic-growth estimates to zero to 0.3 percent for 2008, from 1 percent to 1.6 percent previously, the median forecast of Fed governors and district- bank presidents showed. The predictions for GDP next year ranged from a contraction of 0.2 percent to growth of 1.1 percent. The jobless rate is projected to be 7.1 percent to 7.6 percent.

Derivatives contracts tied to the value of the yen have helped drive down 10- and 30-year interest-rate swap spreads as the Japanese currency rallies against the dollar, Ahrens said. The yen has gained 12 percent since September as investors purchase the currency to repay loans made in Japan in order to unwind investments in higher-yielding assets.

Paulson’s Decision

The price to exchange, or swap, floating for fixed-rate payments for 30 years fell below the yield on similar maturity Treasuries by the most ever as dealers hedged against risk related to derivatives, Ahrens said. The yield on the 30-year bond was as much as 51 basis points higher than the 30-year swap rate. The swap rate has remained below the long bond’s yield since Nov. 5.

The gap between 10-year swaps and the 10-year note yield reached as low as 6 basis points, the narrowest since at least 1988, when Bloomberg data began tracking the instruments.

Yields have hit record lows since Treasury Secretary Henry Paulson said on Nov. 12 he would abandon plans to use the Troubled Asset Relief Program to buy mortgage assets from banks. The London interbank offered rate has spiked 11 basis points in the three days after Paulson’s shift. Before Paulson’s announcement Libor, which banks charge each other for three- month loans in dollars had fallen for 23 straight days.

“Changing the terms of the TARP as suddenly as he did undermined investor confidence,” said Richard Schlanger.

Investors erased more than $33 trillion from global stock markets this year as the U.S., Europe and Japan slipped into recession.

Breakeven rates, which show the difference in yields between inflation-linked and nominal bonds, suggest traders are betting the U.S. economy may face deflation over the next two years. The two-year U.S. breakeven rate was minus 4.09 percentage points.

“You have the cloak of a declining inflationary environment,” said Tom Tucci, head of U.S. government bond trading in New York at RBC Capital Markets, the investment- banking arm of Canada’s biggest lender. “People are denying it, but we are mirroring the whole Japanese situation and if that’s the case interest rates are going to go a lot lower.”

Credit rating downgrades are going on, adding fuel to fire. Though of course, it’s the natural outcome of past’s complacency, and the rating agencies should not be blamed for downgrading these firms now, but for not having downgraded them before.

Macy’s Inc., the second-biggest U.S. department-store company, is headed into the holidays facing the possibility of losing its 11-year-old investment-grade rating.

Macy’s debt has started trading like a junk bond, a signal that ratings companies may demote the owner of Bloomingdale’s department stores to non-investment grade. That would increase the company’s cost of raising funds at a time when capital is increasingly difficult to come by and the retailer is preparing for about $1 billion in 2009 debt repayments.

“The last thing Macy’s needs at this point is a downgrade,” Pete Hastings, a fixed-income analyst with Morgan Keegan & Co. in Memphis, said today. “They’ve got enough trouble the way the economy is going, and this would just make things tougher for them.”

Junk Territory

The extra yield, or spread, that investors demand to own Macy’s 5.35 percent notes due 2012 instead of similar-maturity Treasuries was more than 15 percentage points yesterday, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

That was greater than the 13.2 percentage-point spread on non-investment-grade BB rated bonds, according to Merrill Lynch & Co. index data. The spread on J.C. Penney Co.’s similarly rated debt due 2023 was 765 basis points. A basis point is 0.01 percentage point.

Moody’s Investors Service said Oct. 15 that it had a “negative” outlook on Macy’s Baa3 rating — the lowest investment grade — meaning it was more inclined to downgrade the retailer. Standard & Poor’s Corp. did the same on Oct. 10. They may next put Macy’s on review for a downgrade, or simply cut ratings without the interim step.

`Not Ordinary Times’

“Ordinarily they wait until the holiday season is over to make changes to retailing ratings, but these are not ordinary times,” Carol Levenson, an analyst with Gimme Credit LLC in Chicago, said Oct. 15. “Given the agencies’ waning credibility in other areas, they may be quicker to pull the trigger on marginal names such as Macy’s than they would have been before the credit crisis.”

The company plans to pay off debt due next year with cash and may use its $2 billion credit facility, he said. It has borrowed $150 million, he said.

That plan may impair the retailer, Hastings said in a telephone interview.

“If they use cash on the balance sheet to reduce debt to keep the investment grade, they would have less flexibility to weather the downturn,” he said.

Sales at stores open at least a year may fall as much as 6 percent in the fourth quarter, after dropping in 10 of the last 11 quarters, Macy’s said.

A rating downgrade can depresses demand for bonds because some funds prohibit investing in junk. The rating increases borrowing costs by forcing the company to offer investors a higher interest rate to assume more risk.

Macy’s would be joining General Motors Corp. and a growing number of so-called fallen angels — former investment-grade companies. There were 40 as of Nov. 11, compared with 29 a year earlier, according to an S&P report. Fifty-seven more, including Macy’s, are at risk of being downgraded to speculative grade, S&P said.

Macy’s, which runs more than 850 stores, has $350 million of bonds coming due in April and about $600 million in July, according to data compiled by Bloomberg.

The retailer’s ratio of debt to earnings before interest, taxes, depreciation and amortization — a measure of earnings that the credit rating companies track — rose to 3.17 times in the third quarter, from 3.04 times a year earlier. Junk-rated Sears has a ratio of 1.82.

Will Citigroup survive this crisis? It depends entirely on the government. If the government shows hesitancy, they are doomed.

Citigroup Inc. fell as much as 25 percent in New York trading, after losing almost a quarter of its value yesterday, as concern intensified that the U.S. recession will generate losses and weaken demand for financial services.

Citi, down for eight of the past nine trading days, declined 81 cents to a 13-year low of $5.59 on the New York Stock Exchange at 1:09 p.m. The stock, which fell as low as $4.76, slumped even after Saudi billionaire Prince Alwaleed bin Talal said he would boost his stake in the New York-based bank.

Chief Executive Officer Vikram Pandit said this week Citigroup will cut 52,000 jobs in the next year, double the target announced in October, as loan losses surge and the economy shrinks. JPMorgan Chase & Co., the largest U.S. bank, plans to fire about 10 percent of its investment-banking staff, or about 3,000 people, a person familiar with the bank said today. Its shares dropped $3.35, or 12 percent, to $25.12.

Citigroup has lost about $20 billion in the past four quarters as bad loans increased and demand for banking services declined. Analysts surveyed by Bloomberg expect a $673 million deficit for the fourth-quarter.

U.S. Aid

The world’s biggest finance companies have taken almost $1 trillion in writedowns and losses since the credit markets seized up last year. The U.S. has injected more than $200 billion into the top U.S. banks and insurance companies to shore up their finances, and analyst Paul Miller at FBR Capital Markets in Arlington, Virginia, said as much as $1 trillion may be needed.

Jobs, Cars

The U.S. unemployment rate rose to 6.5 percent in October, the highest since 1994, as companies slashed payrolls, the Labor Department said this month. Auto sales plunged 32 percent, manufacturing contracted at its fastest pace in 26 years and consumer confidence fell by the most on record during the month.

The irrational and disastrous expansion of the TARP is continuing. The latest is GMAC. It is obvious that if he could, Mr. Bernanke would save the entire wreck of the financial system of today, and perpetuate it to the next decade. Sadly for him, but fortunately for the US, I suspect that even he can’t save the reckless lenders of these years.

-GMAC LLC, the largest lender to General Motors Corp. car dealers, has applied for status as a bank holding company so it can get access to the Treasury’s $700 billion rescue fund for the financial industry.

The lender also began an exchange offer for $38 billion of notes issued by the company and its Residential Capital LLC home lending unit to reduce outstanding debt levels, Detroit-based GMAC said today in a statement.

GMAC joins money-losing commercial lender CIT Group Inc. in trying to shore up its finances to gain bank status. That may help GMAC quell doubts about its survival after home foreclosures pressured the mortgage unit and GM’s auto sales plummeted to the worst level since 1945. GMAC may also be able to obtain U.S. government guarantees on new debt as a bank.

“If you let this many people participate, the benefit gets so diluted you haven’t done a lot of good,” said Peter Sorrentino, a senior portfolio manager at Cincinnati-based Huntington Asset Advisors. “You can’t save everybody. That’s the hard call.”

Meanwhile the future of GM looks more ominous by the day. The issue is whether it can survive until the next handout under the Obama administration. It’s unclear to me, whether they can do so.

General Motors Corp., the largest U.S. automaker, probably has weeks rather than months left before it runs out of cash without federal aid, said Jerome York, an adviser to billionaire Kirk Kerkorian and former GM board member.

Chief Executive Officer Rick Wagoner “all but said” at congressional hearings in the past two days that GM can’t continue to operate until a new U.S. administration takes over in January, York said in a Bloomberg Television interview today.

GM, Ford Motor Co. and Chrysler LLC should develop a detailed plan for sustained operations and present it to Congress as a condition of receiving support, with “chains” rather than “strings” attached, York said.

U.S. lawmakers after hearing from Wagoner, Ford chief Alan Mulally and Chrysler CEO Robert Nardelli remain deadlocked on an auto-industry bailout. Democratic congressional leaders disagreed with Republicans and President George W. Bush’s administration over how to provide $25 billion in aid to the three companies, with just two days left in Congress’ lame-duck session.

Update on September 18th: The outcome of this event has been even worse than I had anticipated. This post is updated here.  

 

The growth of the CDS market has been parabolic; a growth over 10000 percent over a period of about 10 years can easily be characterised as a bubble. In fact, the growth rate is greater than that of asset backed commercial paper, the implosion of which lies at the root of today’s problems. It remains to be seen if the CDS and bond markets will face the same consequences as asset-backed market, but there are signs that Lehman bankruptcy is providing a turnaround point to this relatively untried and unregulated field.

 

From Bloomberg: “Counterparties are being judicious in their actions at this point, given what’s happened,” said J.J. McKoan, who oversees about $65 billion as director of global credit at AllianceBernstein Holding LP in New York. “Few are willing to take on new risk positions.” In Bill Gross’ words dealers in the corporate bond and CDS market shave mostly been engaged in bookkeeping, as there’s little liquidity.

 

This lack of will to take new risk is reflected in widening spreads today. The number of corporate issues that are trading at distressed (high risk of default) levels is now close to 1100, and this is the highest level of the credit crisis. CDS indexes have also hit all time highs recently. While a brief rally in the stock market is possible in the coming days, provided that a solution to the AIG problem is found, and the Fed cuts rates, the CDS and bond markets are unlikely to participate strongly. Whether these markets will also contract or not is very important for the future of the economy.

 

Right now, contracts on Wachovia are trading at levels close to Morgan Stanley, and at 753 basis points, they are higher than the rates for Goldman Sachs, Citigroup, JPMorgan or Bank of America. CDS are strongly signalling, in this generally distressed environment, that Wachovia and Morgan Stanley present the greatest default risk.

 

Yesterday I posted about the need to follow the corporate bond market, and, here are the words of Mr. Henderson, the COO of GM, on the present state of the capital markets, via Reuters: 

“The bankruptcy filing of investment bank Lehman Brothers Holdings Inc. and the pressure on the financial sector will mean a short-term “contraction” in credit markets for corporate borrowers, General Motors COO Fritz Henderson said today.

Henderson, who was speaking to the Reuters Autos Summit in Detroit, said that the credit markets have been effectively closed to corporate borrowers except those with the highest credit ratings, but said the turmoil in the U.S. financial sector could add to the pressure.

“I would say things have been difficult already,” Henderson told Reuters. “Capital markets have been quite difficult, and this is just going to make it more so.”

He added: “We’re in for some rough waters here at least for this week if not the next couple of months.”

Henderson said GM, like other companies in restructuring, was already facing tough credit market conditions at a time when equity financing and private equity firms have also been in retreat.

“In terms of raising capital, you’ve got pretty much closed debt markets for anything other than triple-A-rated companies. You don’t have that avenue available to you,” Henderson said. “If you look at any company that’s got business challenges, the markets are very difficult to deal with.”

 

These remind of the sudden shutdown of the ABCP market last year.  The same phrases were used at that time “rough waters here at least for this week if not the next couple of months”, “closed to corporate borrowers” are the phrases we kept hearing for months, until writedowns began and financial firms resigned to the end of the securitization market.

Finally, today the Fed has left rates unchanged, but they will have to cut them soon, unless they bail out some large financial firms to calm the situation.

 

 

There’s a lot taking place today, and at times it is hard to remain updated on all that is occurring. It is better to remain distant and assess the developments once the heat of the situation has passed, but the extraordinary change in sentiment on corporate default risk is so quick and momentous that it merits more than a brief examination.

 

Lehman’s demise by itself isn’t of great importance. The firm was a significant actor in many fields, but the fall of a single firm in any field is unlikely to trigger and sustain the fears of systemic risk and financial meltdown that the markets are now experiencing. The real cause of this rapid and worrying change of sentiment in the credit markets is the sudden realisation that the government and the financial system at large are out of options. It is the failure of the fallacious notion that the pockets of the government are bottomless, that all kinds of problems can be resolved if the US government decides to print more treasuries and sell them to Asians and others. This was the idea propagated by the likes of Bill Gross, and apparently endorsed at Wall Street; but as I have repeatedly emphasised here, the financial situation of both the public and private sectors is in very questionable health, and there is no ready supply of funds available for patching all the gaps that are appearing in the financial system.

 

Bear Sterns was transferred to JPMorgan by the Fed. Merrill Lynch and Countrywide have been acquired by Bank of America. The identity of the next firebrigade is unclear; since, in the words of Mr. Gross, the head of Pimco, they are “all underwater. We, as well as our SWF and central bank counterparts, are reluctant to make additional commitments.”

 

This shouldn’t surprise. The company that Singapore’s Temasek bought doesn’t exist anymore. CIC’s investments in Citigroup, Blackstone, and Morgan Stanley are all under water as of today. But most importantly, with the disappearance of three of the most important US investment banks, the long term prospects of US firms are in doubt, and this makes raising capital and covering losses a matter of great difficulty.

 

The problems at AIG are not unique: their problem is the same problem at the root of this entire crisis, and it is leverage. The entire country, from citizens, to corporations, to the government are leveraged, and the maintenance and functioning of such a high level of leverage presupposes an environment of financial sensibility and calm. When goodwill disappears, however, what yesterday was perceived as the door to Paradise becomes the gate of Hell, and the subsequent risk aversion has the potential to ruin everything on its path, from huts, to citadels.

 

It’s quite natural to expect the Fed to cut rates tomorrow, and I claimed that this would be the outcome on my post of September 11th. I wrote that the timing would be determined by markets, and a 500 point fall in the Dow, with three month libor at 3.10, are enough to force them in this direction. But even if they choose not to, it will only be a matter of procrastination; it’s simply inconceivable that the Federal Reserve, or any central bank in its place can raise rates in this environment. Mr. Bernanke is likely to push rates down to zero eventually, but, as he’s an academic, and lacks the necessary strength of will and maybe confidence to steer the entire board to his direction through leadership, we will wait for worse data to confirm his position to see rates reach zero.

 

At the moment,  the most crucial issue is the behaviour of the corporate bond market. It remains to be seen if today’s freezing will lead to a reliving of the disaster in the securitisation markets. The implications of this outcome are beyond statement; if corporates find capital markets frozen at a time when consumers are cutting back on spending and banks are reducing credit, what will prevent a financial catastrophe?

 

Remember how the market for asset backed  securities suddenly seized up in August last year, and evaporated?

According to traders at Loomis Sayles, a bond trading firm, corporate bond market have completely seized up, and bidders have disappeared. It was “not possible to get quotes” in many cases, there was a “complete lack of liquidity”. The same case was being made for the CDS market today.

This reminds exactly of the situation in August of last year, when securities firms and brokerages found it impossible to value their asset backed securities. If this is confirmed by developments of the next few days and weeks, the significance and seriousness of this situation cannot be overemphasised.

The expectation, until recently, that no large financial firm would be allowed to fail reminds of the conviction that securities rated AAA would never lose their value. When that conviction evaporated, the markets for those assets disappeared, bringing us to where we are right now.

If this same chain of events is repeated for CDS and corporate bonds, it will lead a doubling of the economic troubles that we’re suffering today; a rapid escalation in corporate bankruptcies would be the outcome. The next few days and weeks will be crucial.

We will now see major deleveraging in a large number of firms, as derivatives, swaps and other positions to which Lehman was a counterparty are unwound. According to Bloomberg, 10 large banks including JPMorgan , Goldman Sachs and Citigroup have pooled 70 billion in a fund to create liquidity as deleveraging and unwinding of positions is taking place. As of May 31st, Lehman’s total debt is 613 billion dollars, according to Financial Times.

 

 

With respect to the CDS market, because Lehman’s bankruptcy filing came one hour after ISDA’s cancellation deadline,  there’s some fear that netting trades that were agreed between counterparties may have become useless. This would significantly complicate the counterparty risk issue. 

 

 

From FT Alphaville:

 

“The cost of insuring European corporate debt against default shot up on Monday morning, however, market participants said very little trading was actually going on and that market liquidity could be frozen for days or even longer as everyone awaited clarity on the impact of the collapse of such a large counterparty as Lehman Brothers. Traders and analysts said they hoped there might be some improvement once the US credit default swap markets opened this afternoon, but that that was far from assured.

 

“This is a big threat to the CDS markets as a whole, which is truly scary because that was the last liquid market. Here, we’re all wondering whether Lehman might have blown up the market”, said one hedge fund trader”

 

 

To deal with liquidity issues, BoE has offered 5 billion pounds for three days in an exceptional operation, attracting bids for 24.1 billion pounds. The European Central has also allotted 30 billion euros ($42.04 billion) in a one-day liquidity operation; again, there was far greater demand, with 51 bids for 90 billion euros. The Fed has increased the collateral window for PDCF to include stocks, and the amount offered on term securities lending facility has been expanded by 25 billion.

 

 

The hope is that a bottom can be found to the firesales, and liquidity issues that arise can be prevented from turning into solvency issues at any major firm.

 

 

Meanwhile, Fitch has downgraded Lehman’s long and short term issuer debt rating to D, and outstanding debt has been downgraded to C. The expectation for recovery in Lehman’s highest ranking, senior unsecured debt, is thought to be around 60 cents on the dollar, with  138 billion of Lehman’s bond debt owned by Bank of New York Mellon and Citigroup. Bank of New York Mellon’s role is that of a trustee, and the firm has no direct exposure, according to its statement. 

 

 

There’s also the issue of AIG’s rating downgrade, which could potentially be more problematic on the longer run.

 

Lehman’s CDS Risk

September 14, 2008

*See below for a list of Lehman counterparties in derivatives*

There’s right now fear of financial chaos on Monday, in case Lehman is forced into a liquidation. The problem is the size of the CDS market, and Lehman’s important role as a counterparty to a large number of deals. The CDS market is larger than the MBS, stock and treasury markets combined, and it’s unregulated. There’re often more contracts on credit insurance than there are bonds outstanding: in other words, leverage has found its way into this section of the financial markets too. Today the size of this market is 62 trillion dollar on notional amount, which means that it kept growing in size even while the stock market, commercial paper market, and the securitisation markets shrank during the last year.

Gra ph of CDS market’s size

My expectation is that Lehman’s end will happen with less trouble than some are fearing at the moment, since there has been ample time to make preparations for this widely publicized and discussed eventuality. The end of Bear Sterns was abrupt and relatively unexpected. There were rumours, but the collapse of the firm was too fast to allow a period of readjustment. In that sense, the Fed was right in bailing out Bear’s counterparties. The choice of less involvement is also the proper way of dealing with the particularities of the Lehman issue.

The size of Lehman’s CDS involvement is unknown, according to Wall Street Journal’s article. In a survey last year by Fitch Ratings, Lehman was listed among the 10 largest CDS counterparties by number of trades and the amount of debt to which the contracts were tied.

Update on CDS developments related to Lehman for September 15th is here.

Updated on September 15th, from JPMorgan, via Financial Times:

Lehman counterparty exposure

Lehman counterparty exposure

Counterparty exposure to Lehman of various major European firms. The top three are JP Morgan, UBS, and Societe Generale,  in that order. The exposure of  Deutsche Bank is in the order of 1 trillion dollars, although the actual losses on this notional amount is unclear.