Meltdown's Next Issue: Settling Trillions in Credit Default Swaps

(MoneyWatch)  One of the next shoes to drop in the financial crisis will soon clunk down at a privately-held clearing house on Wall Street.

The Depository Trust and Clearing Corp., which settles debts related to finance, will plow into resolving what could be trillions of dollars worth of unregulated credit default swap contracts.

A CDS is a protection arrangement designed to insure against loan defaults. In the financial meltdown, problem CDS contracts have related mostly to securitized mortgage obligations.

Now that several major financial institutions have failed or are being bought out because of bad mortgage lending, trillions of dollars worth of CDS instruments needed to be settled. How much they would fetch and whether they can be settled are major questions that, if unresolved, could touch off yet another wave of Wall Street angst. Estimates of the CDS market range from $35 trillion to $55 trillion.

The DTCC typically holds auctions to dispose of troubled assets, yet how much value CDS contracts retain is a major issue. For example, an auction earlier this month determined that investors who held protection against a default by bankrupt Lehman Brothers got a little more than 91 cents on each dollar of protection purchased. DTCC holds something like $72 billion of CDS contracts on Lehman alone.

CDS holders worried about not only about how much of a haircut they face, but whether the debtors will be able to pay. With huge banking bailouts now gearing up, the chances of major reneging seem slight. But if it happens, the financial markets could be rocked anew.

Regulators worry that CDS are uncharted terrtiroy since they are mostly unregulated. According to Eric Dinallo, New York state's top insurance regulator:

Credit default swaps played a major role in the financial problems at AIG, Bear Stearns and the bond insurance companies.... But, just as with short selling of stock, most swaps are now used by speculators who do not own the bonds and the value of swaps outstanding are generally much more than the value of a company's debt."