Worries are mounting that some banks and hedge funds that sold credit default swaps (CDS) on Lehman Brothers' debt might not have enough cash to make the big payouts they promised.
The settlement date is today, Tuesday, October 21 which means that a transfer of cash must be completed. That's when CDS, which guarantee to compensate trading partners for losses on Lehman bonds, need to be paid out.
Credit analysts predict some firms could take a huge financial hit amounting to billions of dollars in combined losses.
"I believe it was a tragic error for the Fed to allow Lehman to go under," Weil, Gotshal & Manges Senior Partner Harvey Miller told CBS News. Miller who is currently overseeing the Lehman Brothers bankruptcy added, "It's not a contained situation."
The concern is whether the paying side of the swap will be able to make their payments. Swap sellers are required to make up the difference on the price of the debt if a company goes bankrupt. Because the price of the Lehman debt was set at 8.625 cents, it means Some of the biggest players on Wall Street will now have to pay 91-cents-on-the-dollar for those contracts, if they can afford to.
If the sellers of the swaps can't afford to pay up, the counterparty who bought the so-called protection will be forced to take the losses as well.
Outstanding Lehman Brothers' CDS have an estimated value of $400 billion.
No one knows just how many CDS have been traded or whose balance sheet they are on because the market for these swaps is unregulated. The International Swaps and Derivatives Association recently estimated the market at $54.6 trillion. But since there is no central clearinghouse, trade volume can't be tracked and publicly posted.
The Depository Trust and Clearing Corporation (DTCC) put out a press release last week saying that worries about Lehman swaps are overblown. DTCC, which runs its own voluntary trade registry, says outstanding CDS only total $6 billion.
"That's the sunny side of the street," said Satyajit Das, a former derivatives trader and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.
Das says the $6 billion figure assumes that all of the sellers took out additional investments to effectively cancel out the risk they had with Lehman but believes this is not the case, particularly with hedge funds.
The CDS market doesn't require financial firms to keep capital in reserve in case they have to pay off their bets.
Das says he thinks there will be some problems tomorrow in terms of the payout but says this is the first sign of just how deep the CDS problem could run. "This is a test for the market, but there will be a lot more to come," said Das.
By Kim Lengle