CDS losses are going to sink some funds Monday, October 06, 2008
With a number of financial institutions going under, receiving state aid or being nationalised, large payouts under credit default swaps ("CDS") are looming since these constitute credit events under any normal contract.
Payouts under CDS contracts are typically determined via an auction for the debt - the deficit between the auction price and par being the payout. This week defaulted credit derivatives linked to Fannie Mae and Freddie Mac were settled at 92 to 93 cents in the dollar. With up to $500bn of credit derivatives linked to them, this could mean pay-outs of $35-40bn by sellers of default protection.
Due to the OTC nature of CDS deals, the identity of the end holders of these losses i.e. the "insurers", are not a matter of public record. Hence, worries abound regarding who will have to absorb these losses and their ability to settle the claims. These concerns are further fuelling the panic in the markets since it could result in further collapses. Hedge funds, insurers and banks are all potential "victims".