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Lehman Collapse Spurs Call for Credit Derivatives Clearinghouse

By Shannon D. Harrington
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Sept. 16 (Bloomberg) -- Banks may accelerate efforts to move trading in the $62 trillion credit-default swaps market through a central clearinghouse or to an exchange after the bankruptcy of Lehman Brothers Holdings Inc. and the credit downgrade of American International Group Inc.

Lehman, the first major market-maker to go bankrupt in the decade-long history of the privately negotiated, unregulated business, may leave behind billions of dollars in potential losses for trading partners, according to Barclays Plc of London. No one knows exactly how much because there''s no central exchange or system for recording trades.

``The fact that I can''t tell you the notional value of derivatives contracts Lehman has written the day after a bankruptcy is a scary thing,'''' Brian Yelvington, a strategist at New York-based bond research firm CreditSights Inc., said yesterday.

A clearinghouse capitalized by owners could have reduced the risks because it becomes the so-called counterparty, for a fee, to each side of the trade. Now, banks are sifting through trading positions to ``net'''' trades that offset each other and reduce potential losses. Untangling that web may last into 2009, said John Jay, a senior analyst at Boston-based Aite Group, a financial services consulting firm.

``Just figuring out what they have could take a week, but the thornier issue is to figure out valuations,'''' said Jay. ``It''s a Gordian knot because you have different ratings, different counterparties, different end-dates and you have to somehow attach a value to these contracts. It''s an operational nightmare and a legal nightmare of interpreting what each contract says.''''

AIG Concerns

The Markit CDX North America Investment Grade Index, which rises as confidence in companies deteriorates, climbed as high as 195 basis points yesterday, from 152 basis points at the close of trading on Sept. 12, according to broker Phoenix Partners Group. The index reached a record 200 during an emergency trading session on Sunday, Sept. 14 as investors tried to prepare for the collapse of New York-based Lehman. A basis point is 0.01 percentage point.

Prices continued to rise in Europe and Asia today after credit ratings on AIG, the biggest U.S. insurer by assets, were cut by Standard & Poor''s and Moody''s Investors Service.

European, Asian CDS

Contracts on the Markit iTraxx Crossover Index of 50 companies in Europe with mostly high-risk, high-yield credit ratings climbed 33.5 basis points to 627.5, according to JPMorgan Chase & Co. prices at 7:19 a.m. in London. The Markit iTraxx Australia Series 9 Index increased 35 basis points to 220 basis points, matching the all-time high of March 17 when Bear Stearns Cos. was bailed out by the Federal Reserve, according to ABN Amro Holding NV.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. Each contract is a separate agreement between two so-called counterparties and trades in over-the-counter transactions, leaving parties exposed to the risk that their partner will default.

Barclays analysts estimated in February that if a financial institution that had $2 trillion in credit-default swap trades outstanding were to fail, it might trigger between $36 billion and $47 billion in losses for those that traded with the firm. That doesn''t include the market-value losses investors face as the cost to protect companies against a default widens.

``There should be some central agency which prevents risk in the future of a large counterparty failing and causing losses,'''' said Puneet Sharma, the head of investment-grade credit strategy at Barclays Capital, the U.K.''s third-biggest bank. ``This was not necessary.''''

Wall Street created credit-default swaps more than a decade ago to help banks hedge against loan losses. Dealers later came up with contracts and indexes that allowed investors to speculate on a borrower''s creditworthiness without owning any bonds.

100-Fold

The market grew 100-fold in the past seven years leaving dealers, who until a few years ago recorded trades on scraps of paper, struggling to keep up. New York Fed President Timothy Geithner assembled dealers in September 2005 to develop a plan to reduce the backlog of paperwork and unconfirmed trades.

In July the 17 dealers agreed to form a clearinghouse, create a system to better manage the collateral that protects trading partners from losses and tear up offsetting contracts to reduce the number of positions that banks have to oversee.

The clearinghouse may fall behind schedule, delaying completion until next year, said a person familiar with the process who asked not to be identified last week because the discussions weren''t made public. The development was postponed after the Fed pushed Chicago-based Clearing Corp. to obtain a banking license, which would place it under the central bank''s watch, the person said.

Clearing Corp.

A spokesman for the Federal Reserve Bank of New York, Andrew Williams, declined to comment. Clearing Corp. spokesman Andy Merrill declined to comment, pointing to a statement last week that the company ``and its clearing participants have been moving aggressively to prepare the CDS platform for launch as soon as the appropriate regulatory approvals are achieved.''''

``The industry''s progress in building a strong foundation for our business will enable it to successfully address current issues,'''' said Eraj Shirvani, chairman of the International Swaps and Derivatives Association and head of European credit at Credit Suisse Group in London, said yesterday in a statement.

Clearing Corp. said it will guarantee trades between dealers, at least at first, and only contracts on benchmark indexes rather than on individual companies.

`Different Architecture''

``We''ve got to come up with a different architecture,'''' said Carlos Mendez, senior managing director at Institutional Credit Partners, a New York-based hedge fund with $13 billion in assets. ``Right now, we''re just doing what we can, but we''re in essence concentrating risk when we should be spreading risk. And I think that''s what the government is not quite grasping right now.''''

The Lehman failure may also increase efforts to move trading to an exchange. Chicago-based CME Group Inc. and Chicago Board Options Exchange both have offered contracts that mimic credit- default swaps.

``If we were going to see a catalyst to bring over-the- counter trading on to an exchange, this is the time when we will see it,'''' said Bill Cline, a former Accenture Ltd. partner who founded his own financial services consulting company in Pawleys Island, South Carolina, this year. ``When investors don''t feel they have a transparent view as to the risk they''re are taking, then that really undermines investors confidence.''''

To contact the reporter on this story: Shannon Harrington in New York at Sharrington6@bloomberg.net
Last Updated: September 16, 2008 02:33 EDT