Press Release: Moody's report explores CDS impact of Lehman Brothers' bankruptcy

          The bankruptcy of Lehman Brothers has put the CDS market to an unprecedented test and has resulted in losses in the hundreds of millions dollars for a number of Moody's-rated firms, but these CDS market disruptions have not, in and of themselves, resulted in the downgrade of any rated company to date, Moody's Investors Service concludes in a new report.
          Moody's, however, also sees the possible failure or failures of other large CDS market participants as a continuing source of systemic risk. In Moody's opinion, it is highly unlikely that the CDS market would have been able to deal effectively with a simultaneous default by AIG -- probably the largest net seller of CDS protection.
          A survey conducted by Moody's of the major Moody's-rated banks and insurance firms active in the CDS market suggests that the overall market has fared better than many observers had anticipated. "Lehman's bankruptcy, although resulting in sizable losses for a number of market participants, did not lead to the unraveling of the CDS market," Moody's VP/Analyst Alexander Yavorsky concludes.
          Still, he adds that the emergency unwinding of Lehman's CDS book by major dealers and hedge funds though the "Risk Reduction Trading Session" on the weekend preceding Lehman's anticipated bankruptcy filing demonstrates that the over-the-counter CDS market is "ill-equipped to reliably deal with such events."
          Given Lehman's role as a major CDS dealer, its default and the resultant credit spread widening left its CDS counterparties needing to replace lost protection at much higher prices. For a number of the major CDS dealers, this resulted in losses that, while substantial, did not fall outside of the range that could be tolerated at any company's rating level at the time.
          Moody's noted that major dealers also did not suffer losses in excess of their ratings-tolerance on CDS contracts referencing Lehman Brothers as an obligor, despite the low auction-determined settlement price of 8.625 cents on the dollar for Lehman's senior bonds.
          "Many dealers had flat or net short CDS exposure to Lehman's credit as a way to hedge their counterparty exposure to the firm," Moody's Yavorsky explains.
          The report also discusses what Yavorsky characterizes as "encouraging progress" among market participants and regulators to move the CDS market, or at least a portion of it, to a central counterparty model. If implemented effectively, a central clearinghouse could substantially reduce, although not completely eliminate, counterparty and trade replacement risks. It could also impose economic limits on effective leverage and excessive credit exposure by requiring protection sellers to post appropriate initial margin.
          The report "Credit Default Swaps: Market, Systemic, and Individual Firm Risks in Practice" follows another study published by Moody's earlier this year to highlight some of the key risks of the CDS market, the most significant of which the rating agency concluded at the time was the consequences of a possible default by a major dealer.
          In addition to the report, Moody's will host a teleconference to discuss its opinion on the credit default swaps market on Monday, October 31st at 01:00pm EDT. Visit www.moodys.com/events for further information.