$65 Trillion credit defaults swap is unregulated

What happens tomorrow to billions of dollars worth of an arcane investment instrument called a credit-default swap could determine whether the frozen credit markets can regain liquidity.

The swaps -- a type of quasi insurance for investments -- were written against $110 billion worth of senior debt from Lehman Brothers Inc., an investment bank that filed for bankruptcy protection last month.

That debt has gone into default and the organizations that issue the swaps to guarantee the debt are supposed to pay up tomorrow.

But no one knows if they have the money to do so. It will be first major test of these complicated financial instruments in the current credit crisis, said Kent Engelke, chief economic strategist for Capitol Securities Management in Richmond.

Many economists say a key cause of the financial crisis is the lack of transparency in instruments such as credit-default swaps, making it difficult to value assets.

Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corp., said in remarks this week to the National Association for Business Economics that the leveraging of debt through instruments such as credit-default swaps could be the painfully huge lesson of 2008.

Q: What is a credit-default swap?

A: It's insurance against an investment, but it isn't regulated, so it is not real insurance, Engelke said.

The company issuing the swap is not required to maintain capital reserves to back it as an insurance company would.

Q: How does it work?

An investor, for example, buys $1 million worth of bonds to leverage even more debt and then buys a credit-default swap for a fee from a private-equity group, insurance company or hedge fund to protect the initial investment.

One twist: Investors can buy insurance on a security without having to buy the security itself. This has created a market in which speculators are betting that mortgage-backed securities will lose their value.

Q: What happens if the swaps on the Lehman debt are not settled?

A: "It will send a major tremor through the market," Engelke said.

"There is the potential that any remaining confidence in the financial system will be gone."

"We will question all these other hedges. Are they worth anything or are they just worth a piece of paper?"

Q: What happens if the swaps are settled?

If the debt is paid, the markets should settle down and the measures that have been taken to shore up the financial system, including the Fed's lowering of a key interest rate yesterday, should begin to have an effect.

"If settlement is a nonevent, I think there will be a distinct probability short-term credit markets will begin to show signs of liquidity," Engelke said.

Q: How much money is invested in credit-default swaps?

A: It's difficult to estimate, because the market is unregulated.

However, the International Swaps and Derivatives Association, a trade group, estimates the total value of outstanding at $54.6 trillion.

That's nearly four times the entire U.S. production of goods and services.

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