Best news of last week: the unregulated free market did not collapse

It's an arcane topic and that's probably why you haven't heard much about it, but the settlement of $400 billion of credit default swaps on Lehman bonds that occurred a few hours prior to Friday's market close was a major positive event. You can read a lot of the details here, here and here, but here's my quick summary:

For the past two weeks the market had feared the results of an auction that was to be held last Friday to determine the settlement price of credit default swaps on Lehman bonds, an event that was triggered by the government's earlier takeover of Lehman. Some $400 billion in CDS contracts were at stake. No one really knew who was going to end up owing how much money to whom. Major dealers might end up on the hook for hundreds of billions if their counterparties failed. As the auction approached, those who were on the losing end of the swaps (those who had sold protection) were selling assets to raise money in case their counterparties failed and they had to make good on their swaps. In addition to precautionary sales of assets, many others did their best to avoid exposure to the banks and dealers rumored to have potentially large and losing positions. This all added up to intense fear among major market players, and that in turn probably explains why short-maturity swap spreads soared in the past two weeks.

In the end, it was almost a nonevent. In the greatest story of this crisis not yet told, the private market mechanism set up to handle the settlement of the swaps worked perfectly. Collateral requirements in place from the beginning ensured that money was available to make payments to those who had purchased protection. Major dealers had offset most of their exposure with other counterparties, and the counterparties came through (no doubt thanks to collateral requirements). The net amount of money that changed hands was only a small fraction of what many had feared.

(When you hear that outstanding swap contracts have a notional amount on the order of many tens of trillions of dollars, that doesn't equate to the actual or net exposure that is in the system. If Dealer A sells protection to Investor B, Dealer A might also buy protection from Investor C to end up with no exposure; Dealer A is simply a middleman. But the two contracts are different, and so their notional amount is counted twice. The only risk to Dealer A is that Investor B might not deliver on his promise. But collateral arrangements built into CDS contracts are there to mitigate that risk, requiring the party on the losing side of the swap to post collateral to cover his potential loss. As a rule of thumb, the net exposure of any given notional amount of CDS contracts is a very small fraction of the total notional amount; probably something on the order of 2% or so. This makes swaps a lot less scary than most people think.)

So while everyone feared that major dealers and banks might end up exhausting their capital and triggering mass cascading bankruptcies last Friday, the private sector, without the help of the government, managed to settle a huge amount of CDS transactions with no government oversight, no government bailouts, and no government agencies, and all in the space of a few hours.

The relief that ensued in the wake of the successful settlement was probably the trigger for the ferocious rally that the market staged in the closing hour on Friday.

That might be the key to marking a bottom in the market, but now attention turns to the auction for the settlement of the Washington Mutual CDS contracts, which is scheduled for October 23. I would be willing to bet that will go off without a hitch, just as the Lehman settlement did, but the market is going to be worried nonetheless so we're not completely out of the woods yet.

In any event, I feel a lot better about the carnage of last week, because I now understand the source of the fear that had virtually paralyzed the market. Those fears proved groundless, and that's a big step in a positive direction. Politicians, please take note: the private market can work wonders, if government refrains from meddling. More regulation is not the cure for this crisis.

UPDATE: The WaMu CDS auction went off without a hitch Oct. 23rd, according to the CDS clearing house DTCC. Derivatives have not contributed to the current financial crisis.