The Next Wave

We are truly experiencing a post modern financial crisis. Uncertainty abounds. No one knows when the next wave is going to hit, or how big it's going to be. A front runner for churning out the next financial tsunami is the turbulence in the credit default swap market caused by the Lehman Brothers bankruptcy. Credit default swaps are a form of insurance sold to protect the buyer of a fixed income product from a default. In Lehman's case a buyer of Lehman's bonds could, as many apparently did, buy credit default swaps to insure against a Lehman default. By declaring bankruptcy Lehman has essentially defaulted on its bonds and the parties that insured those bonds now have to pay up. But no one knows how big a payment those parties have to make or whether they have the money.

This unknown liability on the part of the insuring parties could in turn set off a chain reaction of defaults by the parties if the combination of their credit default swap liabilities and their other liabilities exceed their assets and they are unable to get credit to meet their obligations because the credit markets are frozen. And if those defaulting counter parties' liabilities are in turn insured by credit default swaps, the next wave is going to get bigger. Lehman's default could lead to the default of parties that insured the Lehman debt, and the default of those parties could lead to the default of additional parties who insured the debts of the Lehman parties. This is one of the reasons the government is bailing out AIG: the concern that the failure of one party in the credit default swap market would lead to a wave of defaults .

It doesn't help that you don't have to own the underlying bond to buy a credit default swap for it. This fact results in the possibility that the liabilities of the Lehman credit default swap counter parties could be greater than the actual debt that Lehman issued if more than one party bought a credit default swap on the same bond.

What makes this whole thing post modern is that no one knows the extent of the Lehman credit default swap party liability because there is no central clearinghouse for credit default swaps that can provide this information. Essentially the credit default market as a whole behaved irrationally in that it acted as if the possibility of a large scale default was non-existent, and thus the necessary market mechanisms to cope with a large scale default never emerged. This was a direct result of a lack of regulation of the derivative markets.