Tomorrow's Lehman Auction: Why You Should Care

Tomorrow, the credit default swaps backed by bankrupt investment bank titan Lehman Brothers will be settled.

What does that mean and why should you care?

The credit default swaps -- along with the mortgage-backed securities you've been reading so much about -- were one of the financial instruments at the heart of the current credit crisis.

A credit default swap, or CDS, is essentially an insurance policy against default on a debt. It's explained quite nicely here in this passage from a Time magazine article from March 17 of this year:

"Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default...The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.

Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded -- or swapped -- from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends -- the insured and the insurer.

All of this makes it tough for banks to value the insurance contracts and the securities on their books."

And the Lehman auction tomorrow will do just that: Begin to place a value on the CDSs that had been backed by Lehman.

Because no one is really sure what the Lehman CDSs are worth, there's no way of telling how much the auction will bring. Some fear the CDSs will settle for only pennies on the dollar.

What does it mean for taxpayers?

Many believe that the main force behind the credit market freeze that's preventing you from getting a student loan or your business from getting a bridge loan at a decent rate is that lenders are waiting on the Lehman auction.

It could cost billions to settle these CDSs, leading to greater losses in the financial sector, a thought that scares big investors.

The auction may give the federal government an idea of what to pay for the toxic assets when Treasury Secretary Hank Paulson and his protege, Neel Kashkari, begin spending the $700 billion Wall Street bailout/rescue in the next several weeks.

Also: It may give the government an idea of what the toxic assets will eventually be worth when they are sold back into the private sector over the next year or so. Those who are most bullish on the bailout/rescue plan imagine a windfall profit for taxpayers when the toxic assets are sold back.

We'll know more after tomorrow's auction.

-- Frank Ahrens

October 9, 2008; 3:04 PM ET  | Category:  business
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Please email us to report offensive comments.

Credit Default Swaps were pure and simple FRAUD. Nothing complicated about it.

Posted by: Jim West | October 9, 2008 3:44 PM

Based on this article, and if we tend to accept the definition given by Time Magazine for "Credit Default Swaps", in my opinion these so called contracts of insurance against defaults is void abinitio. Atleast one party to the contract knew more about the risk and he deliberately concealed those "material" facts. This contract is therefore null & void under law. That these CDS were given a "rating" by some Rating Agency has no relevance. A fraud is a fraud; and any contract based on a fraud is no contract at all.Those who perpetrated it and fooled the financial institutions thr world over
must be asked to pay the highest penalty
under International law.

All those who were abetters to this crime
must be brought to books too and punished.
This is a CRIME ON HUMANITY and must be
dealt with accordingly similar to the way Law deals with International crime/faud sydicates.

I fully endorse Mr. Jim West.

Posted by: usatya31 | October 10, 2008 10:05 AM

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