A tough spot

I’ll be thinking out loud about the tough spot of a seller of a distressed CDS. I’m trying to figure out how the Lehman auction would transpire.

Let’s see an example of how swaps trade:

ABC Corporation may have its credit default swaps currently trading at 265 basis points.
In other words, the cost to insure 10 million euros of its debt would
be 265,000 euros per annum. If the same CDS had been trading at 170
basis points a year before, it would indicate that markets now view ABC
as facing a greater risk of default on its obligations.

Let me get myself into a seller’s shoes.

If I’m in trouble because I’ve been selling CDS swaps (insuring companies’ debts) like there’s no tomorrow, and collecting the fat annual swap (premium) income, the only way I see that I can extract myself out of the bind I’m in –supposing companies are defaulting on their debt–, is to buy back enough swaps of the same company to cover my fannie.

I also know there are a lot more swaps out there than needed to cover the debt –something like ten times, so there is a good chance I can get my hands into the few that I desperately need to get out of the corner I’m in.

Trouble is buyers are sitting pretty, in what may be a freight-car full of cash, if the company bonds go under –and, they know it.

Trouble for the swap buyer is collecting, if I go under, they collect ‘nada’.

Now, what the heck is the Fed going to do with all my swap contracts?

Ok. My bulb is dim, but beggining to produce the goods. In essence through the price discovery of the swap auction, the Fed will discover how much it will cost to buy the swaps to get me out of trouble. Considering a mix of bad apples and not so bad ones, there will be a final tally of the cost to clear my swap obligations, and I would expect at this point that the Fed will require my soul in exchange –or the same as prefered stock– and will lend me the rest to survive, if the price of my stock is so degraded.

Fair enough.