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Commentary

Three Iceland banks CDS auctions completed, exposure > Lehman

Three auctions for Credit Default Swaps of the three Icelandic banks that failed (Glitnir, Landsbanki and Kaupthing) have been completed today. (CDS is basically insurance against default – a bond holder can buy a CDS to ensure he gets paid if the bond issuer defaults, and all three banks have defaulted. To settle the CDS, an auction is held)

The settlement adds up to an astounding $7.3 billion – an amount greater than the Lehman CDS trade:

Three auctions in three days set the payouts for Landsbanki Islands at about 99 percent, for Glitnir at more than 97 percent and for Kaupthing at more than 93 percent, based on numbers provided by auction administrators Markit and Creditex.

The date for sellers of protection to hand over the cash is set for Nov. 20.

Analysts expect these payments to have little effect on financial markets, however, because there was little difference between the auction results and underlying bond prices.

Protection sellers have already had to put up almost the entire payment amount as collateral in the weeks leading up to the auction as the market values of the banks’ debt declined.

The notional value of net exposures in the credit derivatives market are $1.8 billion for Landsbanki, $2 billion for Glitnir and $3.8 billion for Kaupthing, or $7.6 billion altogether, according to calculations by the Depository Trust & Clearing Corp. (DTCC), which operates the central electronic registry for the market.

The combined payout of around $7.3 billion exceeds the net cash payments of around $5.2 billion for settling CDS for Lehman Brothers and $1.3 billion for Washington Mutual , according to DTCC data.

Credit strategists at BNP Paribas caution, however, that registration with the DTCC is voluntary, does not include all trades in the market, and so could understate cash transfers.

For those more interested in specifics, go here for full details.

No impact on the markets, as the money’s been put up already. Fantastic. But this will mean more deleveraging, and perhaps downgrades because of huge lost capital. Not much transparency in this market, but how deep in the smelly stuff are the banks in?

Bloomberg certainly thinks there’s a problem, it seems:

The most comprehensive report on unregulated credit-default swaps didn’t disclose bets in the section of the more than $47 trillion market that helped destroy American International Group Inc., once the world’s biggest insurer.

A report by the Depository Trust and Clearing Corp. doesn’t include privately negotiated credit-default swaps that insurers such as AIG, MBIA Inc. and Ambac Financial Group Inc. sold to guarantee securities known as collateralized debt obligations. It includes only a “small fraction” of contracts linked to mortgage securities, according to Andrea Cicione at BNP Paribas SA in London.

New York-based DTCC’s data, released on its Web site Nov. 4, showed a total $33.6 trillion of transactions on governments, companies and asset-backed securities worldwide, based on gross numbers. While designed to ease concerns about the amount of risk banks and investors amassed on borrowers from companies to homeowners, the report may have missed as much as 40 percent of the trades outstanding in the market, Cicione said.

The data are “likely to underestimate the amount of net CDS exposure,” Cicione, who correctly forecast in January that the cost of protecting European companies from default would rise, said in an interview. “A broadening of the coverage to the entire market is what investors really need.”

This is pretty bad – if it gets out of hand, the market will be littered with graves. I have a feeling it’s already gotten out of hand.

And one of the insurers who has had CDS exposure – Ambac – has been downgraded by Moody’s today. If they go bust, then that triggers counterparty issues – some joker sitting happy on a CDS bought from Ambac, thinking he doesn’t care about defaults because Ambac will pay, suddenly has to take the hit. And this could be anything – Ambac’s main business used to even be muni-bond insurance. Ahem.

Trickle, trickle, trickle.

And suddenly the dam will burst.

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