Fed to hold derivative clearance talks!

NEW YORK - October 6, 2008 - Banks are hoarding cash in expectation of payouts on up to $400bn of defaulted credit derivatives (CDs) linked to Lehman Brothers and other institutions, according to analysts and ­dealers.

This added pressure on the frozen financial system comes as authorities prepare to meet participants in the so-far unregulated $54,000bn credit derivatives market to speed up plans for the creation of a central clearing house.

The Federal Reserve will meet dealers, investors and exchange executives in New York on Tuesday. Although big dealers had committed to setting up a central counterparty by the end of the year, urgency has increased in light of the collapse of banks around the world and as company bankruptcies loom.

“The New York Fed will hold a meeting Tuesday with a small number of banks and buy side firms to discuss the progress being made toward the creation of a central counterparty for credit default swaps,” said a Fed official, adding that this would “help reduce systemic risk associated with counterparty credit exposure and improve how the failure of a major participant would be addressed”.

Credit default swaps, a form of insurance against bond defaults, are the most common type of credit derivative. On Monday, the default of up to $500bn in derivative contracts linked to Fannie Mae and Freddie Mac was settled, the biggest such exercise ever carried out.

“We now clearly have the capacity to handle very large-scale settlements,” said Tom Price, managing director at Markit.

The Fannie and Freddie CDs settled at between 91.5 and 99.9 cents on the dollar, reflecting the fact its underlying debt is not in default after the mortgage groups were seized by the U.S. government. The seizure did trigger defaults on derivatives, however.

The next test will be the unwinding of CDs linked to Lehman, which filed for bankruptcy three weeks ago. Michael Hampden-Turner, a credit strategist at Citi, estimates that there could be $400bn of credit derivatives referenced to Lehman.

These contracts will be settled on Friday, and with the recovery value on Lehman bonds currently estimated at about 10 cents on the dollar, the payout by banks and other sellers of credit protection on Lehman could reach a gross $360bn.