AIG woes could swat swap markets
The fast-growing credit-default swap markets, already jolted by Lehman, could get clipped if the insurer can't right itself.
NEW YORK (Fortune) -- If the death of Lehman Brothers upset the financial world, a collapse at AIG would have turned the credit markets upside down.
That's because AIG is more deeply involved than Lehman was in the fast-growing market for a kind of derivative called a credit default swap.
On Tuesday night, the Federal Reserve Board announced an $85 billion rescue plan.
A credit default swap is like an insurance contract. One side buys protection against the threat of default by a company, a municipality or a package of debt backed by, say, residential mortgages. That buyer pays the seller a premium over a set time period. The seller pays out if the default occurs.
Swaps trading has become a major part of the financial system. The market, which relies heavily on borrowed money, is notionally nearly three times as large as the U.S. stock market. It touches most every major financial institution, hedge fund, and mutual fund manager in the world.
Moreover, the swaps market ballooned in size before it could be tested by an economic downturn, in which defaults rise and players facing credit downgrades have to pony up additional capital to back their positions. That in turn could lead to more losses in the financial system, which would make credit generally harder to come by for consumers and businesses.
"I feel a little bit like the citizens of New Orleans after Katrina hit and everyone breathed a sigh of relief... right before the levees collapsed," says Steve Cesinger, chief financial officer at private equity firm Dewberry Capital.
Because there were so few defaults over the past few years, mutual funds, investment banks and insurers like AIG wrote lots of swap contracts as an easy way to make money. It was like writing auto insurance policies in a world with no car accidents.
AIG (AIG, Fortune 500) sold protection on nearly $600 billion of fixed income assets in the form of credit default swaps - including $57.8 billion tied to subprime mortgages.
If AIG should end up in bankruptcy and isn't there to stand behind those contracts, players who wrote swaps insuring against an AIG debt default will have to come up with payments that could reach well into the billions of dollars.
In addition to investors who may lose AIG as a counterparty, there are lots who will also suffer because they assumed that the insurance giant would never default. Among the potential losers in the event of a default are some big financial players like Pimco, whose Bill Gross manages the world's largest bond fund.
Pimco has sold credit default swaps that guarantee $760 million of debt issued by AIG, according to Bloomberg. Should AIG file bankruptcy, Pimco would likely have to pay out on those swaps.
An AIG default is far from the only risk facing the California-based bond investor in the credit default swap market. Pimco had sold insurance on a total of $7.7 billion of bonds, including $4.8 billion issued by financial-services companies, as of the end of June.
But the possible losses at well capitalized firms such as Pimco are only the beginning. Among the fears investors harbor is that less deep-pocketed firms, such as hedge funds, won't be able to meet their obligations in the event of a default - causing even investors who thought they had hedged against the prospect of, say, an AIG bankruptcy to take losses on their holdings of AIG debt.
Lehman's role in the swaps market was different than AIG's. In the absence of an official swaps exchange, Lehman performed the role of matching buyers and sellers, called counterparties, and it often stood behind contracts.
That's an important job because of how opaque the swaps market is. Contracts are sold many times over. So when it comes time for party A to collect from party B, say a major U.S. bank, it may have already sold the contract to a German bank. That bank in turn may have sold the contract to a hedge fund, and so on.
"Like [Warren] Buffett said, the tide has gone out and we're really seeing which people are swimming naked," says Bob Sloan, whose S3 Partners finances and advises hedge funds. "It could get very interesting because for the hedge funds this is new territory."
A lot of the outcome, Sloan says, depends on how well investors negotiated their contracts.
The total size of the swaps market approaches $62 trillion, though that figure includes positions which are often off-setting. Still, potential losses are huge. In a report released earlier this year, Barclays credit analysts said that a major counterparty that had $2 trillion outstanding in credit derivatives could in a worst case scenario see $36 billion to $47 billion in losses.
"There is a lot of suspicion and continued fear on Wall Street vis a vis counterparty risk, and people want to hoard cash," says Jason Brady, a bond portfolio manager at Thornburg Asset Management. "We're in a state of limbo."
Lehman's demise could have the positive effect of forcing the swaps market to become more transparent, says Don Marron, who runs Lightyear Capital, a buyout fund that specializes in the financial services space.
An official exchange for derivatives could even be in the cards, though outsiders have advocated that outcome for years, with little success. Until now, derivatives deals have been a major profit center on Wall Street, though perhaps this month's brush with disaster will change execs' thinking.
"The vested interests in this market have resisted the idea of an exchange so they could remain unregulated and do whatever they want, says Jim Robinson, who led American Express when Lehman was a unit of the credit card juggernaut. "Hopefully wiser heads will see it's in no one's interest to continue to put the system at risk." 
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