Even though credit default swaps (CDS) are basically insurance policies against the default of a bond issuer, many investors had used these securities to take a view on a particular credit event. The major bankruptcies that occurred in the fall of 2008 caught some investors in these contracts off guard; after all, a major CDS event had not occurred since Delphi in November 2005.

The events of the fall of 2008 were a test of the systems that settle credit default swaps. This article will explore what happens to CDS holders when a company experiences a credit event. We'll look at what happened in the Lehman Brothers (OTC:LEHMQ) failure as an example. (To learn more, read Case Study: The Collapse Of Lehman Brothers.)

The Basics of Single-Name Credit Default Swaps
To understand the credit event auction default process, it is helpful to have a general understanding of single-name credit default swaps. A single-name CDS is a derivative in which the underlying instrument is a reference obligation, or a bond of a particular issuer or reference entity.

Credit default swaps have two sides to the trade: a buyer of protection and a seller of protection. The buyer of protection is insuring against the loss of principal in case of default by the bond issuer. Therefore, credit default swaps are structured so that if the reference entity experiences a credit event, the buyer of protection receives payment from the seller of protection. (For more on credit default swaps, see our article Credit Default Swaps.)

Credit Event
In the CDS world, a credit event is a trigger that causes the buyer of protection to terminate and settle the contract. Credit events are agreed upon at the time the trade is entered into and are part of the contract. The majority of single-name CDSs are traded with the following credit events as triggers: reference entity bankruptcy, failure to pay, obligation acceleration, repudiation and moratorium.

Physical vs. Cash Settlement
When a credit event occurs, settlement of the CDS contract can be either physical or in cash. In the past, credit events were settled via physical settlement. This means that buyers of protection actually delivered a bond to the seller of protection for par. This worked fine if the CDS contract holder actually held the underlying bond.

As CDSs grew in popularity, they were used less as a hedging tool, and more as a way to make a bet on certain credits. In fact, the number of CDS contracts written outstrips the number of cash bonds they are based on. This would create an operational nightmare if all CDS buyers of protection chose to physically settle the bonds. A more efficient way of settling CDS contracts needed to be considered.

To that end, cash settlement was introduced to more efficiently settle single-name CDS contracts when credit events occurred. Cash settlement better reflects the intent of the majority of participants in the single-name CDS market, as the instrument moved from a hedging tool to a speculation, or credit-view, tool.

CDS Settlement Process Evolves
As CDSs had evolved into a credit trading tool, the default settlement process needed to evolve as well. The volume of CDS contracts written is much larger than the number of physical bonds. In this environment, cash settlement is superior to physical settlement.

In an effort to make cash settlement even more transparent, the credit event auction was developed. Credit event auctions set a price for all market participants that choose to cash settle.

The credit event auction under the International Swaps and Derivatives Association (ISDA) global protocol was initiated in 2005. When buyers and sellers of protection submit to adhere to the protocol of a particular bankrupt entity, they are formally agreeing to settle their credit derivative contracts via the auction process.

To participate, they must submit an adherence letter to ISDA via email. This occurs for every credit event. In other words, you would have to formally submit a letter for Fannie Mae (NYSE:FNM), a separate one for Lehman Brothers, a separate one for Washington Mutual (OTC:WAMUQ), etc. The auction process is described below.

Credit Default Auctions
Buyers and sellers of protection participating in the credit event auction have a choice between cash settlement and what is effectively physical settlement. Physical settlement in the auction process means you settle on your net buy or sell position - not every contract. This is superior to the previous method as it reduces the amount of bond trading needed to settle all of the contracts.

There are two consecutive parts to the auction process. The first stage involves requests for physical settlement and the dealer market process where the inside market midpoint (IMM) is set. Dealers place orders for the debt of the company that has undergone a credit event. The range of prices received is used to calculate the IMM (for the exact calculation used, visit http://www.creditex.com/).

In addition to the IMM being set, the dealer market is used to determine the size and direction of the open interest (net buy or net sell). The IMM is published for viewing and then used in the second stage of the auction.

After the IMM is published, along with the size and direction of the open interest, participants can decide if they would like to submit limit orders for the auction. Limit orders submitted are then matched to open interest orders. This is the second stage of the process.

The Lehman Brothers Auction
The Lehman Brothers failure in September 2008 provided a true test of the procedures and systems developed to settle credit derivatives. The auction, which occurred on October 10, 2008, set a price of 8.625 cents on the dollar for Lehman Brothers debt. It was estimated that between $6 billion and $8 billion changed hands during the cash settlement of the CDS auction. Recoveries for Fannie Mae and Freddie Mac (NYSE:FRE) were 91.51 and 94.00, respectively. (To learn more, read How Fannie Mae And Freddie Mac Were Saved.)

Recoveries were much higher for the mortgage-finance companies placed into conservatorship, as the U.S. government backed the debt of these companies.

What does the price of 8.625 mean? It means that the sellers of protection on Lehman CDS will have to pay 91.375 cents on the dollar to buyers of protection to settle and terminate the contracts via the Lehman Protocol auction process.

In other words, if you had held Lehman Brothers bonds and had bought protection via a CDS contract, you would have received 91.375 cents on the dollar. This would offset your losses on the cash bonds you held. You would have expected to receive par, or 100, when they matured, but would have only received their recovery value after the bankruptcy process concluded. Instead, since you bought protection with a CDS contract, you receive 91.375.

The CDS "Big Bang"
Further improvements and standardization of CDS contracts continue to be made. Together, the various changes being implemented have been called the "Big Bang".

In 2009, new CDS contracts will begin trading with a fixed coupon of 100 or 500 basis points, with the upfront payment differing based on the perceived credit risk of the underlying bond issuer.

Another improvement is to make the auction process a standard part of the new CDS contract. Under current contracts, the auction process is voluntary or an "opt-in" and investors have to sign up for each protocol individually, increasing administration costs. Investors will now have to "opt-out" of the protocol if they would like to settle their contracts outside of the auction process (using a preapproved list of deliverable obligations).

The Bottom Line
All of the changes to CDS contracts should make single-name credit default swaps more popular and easier to trade. This is representative of the evolution and maturity of any financial product. (To learn more about CDSs, check out Credit Default Swaps: An Introduction.)

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