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The Next $350 Billion Hole

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Tomorrow will be a massive test for the credit default swaps market as dealers and investors get together to determine the settlement value of credit default swaps (CDSs) on failed broker Lehman Brothers. With approximately $400 billion in notional amount of swaps outstanding, if the swaps settle at 12.5 cents on the dollar (which is where Lehman’s reference bonds are trading), swap sellers could face losses totaling $350 billion.

That was no error: The figure is $350 billion -- half the amount of the Paulson bailout plan. For comparison, it’s almost ten times the CDS losses due to the nationalization of mortgage giants Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) .

More for the survivors to choke on
To add insult to injury, Lehman’s bankruptcy puts more pressure on the large swaps dealers that remain who must fill the vacuum in supply and take on more risk. These dealers include Goldman Sachs (NYSE: GS  ) , Morgan Stanley (NYSE: MS  ) , Merrill Lynch (NYSE: MER  ) and JPMorgan Chase (NYSE: JPM  ) .

Lehman isn’t the last hurdle for the CDS market, either. At the end of the second quarter, AIG’s (NYSE: AIG  ) AIG Financial Products unit had almost $450 billion in exposure to credit default swaps, which was instrumental in the insurer’s downfall.

Final losses are highly uncertain
One glimmer of hope: The loss numbers I cite are gross losses. Imagine two CDSs with respective losses to the seller of $500 million and $400 million. Gross losses total $900 million; however, if a CDS dealer sold the first and bought the second, net losses to the dealer are only $100 million. Unfortunately, due to the lack of transparency in the market, it’s anyone’s guess as to what degree losses may offset each other.

In a speech he delivered yesterday, SEC Chairman Cox urged lawmakers to increase oversight of the CDS market. That may help to avert a future crisis, but in the meantime, we may be inching closer and closer to Buffett’s nightmare scenario.

More credit crisis Foolishness:

Paying dividends forces companies to be disciplined. Perhaps it’s no coincidence that the bank that is riding out the current crisis best – JPMorgan Chase – has been a Motley Fool Income Investor recommendation for over three years. To find out the service’s latest recommendations, take a 30-day free trial today.

Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. JPMorgan Chase is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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