Outlook 2009: CDS market remains intact after Lehman, Bear Stearns collapse; CDS may become more like bonds

By Andrea Heisinger

New York, Dec. 31 - The collapse of Lehman Brothers and Bear Stearns in 2008 was well contained, at least in the credit derivative market.

GFI Group Inc. put on a credit outlook presentation in December, covering topics such as challenges and opportunities in the U.S. CDS market, credit derivatives and the current credit environment.

The credit derivative markets continue to function, said GFI chief executive officer Michael Gooch.

"The Lehman exposure has been closed out," he said. "The system worked successfully. It [Lehman's collapse] touched every aspect of the marketplace, but it was a very smooth unwind."

After Lehman and Bear Stearns collapsed, the main question was where the dominoes would stop falling, Gooch said.

Lehman's senior debt was trading at 85 cents on the Friday before, and was at 9 cents by the Monday after, he said.

"What do you do then? It's fraught with danger."

James Higgins, the head of North American credit for GFI, said credit derivatives were blamed for the downturn of Bear, Lehman and AIG, among others.

However, the defenders of CDS say the blame is shared with ratings agencies and others, he said, adding that the cash bond market doesn't reflect pure market risk.

After Lehman was gone and Merrill Lynch was sold, really what was left was Morgan Stanley, Higgins said.

"No one knew where Morgan Stanley [CDS] was trading, and it fueled a lot of fear and uncertainty."

In 2009 and beyond, the standardized CDS contract will look more like a bond, he said.

"It will attract a wider range of financial names to use it," he said. "If they made it [CDS] have a fixed coupon it would make it easier to clear and trade."

The past year saw varied liquidity, said Francesco Cicero, head of e-trading for GFI.

The biggest activity was in January through September, and then issuance was driven by fear, he said.

"The average dealer desks were told not to take any unneeded risk," he said. "In the next year things will pick up in the spring, but there's still going to be fear in the first quarter."

Cicero also referred to Morgan Stanley's precarious position in 2008. "We were looking at the edge of a precipice and were afraid Morgan Stanley would go out of business after the Lehman collapse," he said.

This fear eventually passed as Morgan Stanley became a bank holding company, along with Goldman Sachs.

One thing that changed in 2008 was small regional banks becoming interested in credit derivatives, Cicero said.

Also, he noted that Nestle did a debt offering where the interest rate was tied to a CDS spread.

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