AIG’s CDS Unwinding: A Messy and Expensive Process

Businessweek’s staff editor Ben Levisohn wrote an informative piece today (Monday) on the process of unwinding AIG’s credit default swaps [CDS], (insurance policies purchased against the default of various forms of debt) that needless to say will be a messy and expensive one. Here are few excerpts from the article:

So what’s so hard about unwinding a CDS?

Part of the problem is that not only are the financial instruments themselves complicated, but they involve tangled relationships of companies and investors, each with their own interests. AIG owns $1.5 trillion in derivatives, including CDSs, interest rate swaps, and currency swaps, among others….Since everyone knows that AIG needs to rip up its contracts, its partners are holding out for the best deal possible.

There is no centralized market for derivatives, so AIG’s traders in Wilton, Conn.; London; Paris; and Tokyo can’t just look at a PC screen and see the current price, as a trader would do with a stock. Instead they look at the available data on…interest rates and the earnings of the companies whose debt is insured, and then use mathematical models to determine what they want to pay….At the same time, the trader has to figure out the overall impact the trade will have on AIG’s book.

Because they are contracts between two parties, AIG’s credit default swaps can’t simply be sold. Some will expire on their own, like the $234 billion of swaps that are expected to come off the books in the next year and a half. Others will be terminated at the request of the owner. AIG can opt to let the contracts expire. But $34 billion worth of CDSs is set to run down over the next five—or more—years, which would seem to run counter to its avowed plan to wind the contracts down as quickly as possible. If AIG wants out, it will have to go back to the other side of those trades and negotiate an exit.

That won’t be easy—or cheap. CDSs are still trading, but the spreads….have widened, making it more expensive to get out.

“The Street knows they have to unwind positions,” says TABB Group’s Kevin McPartland, an analyst who specializes in derivatives. “It gives AIG little pricing power.” [via BW]

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