In William Dudley‘s very informative speech on the what and why of the investment bank failures, there is a very interesting footnote:
One final factor that was important in exacerbating the funding crises was the novation of over-the-counter (OTC) derivative exposures away from a troubled dealer. In a novation, a customer asks a different dealer to stand in between the customer and the distressed dealer. This process results in the outflow of cash collateral from the distressed dealer. The novation of OTC derivatives was an important factor behind the liquidity crises at both Bear Stearns and Lehman Brothers.
Dudley cites three sources of the failure:
(i) withdrawal of repo credit backed by illiquid assets
(ii) loss of primary dealer accounts, and
(iii) drain on cash collateral via novation of OTC derivatives
Given the aggressive action in the credit default swap (CDS) market that was demanded by the NYFed after the Bear Stearns failure, I think that it is safe to conclude that the novation of CDS was an important source of cash outflow for Bear Stearns. This is worth noting because one periodically runs into claims by financial market participants that CDS markets operated effectively throughout the crisis and that CDS are being unfairly targeted by people who don’t understand them.
I suspect that when the full history of the Bear Stearns collapse is written, CDS will play a non-trivial role in the story.
