Sept. 16 (Bloomberg) -- A year after the bankruptcy of Lehman Brothers Holdings Inc., credit-default swaps have lost their stigma for disaster and are contributing to the growing confidence in the credit markets.

The cost to protect against a failure by New York-based Goldman Sachs Group Inc., Charlotte, North Carolina-based Bank of America Corp., and 12 of the other biggest derivatives dealers dropped 66 percent in the past six months, according to an index of swaps compiled by Credit Derivatives Research LLC. While the U.S. struggles with the slowest recovery since 1945, the market where investors protect themselves from default and speculate on corporate debt shows confidence is the highest since June 2008.

Credit-default swaps worsened the biggest financial crisis since the 1930s as the meltdown of Lehman and American International Group Inc., two of the largest traders, caused a seizure in lending. Now, Wall Street is accelerating reforms Treasury Secretary Timothy Geithner started in 2005 when he was president of the New York Federal Reserve to increase transparency in a market lawmakers plan to regulate.

“A functioning credit-default swaps market contributes to more efficient extension of credit” by giving investors and lenders confidence that the industry won’t implode, said Alexander Yavorsky, a senior analyst at Moody’s Investors Service in New York. The consequences of Lehman’s failure “were astronomical, broadly speaking, but the CDS market worked well,” he said.

Receding Concerns

Credit-default swaps pay the buyer face value in exchange for the underlying bonds or the cash equivalent should a company fail to meet its debt obligations. Prices rise when perceptions of creditworthiness deteriorate and fall when they improve.

Banks have had unparalleled access to money after Federal Reserve Chairman Ben S. Bernanke reduced the target rate for overnight loans between banks to a range of zero to 0.25 percent, from 5.25 percent in 2007. The Fed and the government spent, lent or committed $12.8 trillion to revive the economy.

One result is that expectations another big financial institution will fail have receded. Credit Derivatives Research’s Counterparty Risk Index, which measures default swaps on 14 firms, has dropped to 104 basis points, after peaking on March 9 at a record 305.6 basis points, or 3.056 percentage points. That means it costs an average of $104,000 a year for a credit-default swap protecting $10 million of debt.

The Libor-OIS spread, a gauge of banks’ reluctance to lend, contracted to 0.11 percentage point yesterday from a peak of 3.64 percentage points in October. Former Fed Chairman Alan Greenspan said in June 2008 he would consider credit markets back to “normal” if the spread was 0.25 percentage point.

Record Bond Sales

In addition to supporting banks by lowering rates and providing financing for troubled loans, Bernanke has succeeded in this year’s goal of reducing the cost of credit for consumers.

Companies have issued a record $2.6 trillion of debt this year in dollars, euros, pounds and yen, the fastest pace on record and up 21 percent from 2008, according to data compiled by Bloomberg.

The gap between borrowing costs for investment-grade rated U.S. corporations and the government narrowed to 242 basis points on Sept. 11, the slimmest margin since February 2008 and down from a record 656 basis points on Dec. 5, Merrill Lynch & Co. indexes show. The decline means a company would save $41 million in annual interest on $1 billion of bonds sold.

Rates on 30-year mortgages average 1.82 percentage points more than 10-year Treasuries, down from 3.27 percentage points in December, according to North Palm Beach, Florida-based Bankrate.com.

Lehman, AIG

Credit markets seized up after New York-based Lehman, then the fourth-largest U.S. securities firm, filed for bankruptcy protection on Sept. 15, 2008, and the government bailed out New York-based insurer AIG with an $85 billion investment a day later. That amount ballooned to $182.5 billion.

AIG needed to be rescued after handing over more than $18 billion in collateral tied to credit swaps sold to banks including Goldman Sachs and Societe Generale SA. The insurer had sold about $400 billion of swaps protecting against losses on securities backed by U.S. subprime mortgages and corporate loans.

The downfall of Lehman, which was founded in 1850, and AIG, at one point the world’s biggest insurer, raised concerns that no financial institution was safe. Markets for short-term credit locked up.

Credit Rates

The benchmark rate banks charged each other for three-month dollar loans, the London interbank offered rate, almost doubled in a month to 4.82 percent, British Bankers’ Association data show. The Dow Jones Industrial Average fell 43 percent over the next six months to the lowest level in six years.

New York Attorney General Andrew Cuomo began investigating whether credit-default swaps were manipulated to spread rumors about financial companies and drive down stock prices, a person in his office who asked not to be identified by name said at the time.

President Barack Obama said in a June 17 speech on his plans for finance industry regulatory reform that credit swaps and other derivatives “have threatened the entire financial system.”

U.S. Congresswoman Maxine Waters, a California Democrat, introduced a bill in July that tried to ban credit-default swaps because she said they permitted speculation responsible for bringing the financial system to its knees.

Wall Street responded to rising criticism in late 2008 by bringing more order to the market, which was developed more than a decade ago by traders at New York-based JPMorgan Chase & Co. as a way for banks to hedge against losses on corporate loans.

Scraps of Paper

Contracts outstanding exploded from less than $632 billion in the first half of 2001 to as much as $62 trillion at the end of 2007, almost 10 times the amount of U.S. government debt outstanding, according to surveys by the International Swaps and Derivatives Association, a trade group based in New York.

The market grew so fast that dealers couldn’t keep up with the administrative details. Former Fed Chairman Alan Greenspan said in 2006 that trades often were recorded on scraps of paper.

Banks want to show regulators the market doesn’t need fixing from outsiders. Canceling redundant trades cut the overall notional amount of credit-swap contracts almost in half to $32 trillion as of last week, according to data compiled by New York-based Depository Trust & Clearing Corp.

Clearinghouse

This year more than 2,100 institutions agreed to standard terms to make the privately negotiated contracts easier to trade. For the first time they’re being processed through a clearinghouse, reducing the chance that one party will fail to make payments. About $2.5 trillion of swaps have been cleared since March. None of the almost 50 auctions that have been held to settle swaps tied to borrowers who defaulted over the past year have failed.

“The only market that I know of that seems to have worked virtually every day has been the CDS market,” Eraj Shirvani, chairman of ISDA and Credit Suisse Group AG’s head of fixed income for Europe, the Middle East and Africa, told reporters yesterday at the industry group’s regional meeting in New York.

George Soros says the market is still unsafe. The 79-year- old billionaire investor said in an interview that credit- default swaps are “toxic” and “a very dangerous derivative” because it’s easier and potentially more profitable for investors to bet against companies using them than through so- called short sales.

‘Toxic’ Instrument

The market “held up because it was effectively put on artificial life support” by government bailouts, said Soros, chairman of New York-based hedge fund Soros Fund Management, which has $24 billion under management. “It is a toxic instrument, and if people want to forget it, I think they’ll regret it.”

Lawmakers from Washington to Brussels are considering regulations to oversee the market. In the U.S., the Justice Department said it’s examining potentially anticompetitive practices related to clearing, trading and information services.

“We believe there are massive risks that have gone undetected by both market participants and regulators,” said U.S. Treasury spokesman Andrew Williams. “That’s why we’re working with Congress to bring greater transparency and regulation to these markets.”

The Obama administration sent Congress proposed legislation last month that would require the most active contracts in the $592 trillion over-the-counter derivatives market to be backed by clearinghouses and traded either on an exchange or on regulated systems.

Fixed Premiums

Derivatives are contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather. Unlike exchanges, the business is unregulated and prices aren’t public.

Dealers and investors in the U.S. agreed in April to buy and sell swaps for fixed annual premiums and an upfront exchange of cash that fluctuates with market values, similar to how bonds trade in an effort to make the market more uniform. Europe followed in July.

U.S. premiums are set at either 100 basis points or 500 basis points, meaning buyers pay an upfront fee and $100,000 or $500,000 annually to protect $10 million of bonds from default for five years.

Previously, no upfront payments were required on contracts trading below 800 basis points, and the annual payment was set based on current market values.

Dealers’ Committee

The industry also created a committee of banks and investors that determines when contracts must be settled, rather than leaving the decisions open to dispute among traders. The swaps now are automatically resolved at auction when the committee rules a default or bankruptcy has occurred.

At Geithner’s urging, dealers no longer reassign counterparties on a trade without the written consent of all parties in the contract. Banks also cut the amount of time it takes to confirm trades to less than a day, from about 17 days in 2005, according to data compiled by London-based Markit Group Ltd. and the Fed.

“The healing and transformation of derivatives started back with Geithner and the Fed trying to change the way derivatives were traded before the crisis hit,” René Canezin, head of global high-yield trading at Barclays Capital in New York, said.

Although trading is now dominated by a smaller number of dealers, according to a Fitch Ratings survey last month, the reduction of contracts outstanding and the move toward clearing has lowered the risk of default by any one bank.

‘Blood Pressure Medicine’

“It’s kind of like blood pressure medicine,” said Athanassios Diplas, global head of counterparty portfolio management in New York at Frankfurt-based Deutsche Bank AG. “You lowered the pressure so the body could function. Even though they represented net-zero economic risk, it did represent a lot of counterparty risk.”

Two weeks after introducing her bill, Waters said she would be open to other ideas to keep the market going while cracking down on abuses. Waters didn’t return calls for comment.

Fed officials now say that for all the concern about the fallout from Lehman’s bankruptcy, the effect on the business of the derivatives market was negligible.

Unwinding derivatives trades including credit-default swaps that Lehman held “was operationally complex, but it wasn’t a systemic problem,” said Theo Lubke, the senior vice president of the New York Fed who is responsible for the central bank’s efforts to curb risks in the OTC market.

“The industry is starting to feel the future is not looking as bleak as it was in terms of what regulations would be imposed,” said Jeremy Jennings-Mares, a partner in the capital markets group at Morrison & Foerster LLP in London. “There was a concern that regulation would not be well suited to the market and its proper functioning. Recent news has helped assuage those concerns somewhat.”

To contact the reporter on this story: Abigail Moses in London at Amoses5@bloomberg.net; Shannon D. Harrington in New York at sharrington6@bloomberg.net.

Last Updated: September 16, 2009 08:54 EDT