Merrill Lynch & Co. has publicly opened the door to what many believe could be an even larger problem to the credit markets than the widely publicized sub-prime mortgage debacle – the little understood and sledom discussed “swaps” market.
Perhaps the world’s most high-profile financial firm, Merrill – itself a frequent complainer about lawsuits – has filed a monster of a suit in a New York court against bond insurer Security Capital Assurance Ltd. (SCA). Merrill Lynch sued the insurer alleging it failed to honor seven contracts promising to cover losses on $3.1 billion in “credit swaps,” after which SCA filed a countersuit against Merrill for $28 million. .
Merrill claims SCA walked away from signed insurance contracts guaranteeing Merrill against losses. SCA counterclaims that Merrill broke a stipulation in one of the contracts which entitles SCA to terminate all the agreements and collect damages. (Perhaps Merrill is getting a taste of what many us have experienced: an insurance company happy to collect premiums but which later relies on a technicality to avoid payment.)
Under the contracts, SCA says it was granted “control rights” over the CDOs, meaning it had control over decisions affecting the investments. SCA alleges that “Merrill Lynch made the decision to blatantly ignore its prior commitments,” when, in a “rushed campaign” to dump risk from its books, Merrill Lynch promised such control rights to others.
Yet, some believe the greater importance of this suit is that it reveals the tip of the iceberg regarding the exposure of the world’s financial institutions to the multi-trillion dollar “swaps” market. The swap contracts in question were agreements to cover missed payments on collateralized-debt obligations, but an untold amount of “swaps” agreements outstanding cover more possibilities and circumstances than most of us can imagine!
Because the “swaps market” is almost totally unregulated and involves agreements eerily similar to those engineered at Enron, few publicly venture a guess as to the gravety of the exposure to the financial markets should such swap agreements simply began to unwind.
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