Reader Tim sent us a link to a press release from The Depository Trust and Clearing Corporation which says that the net payout on Lehman credit default swaps will be comparatively minor, a mere $6 billion, versus the gross exposure, which has been widely reported as in excess of $400 billion. If this proves correct, that will be the best news we have heard for some time, since one of the unknowns hanging over the market has been the prospect of further bank failures resulting from Lehman payouts.
DTCC’s report, if accurate, is consistent with the industry’s claim that protection writers hedged their exposures, and in this market, the only effective way to do so was by entering into an offsetting swap).
The problem is that even if many of the trades were hedged, for any dealer, the quality of its hedges depends on the quality of its counterparties. Even though CDS protection-writing was concentrated among a short list of names (all big suspects), hedge funds were also writing protection. So way BigBank had $30 billion of Lehman CDS exposures, $15 billion each way. Let’s say 15% of the protection was written by hedge funds that can’t make good. That leaves a $2.25 billion failure, which multiplied by the payout, is a $2 billion loss. In this environment, any meaningful losses would be a source of worry.
A reader reported that the settlement date for the Lehman auction (held last week) is October 21, so we cannot be certain the market has passed this test until then.
From the DTCC (boldface theirs):
DTCC Addresses Misconceptions About the Credit Default Swap Market
NEW YORK–(BUSINESS WIRE)–
The idea that the industry lacks a central registry for over-the-counter (OTC) credit default swaps (CDS) is grossly misleading and has resulted in inaccurate speculation on a number of matters, including the overall size of the market, its role in the mortgage crisis, and the size of potential payment obligations under credit default swaps relating to Lehman Brothers. The extent to which such speculation has fueled last week’s market turmoil is difficult to determine. The facts are these:
Central Trade Registry
In November 2006, The Depository Trust and Clearing Corporation (DTCC) established its automated Trade Information Warehouse as the electronic central registry for credit default swaps. Since that time, the vast majority of credit default swaps traded have been registered in the Warehouse. In addition, all of the major global credit default swap dealers have registered in the Warehouse the vast majority all contracts executed among each other before that date….
One of the many central servicing functions of the Trade Information Warehouse is to calculate payments due on registered contracts, including cash payments due upon the occurrence of the insolvency of any company on which the contracts are written. Calculated amounts are netted on a bilateral basis, and then, for firms electing to use the service, transmitted to CLS Bank (the world’s central settlement bank for foreign exchange) where they are combined with foreign exchange settlement obligations and settled on a multi-lateral net basis. Currently, all major global credit default swap dealers use CLS Bank to settle obligations under credit default swaps. It is expected that all major institutional players in the credit default swap market will use the same process for settlement by the end of 2009.
The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range (in U.S. dollar equivalents).