The Financial Times headline reads “Bad news on Lehman CDS” when by most readers’ standards, the content is almost entirely good news. It elaborates on and generally confirms the report that we posted earlier from the DTCC, that the net exposures on Lehman credit default swaps by major protection writers was in fact minor. However, as noted in an earlier post, that does not eliminate the possibility that hedge side of a position might fail (that is, a trade to offset the protection written), since hedge funds were reported to have been protection writers too. Even if their involvement was minor in aggregate, it could turn out to be significant for particular firms.
The bad news is that a further Lehman settlement happens on Monday and it appears the prices will be tweaked somewhat lower.
Note the use of the term settlement in the article is somewhat confusing. The auction prices will be set tomorrow. but the actual payment does not occur then. A reader said that the final day for the payment is October 21. While we have not seen the details in the media, the payments would clearly not take place on the date of the auction.
From the Financial Times (hat tip reader Tim):
The pay-outs on around $400bn of defaulted credit derivatives linked to Lehman Brothers are likely to be higher than anticipated after initial results from auctions to settle these credit default swaps resulted in a lower recovery price.
The initial auction results were settled at 9.75 cents in the dollar, meaning banks and other investors who had agreed to make these payments in the event of Lehman’s default will have to pay out 90.25 cents on the dollar.
The final auction for Lehman credit default swaps (CDS) was due to settle in the New York afternoon. The final prices were likely to be lower than the initial ones because there were a lot more sellers of bonds to settle the auctions than buyers, according to traders.
There have been widespread concerns that the prospect of these payouts – the gross value of which is roughly $360bn – is contributing to banks’ hoarding of cash. As well as Lehman’s default, the steady collapse of banks will require pay-outs on other credit derivatives, such as Washington Mutual and three Icelandic banks.
Eraj Shirvani, chairman of International Swaps and Derivatives Association (ISDA), the industry body that manages the auctions, said these concerns were misplaced. “Sellers of protection mark their positions to market every single day. So those firms have already marked down and provided collateral against their positions. As a result, there should be little or no unanticipated additional cost involved in the settlement of Lehman CDS,” said Mr Shirvani, who is co-head of European credit at Credit Suisse.Net exposures were usually around two per cent of the gross amount, which vastly reduced the potential cashflows. Assuming $360bn of gross exposure, this would translate into $7.2bn if these estimates are correct.
“Despite immoderate claims relating to the magnitude of the Lehman settlement, these are insignificant when put into the context of $5 trillion in payments on foreign exchange transactions that occur each and every day,” he said.
The settlement of the Lehman CDS highlights the plunge in value of the debt of the investment bank, which filed for bankruptcy nearly four weeks ago. With around $130bn of outstanding bonds, holders of this debt have made severe losses. The bonds were trading at around 80 cents on the dollar just days before Lehman collapsed. The value of Lehman Brothers’ near-$130bn of outstanding bonds plunged to a new low of 8.5 cents on the dollar after initial prices set on credit derivatives linked to Lehman Brothers came in lower than anticipated.