How Credit Default Swap Settlements Are Draining Liquidity From Interbank Market

This informative discussion that sheds further light on the stresses created by credit default swap settlements comes in the current issue of the Institutional Risk Analytics weekly, “In the Fog of Volatility, the Notional Becomes Payable“:

Another example of the ongoing discontinuity in the markets comes in the linkage between the unwind of credit default swap (“CDS”) positions written regarding Lehman Brothers, Fannie Mae and Freddie Mac, and dollar LIBOR rates in Europe.

The auction process begun by DTCC, by which holders of CDS on bankrupt Lehman Brothers settled in cash via the DTCC’s facility, caused many tongues to wag as to the “net” amount providers of protection must pay to holders of CDS. Several members of the media called last week to ask if Don Donahue, CEO of DTCC, was speaking truth when he said that the net payments on Lehman contracts processed by the DTCC’s warehouse were a mere $6 billion or so.

Of course Don Donahue is providing the straight skinny on the flow of transactions which have actually participated in the DTCC auction. But consider that other than holders of CDX and some holders of single name CDS not offended by the prospect of cash settlement, there remain a large number of total holders of CDS for Lehman who do not wish to take cash settlement and indeed are expecting to receive the underlying bonds.

Now the apparent non-event from the Lehman CDS auction is a source of media frustration. Wasn’t there supposed to be a breakdown in the CDS markets, a dramatic failure event a la Lehman Brothers? But the merchants of doom should take heart.

The bad effect of the CDS market comes not merely from when there is market dysfunction and an individual counterparty fails. That happens often enough, but the prime broker-dealers clean up the mess quietly so as not to roil the markets. Remember, the dealer already owns the counterparty’s collateral through the credit agreement, so there is no point forcing the issue with a messy and noisy bankruptcy. Right? This is why the media rarely hears of fails in CDS.

No, as with the repatriation of the Structured Investment Vehicles onto the balance sheets of C and other money center banks, the true significance of CDS comes when the markets function smoothly, as after a default event like Lehman. The trigger event putting a single name CDS contract in the money results in a liquidity-raising event for the seller of protection, who must fund the purchase of the debt at par less recovery value – whether or not the other party actually owns the debt!

This process of funding the CDS is reportedly a factor behind the high rates of dollar LIBOR in London and illustrates how cash settlement derivatives actually multiply risk without limit. Through the wonders of cash settlement, the derivative-happy squirrels at the Fed, BIS and ISDA created a liquidity-sucking monster in OTC derivatives that multiplies risk many times, for example, above the amount of underlying debt of Lehman Brothers. But remember two things: a) In some single-name CDS contracts, the buyer of protection must deliver to get paid; and b) in those contracts, where the buyer fails to deliver, the provider of protection can walk away.

We hear that there are more than a few EU banks which wrote CDS on Lehman over the past several years, CDS which were written at relatively tight spreads. These banks did not participate in the DTCC auction and instead have chosen to take delivery on the Lehman debt, forcing them to fund a nearly 100% payout on the collateral. A certain German Landesbank, for example, took delivery on $1 billion in Lehman bonds that are now worth $30 million, and had to fund same. Does this example perhaps suggest a reason why the bid side of dollar LIBOR in London has been so strong?

As one veteran CDS trader told The IRA on Friday, “It’s not that people can’t fund, it is that people have got to fund these CDS positions. These banks don’t have access to sufficient liquidity internally to fund, so they hit the London markets… The Fed and the other central banks must start to deal with the huge overhang of currently hidden funding needs from the CDS and other derivatives.” Another market observer suggests this is precisely why the Fed and other central banks have been furiously putting reciprocal currently swap lines in place.

Then there is the situation with Fannie and Freddie paper, which is currently trading 200-300 over the curve despite the Paulson quasi-nationalization this past August. Some of the very same EU banks that are getting killed on Lehman paper are also taking delivery of GSE paper on CDS positions. In this case, the payout on the CDS is small since the GSE debt is money good, at least in nominal terms, thus the net recovery value is high. But the huge overhang of paper in the markets is making the in theory “AAA” rated GSEs trade like poor quality corporates.

In both cases, the normal operation of the OTC derivatives markets is creating a cash position that must be funded in the real world and is thus distorting these benchmark cash markets such as LIBOR. This distortion is magnified by the dearth of liquidity due to the breakdown in the rules regarding valuation and price. So far, the Fed and other central banks have addressed the on-balance sheet liquidity needs of global banks. But as retail and corporate default rates rise, funding the trillions of dollars in notional off-balance sheet speculative positions in CDS, which become very real and require funding when a default occurs, could prolong the economic crisis and siphon resources away from the real economy.:

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  1. RBG

    Why do these European banks choose to take physical bond delivery? Isn’t doing cash settlement much easier for them?

    Are they betting that the actual payment will be lower if they require physical bond because not all CDS buyers have them? (But CDS buyers can buy them in the market anyway and deliver to the writer. No?)

  2. J BAz

    Requesting a little more help from Yves or other commentators to understand “what’s new” here. How does the article indicate that the CDS problem might be even worse than we’ve been supposing?

  3. Jim Pivonka

    Perhaps I could not understand the piece if it were written in English, but it would be reassuring to be able to at least read it. Is there a translation available?

  4. Richard Kline

    So if I follow Risk Analytics here, they are saying that in the Lehman settlement a significant share of CDS counterparties did _not_ in fact clear; instead, they have collateral in hock to primary dealers as pledge to their positions while they are currently frantically trying to raise the cash to actually pay out and get their collateral back. Counterparties were _not_ then fully hedged against their Lehman written swaps (and how could they all be covered, really?), but only fully pledged. The Lehman shoe dropped, then, but hit the footstool, bounced sideways, and has yet to land. Hmm.

  5. Anonymous

    Each day it becomes clearer to me why Mandelbrot and Taleb are frightened.

    If the unwind were to occur over a long time span then governments could cope. It is happening too fast.

  6. Richard Smith

    I’ve lost track – there should be another auction for CDS referencing AIG bonds soon, shouldn’t there? Can’t find a time line anywhere.

  7. ruetheday

    Re: “OTC derivatives that multiplies risk many times, for example, above the amount of underlying debt of Lehman Brothers”

    How is this possible if A) the contracts permit protection writers to request delivery of the insured bonds and B) protection writers actually are refusing cash settlement and demanding delivery of the bonds?

    It seems to me that if those two conditions hold, there is no “multiplication of risk” stemming from the multiple of CDS written on specific issues.

  8. Anonymous

    Why dont you guys give up on all this “riskology”

    The Lehman credit event took place and it was setlled smoothly despite all the rumors of an upcoming system meltdown.

    Whether a party settles physically (by delivering bonds or paying the difference between par and recovery value), the economic effect is the same, the seller of CDS has to come up with the cash to pay for the mi-judgement he made on the credit. It is as simple as that.

  9. Terry

    There is enough insider language in this article to confuse just about everyone–as the comments above indicate. Some would call that sophisticated, I would call it non-communicative.

    Yves–Can you lay out what this article is saying in straight English language? Better yet (like you don’t have enough to do!), would tell us your assessment of the implications of this line of thinking.

    Thanks–and keep up the great work!

  10. Anonymous

    My summary of the article is that the folks that caused this problem are going to suck all the current money out of the system so there is none there when real businesses come calling.

    Some call it fascism

  11. tyaresun


    What the article is saying is that instead of using DTCC to settle the net amount, many participants chose to take delivery of the assets. They now need to find money to fund taking these deliveries and hence are hitting the market for this funding. This reduces the money available for other things and raises the LIBOR.

    Some one please correct me if I am wrong.

  12. Anonymous

    No problem understanding the article.

    But I don’t buy the argument.

    Those delivering bonds are repaying their own original funding back into the market. It all nets out in the wash – not like capital, which is a net destruction.

    This isn’t whats affecting Libor.

  13. TH

    The discussion of Lehman makes sense to me, (as tyaresun described it) but does anyone understand the part of the article that tries to tie settlement of Fannie/Freddie CDSs with the irrational spreads their debt is fetching relative to Treasuries.

  14. tyaresun


    freddie/fannie spreads are too high because of oversupply. I believe one of the reasons for the oversupply is our foreign masters are unloading/not buying at previous rates.

  15. doc holiday

    Re: "The Lehman shoe dropped, then, but hit the footstool, bounced sideways, and has yet to land. "

    >> Perhaps this state of financially engineered synthetic derivative suspension is related to the existence of the hypothesized Higgs boson and of the large family of new particles predicted by supersymmetry?

    Nonetheless, one tends to want to believe that every shoe at some point must drop and that Santa has what you want in a package in a bag, on a sleigh. However, as with General Relativity, Einstein suggested that mass warps space and time, and may be able to bend light — hence, the apples falling from The Newton Tree, still may not be falling, and thus they may be suspended much like these Lehman CDS.

  16. Alfred

    This article is spot on in his suggestion of a “huge overhang of currently hidden funding needs from the CDS and other derivatives”. It hits the nerve center of the current financial crisis. If it is correct than the global financial rescue package ($3T) is nothing but a drop in the bucket.

    The Lehman bankruptcy pushed the global financial system to the brink of total collapse with the help of credit derivatives.

    I would not agree that this leads to a distortion of LIBOR. This is the free market working and reminds us on how interconnected the financial system is. After the crash of Wall Street in 1929 the first bank to fail was a European Bank located in Vienna.

  17. Anonymous

    tyaresun, you are correct in your understanding, but let point out one more time, that whether you go through the DTCC or you physically settle, the end result is the same, ie. you must come up with the money.

    So, I still question the purpose of the article. Period

  18. Alfred

    Anonymous said:
    “Those delivering bonds are repaying their own original funding back into the market. It all nets out in the wash – not like capital, which is a net destruction.
    This isn’t whats affecting Libor.”

    I would agree with the first part. The net capital destroyed is probably close to what was reported.

    The funding needs for the settlements do affect LIBOR, because of a huge increase in demand for Eurodollars. Of course this effect is magnified by a general lack of liquidity in money markets. But this lack of liquidity was for the most part caused by GSE failure and Lehman bankruptcy

  19. Alfred

    tyaresun said: “What the article is saying is that instead of using DTCC to settle the net amount, many participants chose to take delivery of the assets. They now need to find money to fund taking these deliveries and hence are hitting the market for this funding. This reduces the money available for other things and raises the LIBOR.”

    I am not sure if this is what the article is saying, but I do think that the Lehman CDS contracts have settled (The final settlement date was Oct 21, the market has found “sort of a bottom” since then!) and consequently the funding needs should have subsided by now. The deteriorating economic outlook in the last couple of weeks is preventing LIBOR from going back to more normal levels as well. If the FED cuts 50bp today we should see a strong reduction.

  20. Anonymous

    cash v. physical settle may end up at the same spot but one is a nice highway while patches of deep mud can appear along the other…

  21. Anonymous


    1) I’ve bought protection and have a huge ‘paper’ gain on my LEH CDS position

    2) The person I bought protection from wants be to deliver a bond

    3) Egads, I need to go buy an LEH bond and deliver it.

    4) Even at $0.10 on the dollar, I need to borrow $100,000,000 to buy this bond

    5) And keep my fingers crossed that the counterparty doesn’t go belly up

    Other side of the coin:

    1) The auction is a joke

    2) Bonds in bankruptcy court will probably fetch closer to $0.50 on the dollar

    3)I’m out $1 billion but if I now own the bonds.

    4) If I can finance this for awhile, I might make up half or more what I lost

  22. john bougearel

    I emailed back to Chris Whalen a note about our changing relationship to risk that is taking place:


    Yes indeed, the ground rules have shifted for economists regarding the nature of risk. And it looks like another chapter to the story of their relationship to “risk” has taken place.

    That culture of “anything-goes” relationship to risk over the past decade that destroyed the public trust and scared everyone in the world shitless in September and October 2008 reminds me of the wild game of risk played by Judy, Peter, Alan and Sarah in the movie Jumanji ~ “A Jungle Adventure. Free Game. Fun for some but not for all.”

    “In the jungle you must wait, until the dice roll 5 or 8.” This culture of anything goes with respect to risk was a giant craps game. With each roll of the dice we got sucked further into this mysterious jungle of powerfully dark forces and unimaginable fears. It was fun for those at the top before the nightmare started, but not fun for the rest of us George Jetson’s out on the dogwalk screaming “Help Jane, get me off this crazy thing!”

    The risks superimposed upon us by the folks at the top will have to be overcome in real life by the rest of us. Our relationship to the nature/game of risk will have to be restored (as you say). We certainly can not return to the anything goes culture of the past. A proper relationship to risk must be balanced with transparency throughout the system. Opaque relationships to risk must be entirely eliminated from the financial system. I like the way you have framed it.

    But, I disagree that private mkt participants do not have sufficient political savvy and wit to provide the necessary leadership and direction that must be undertaken. Yes, the same political class that caused this mess in the first place still exists and will not be dismantled. But we have this wonderful internet/blogging community coalescing and weighing on these matters from yourself, FT, Yves Smith’s blogging community at Naked Capitalism, Barry Ritholtz at The Big Picture etc….

    We have all banded together in recent months to create an ad hoc forum that provides fruitful instruction and guidance for our political regime to follow. How else did Paulson go from buying troubled assets at make-believe prices to buying preferred stock in troubled banks to provide needed capital? Granted, it is only one step in a series, but it is nevertheless a step towards an appropriate outcome. I see our voice as a critical and hopefully influential input. The political regimes ability to respond appropriately to our input is critical to establishing appropriate outcomes – namely restoring a proper relationship to risk we can all live with.

    John Bougearel

  23. tom a taxpayer

    Based on the article, it appears there are hundreds of more shoes to drop. I agree with anonymous @ 7:45am.

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