Lehman CDS Final Settlement: Payout of 91.375

All I can say is “ouch”.

The theory is that for every loser there is a winner, but in this market with financial players at risk of failure due to hits to weak equity bases and/or runs, we have a serious asymmetry. A significant loss to an important intermediary, either directly, via CDS payouts, or indirectly, via say forced liquidations by hedge fund leading to distressed prices in instruments they hold, compelling them to recognize losses, would be another blow to b barely functioning markets.

As we have said, the theory was that the major protection writers hedged their positions via offsetting CDS. We’ll soon see how accurate that view was.

Some commentary from Bloomberg:

Based on the results, sellers of protection may need to make cash payments of more than $270 billion, BNP Paribas SA strategist Andrea Cicione in London said. The potential payout is higher than the 90.25 cents indicated by initial results from the auction earlier today. Lehman bonds traded yesterday at 13 cents on the dollar, suggesting a payout of about 87 cents was expected.

No one knows exactly how much is at stake because there’s no central exchange or system for reporting trades. It’s that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market. More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman.

The list of participants includes Newport Beach, California-based Pacific Investment Management Co., manager of the world’s largest bond fund, Chicago-based hedge fund manager Citadel Investment Group LLC and American International Group Inc., the New York-based insurer taken over by the government, according to the International Swaps and Derivatives Association in New York.

Auction details at CreditFixings (hat tip reader Saboor):

Print Friendly, PDF & Email


  1. Anonymous

    Could someone explain to me or point me in the direction of an article explaining how protection writers supposedly hedge their positions? I’m not clear on this.

  2. Anonymous

    Well another milestone passed and no big events. This weekend should be fun, I guess no one in the G7 will get any sleep. Look for FED and paulson to start equity for cash in the major banks, still trying to free up the capaital markets.

  3. bena gyerek



    i think i understand how the process works now.

    this auction determines the final price affecting all bilateral cds contracts, and therefore the cash settlement payment from protection seller to protection buyer. the final price is 8.625%, so the cash settlement amount is 91.325% (100% – final price) of contract notional.

    the dozen or so dealers listed are the institutions that participated in the auction. i expect the amounts shown in the table “Physical Settlement Requests” is the net notional amount in usd mm that each dealer bid / offered. i think this must reflect the net cds position of the relevant dealer prior to the auction (i.e. bnp offered 390mm bonds, meaning it is probably long 390mm cds protection).

    note that most dealers would appear to be net auction offerers / net long cds protection, which makes sense as they would have bought protection against their significant counterparty exposure to lehman prior to the latter’s bankruptcy. the overall net offered position of 4.92bn probably reflects the net long cds protection position of the banks, where the protection sellers are probably hedge funds and insurance companies.

    i would therefore infer that hedge funds / ins cos have to pay out a net cash settlement to these dealers under cds contracts equal to 4.5bn = 4.92bn x (100% – 8.625%).

    as lehamn was trading at 13c immediately prior to the auction, it is likely these net protection sellers will already have had to post 4.28bn in cash collateral, meaning that for the final settlement of these contracts they have to stump up an additional 220mm in cash.

    no bankruptcies today i suspect.

    nb i just saw that citi, boa, jpm are among the few stocks that rallied today. aig took another big hit, down 20%. probably reflects who was on the right side of the surprisingly low final price in the auction..

  4. Bill H

    no one seems to be aware that 90% of all credit OTC trades are matched and fully automated in the DTCC Trade Information Warehouse. Should anyone want to know the net positions of any player in this Market, a call to DTCC will get you the answer.


  5. Been there

    “The theory is that for every loser there is a winner, but in this market with financial players at risk of failure due to hits to weak equity bases and/or runs, we have a serious asymmetry…”

    I’ve been wondering how the CDS losses have gotten so high, as have the related MBS and CDO values, when only a small percentage of total borrowers are actually defaulting upon their obligations.

    Then it occurred to me. It seems probable, that through their financial wizardry, the former masters of the universe fraudulently increased the value of the mortgage securities that were ultimately sold. For example, isn’t likely that these guys would gather up a billion dollars of mortgages… pool, mix, slice and dice them… then through the pure obfuscation of the process… $1.5 billion pops out the other side that then gets sold to the ultimate investors.

    The ratings agencies were the enablers by assigning unreasonably high credit ratings to the fraudulent investment products as they came off the assembly line.

    It would explain part of the asymmetry that’s showing up now. The winners were the multiple tiers of middlemen that extracted profits on the inflated security values, during each step of the process.

    Don’t know if it’s possible, but I wish there was a way to measure the total value of mortgage inputs on the front end to the total value of the mortgage backed security outputs that got distributed on the back end. Might be able to uncover some smoking gun evidence that way.

    Want to restore confidence. Nail these jokers. All of them.

  6. Anonymous

    Yves, Can you explain why there is so much hoopla about the $400B of outstanding CDS as the reason for the banks to be hoarding cash, when the MTM mechanism would have forced most CDS protection sellers to post collateral already (ie the difference btwn 91c payout vs 80-90c that they already should have posted by now isn’t that large). Why would they be hoarding that much cash because of the relatively small final settlement?

  7. bena gyerek

    anonymous @ 9.40

    i think this auction is a big red herring, and you just nailed the real issue.

    hedge funds and insurance cos were bit net sellers of cds protection. as cds spreads blew out, the sellers were required by the banks (their counterparts) to post more and more cash collateral. to fund these margin calls, they had to liquidate whatever liquid assets they owned (e.g. stocks).

    note that this margin call problem arises under all cds contracts, and has nothing to do with whether they have been triggered by a default / bankruptcy of the underlying credit (as in the case of lehman).

  8. Yves Smith

    Your assumptions are incorrect. CDS were never traded. This is an unregulated product (for the instruments to be tradable, they’d need to be securities under applicable law, and they aren’t. That is why hedging is via offsetting contracts, for instance).

    Since this was not traded, and never repoed or borrowed against, why would there be any margin requirements? They only come about contractually, and they were and are a joke:

    Firms that sold premium or Credit Default Swaps were not even required to put up a substantial margin, less than pennies on the dollar, which means that any firm that bought bond insurance against potential default risk of debtors were basically uninsured if they ever had to make a claim. The entire market was so undercapitalized that it is nothing short of criminal neglect to have allowed this avalanche of default liability to escalate to levels that were reached. This was a scam no different than unscrupulous fly-by-night life insurance companies that sell innocent people a promise without the intention of ever paying a claim.

    We have written extensively about counterparty risk. It is a real issue and has the potential all by itself to bring down our financial house of cards.

Comments are closed.