Lehman derivatives bill: Bad, but not a disaster?

Wall Street has been worried all week about the hit some financial firms would take from the settlement of credit default swaps -- basically, insurance policies -- on bonds of bankrupt Lehman Bros. Holdings Inc.

One theory has been that hedge funds and other firms that wrote the insurance have been selling stocks and other assets all week to raise cash for the payments they’ll owe on those derivatives.

The final results are in from the auction held today to calculate those payments, Bloomberg News reports:

Sellers of credit-default protection on Lehman will have to pay holders 91.375 cents on the dollar, setting up the biggest-ever payout in the $55-trillion market.

An auction to determine the size of the settlement on Lehman credit-default swaps set a value of 8.625 cents on the dollar for the debt, according to Creditfixings.com, a website run by auction administrators Creditex Group Inc. and Markit Group Ltd.

Based on the results, sellers of protection may need to make cash payments of more than $270 billion to the buyers, BNP Paribas 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 Thursday at 13 cents on the dollar, suggesting a payout of about 87 cents was expected.

But some estimates I’ve seen suggest that the final cash payments could be modest -- in the billions of dollars, but not hundreds of billions.

As Bloomberg notes:

Banks and investors typically make offsetting trades to hedge their positions, and likely have already posted collateral as the market value of the contracts fall, so the actual amount they need to come up with will be much less, Bank of America Corp. credit strategist Jeffrey Rosenberg said in a note to clients.

"Fears surrounding the Lehman auction settlement are overblown," Rosenberg said. "The economic impact of the Lehman bankruptcy through CDS contracts has for the most part already occurred."

Unfortunately, we don't know, and won't know, because many of these are private transactions that will stay private. They may become public only if some firms that wrote insurance can't pay what they owe and end up failing themselves.

Comments

[Mr.Bilko]

If Bank of America's Jeffrey Rosenberg is correct and the actual credit default settlements are in the billions, not the $300B to $425B range that some feared, then the credit crunch should be easing if not coming to an end altogether. A final Lehman settlement in the billions versus $300B range means there is less of a reason for banks to hoard cash as they have been doing. This should also mean that the two week stock sell off should be coming to an end.

[furiouscalves]

well we would know how much money it is going to be if these securities were traded in a regulated public market. and this whole "crisis" deal probably would not have happened. thanks for thinking it out guys. smart.

EPIC FAIL.

[Mikey]

If all these banks only owe eachother these settlements then why not just null and void all the CDS obligations. Nobody wins nobody loses. If there are Lehamn bondholders who need paying then all hundreds of global banks could stump together and cover those easily.

These stinking CDS are evil and should have been banned years ago. Having only recently read enough about them to understand the mecahnics, i am shocked they were allowed at all.

They could seriously have brought civilisation to a standstill. I dont think this will happen beause no more "systematic" banks will be allowed to fail, but this shows how close we came to economic armegedon.

[Greenwich Advisor]

The Depository Trust and Clearing Corporation which operates the Trade Information Warehouse through which the vast majority of traded Credit Default Swaps are registered has calculated on Saturday that the "net" (net of offsetting hedges) payments resulting from the Lehman default will be $6 Billion. http://www.dtcc.com/news/press/releases/2008/. This is a far cry from what is being reported in the press.

[Mr.Bilko]

DTCC may have estimated that the net payoffs on Lehman will be $6billion but Oct.21st is the cash settlement date for covered transactions. That is the date when we'll find out who won't be able to cover their obligations. And you have to assume someone will not be able to pay up. It could get ugly on Oct.21st if a Morgan Stanley, AIG or hedge fund defaults on their Lehman CDOs. That would trigger around round of credit default swap settlements.

Washington Mutual's CDS auction is set for Oct.23rd. If the Lehman cash settlements by Oct.21 doesn't go off smoothly, the middle of next week could result in more carnage on the stock exchanges.

[Neo]

If company A does a CDS for X Billion and then hedges their bet with company B to cover and then company B hedges with company C to cover and so on.... then somebody down the line owes the X Billion... Who will it be and what happens if the company in the middle of the chain can not pay?...House of cards is what it sound like to me.