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Lehman derivatives bill: Bad, but not a disaster?

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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.

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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.

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