Lehman CDS: It Won't Be Over Today

Vipal Monga today mentions something I was unaware of: The Lehman CDS auction today is not the end of the story when it comes to settling those trades. All it does is set the price: Settlement doesn't happen until October 21, the week after next. In other words, to the degree that there's nervousness over counterparties being unable to meet their CDS obligations, it's going to remain through not only this weekend but also the weekend afterwards.

In fact, the actual settlement price is one of the few things we already know, more or less: It's going to come in somewhere between 10 cents and 20 cents on the dollar. The huge list of things we don't know, by contrast, is going to remain unknown until after October 21. Michael Edwards has a good column up at Seeking Alpha today:

...CDS pricing is even less transparent than it seems at first glance. Setting aside the counterparty risk, the liquidity risk, and the litigation risk (due to absurdly complex CDS contracts), the cash settlement procedure can and does set prices on swaps that are wildly different from their ostensible value as "get out of default free" cards to be paired with some specific physical bond.

The classic trouble with derivatives - as generation after generation of investors has learned the hard way - is that their price has the intended mathematical relationship to the underlying security, right up until it doesn't. The one circumstance in which the value of a credit default swap is certain not to match the risk it is supposed to counterbalance is when there is really a default.

I think it might not be a coincidence that the enormous fortunes which have been made in the CDS market so far, such as that of John Paulson, who bought protection on mortgage-backed securities, were largely made trading CDS (buying low and selling high) rather than holding them through default and settlement. Buying CDS is a good way of betting that spreads are going to widen. Holding CDS in the wake of a credit event, by contrast, is much more of a crapshoot.

Comments

[Gerry Sullivan:]

Settlement is around 91%. Problem is the banks who sold protection on Lehman debt thinking that they had protection from a company like Primus. (PRS) Primus, a Bermuda stock at 80 cents/share, has sold
credit protection in total around $24 billion. Lehman, Wamu, Fannie, Freddie, and yes, Iceland banks.

It could get ugly.

2008 Oct 10 12:34 PM

[JasonC:]

There is forced selling by people trying to raise $250 billion to pay their CDS debts on Lehman. And those who are due to receive them are not buying because they don't know that they will actually be paid, until they have the funds in hand. This is coupled to forced liquidations at hedge funds facing withdrawals. There are also short operators playing the resulting disruption for self fufilling prophecy bets against Morgan Stanley and the like.

All of which scream "buy"...

2008 Oct 10 01:06 PM

[trm:]

This is somewhat shocking to me. I always believed that unless the counterparty went bankrupt, they had to pay out on the debt if the issuer went bankrupt. The idea that you held Lehman debt, protected by a CDS, and now you only get 9-10 cents (as of this morning's decision) of payout is crazy. Given that you probably paid 5-7 cents near the end ($500-700,000 annual payment for protecting $10 million in Lehman debt), the CDS turned out to be almost worthless. I am surprised the CDS market is not shrinking substantially given this lack of true underlying value.

2008 Oct 10 02:03 PM

[Duude:]

Lehman did go bk.

2008 Oct 10 02:26 PM

[tradeforkeeps:]

trm, that is exactly backwards. The final price was 8.625, so if you paid $700,000 to insure $10M, you're collecting $9.1375M, not $862,500.

2008 Oct 10 02:32 PM

[whidbey:]

Will we are being a little naive aren't. The answer is that most sellers of CDS had no concern about paying, it was income they wanted for other pursuits. The house of CDS will have many interrelation parts, it even spills over into bonds and stock forced on the market. Mass destruction is really and understatement. If the defaults start, not on a single liquidation such as LEH, but on defaults by many counterparties, everything is likely to come unglued. Everything.

2008 Oct 10 02:32 PM

[helplessobs...:]

Whidbey is right, weak counter parties that treated the premiums as free money are the real threat. When the CDS bandwagon was rolling it was the big banks and investment banks who wrote the contracts and did not have post any margin, i.e. they were credit good. Soon weaker players joined the game and posted little margin with bankruptcy as their ultimate backstop.

2008 Oct 10 05:34 PM

[Augustus:]

The CDS pricing for LEH was only for the $4 Billion or so of the bonds. That is a small part of the debt. Lots more pain from this than the CDS problem.

2008 Oct 11 11:26 AM

[bill d:]

When I saw LEHMQ at .11 I bought 3000 shares just for the hell of it - in a few days it tripled. (I made a fair amount of money trading LEH options in the past except my last $20 call). Why ? Clowns like me ? There are millions of shares being traded every day. WHY ???? Anybody know something ? Maybe the G will come in and buy my share for $100 each ?
Now that gas is so cheap I could probably buy that Hummer and drive up the price of GM.

2008 Oct 11 02:29 PM

[billp37:]

Do you actually believe that the CDSs are going to pay?


seekingalpha.com/artic...

2008 Oct 11 10:46 PM