Lehman's CDS Mess: Who's on the Hook? 33 comments
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On Oct 21, somebody [group A] will have to pay somebody else [group B] billions in cash to settle Credit Default Swaps (CDS) on Lehman. Estimates on what this entails range from $100 billion to as much as $400 billion.
Group A will almost certainly include AIG, the biggest net seller of CDS, and many hedge funds, who have been using CDS selling as their cheap (HA!) financing source for the past few years. Besides single-name CDS specifically on Lehman, other credit derivatives such as CMCDS, CDS options, or Nth to Defaults, CDX indices and bespoke CDOs with Lehman in them will also settle, partially or in full.
This will be arguably the biggest cash-exchange day in human history to date. I don't care how much taxpayer money the government will use to bail them out, somebody will fail.
Group B includes two types. One has Lehman bonds. They will be made whole by the settlement although Lehman bonds changed hands at 8.625 cents on the dollar at Friday's auction. The other doesn't have Lehman bonds. They bought naked CDS on Lehman. They will have a HUGE windfall -- for every dollar notional, they'll get over 91 cents. If they can collect, that is.
Back to the more immediate concern, who is in Group A?
You could pore over the CreditFixings' auction info and guess. I think a lot of people did just that on Friday. They pounced on MS, GS, CS, and DB, who happen to be the biggest Physical Settlement Sellers (meaning they sold CDS on Lehman). JPM shot up the whole day, which happens to be the biggest buyer.
But I don't know how productive this guessing game is. The dealers could be placing orders and requests for their hedge fund clients. Short of serious insider info, there's no way of knowing how much of those requests are for themselves vs. clients.
More importantly, physical settlement will almost certainly be just a small portion of the overall settlement size. Friday's auction had $5.7B in sell orders. Cash settlements will most likely be at least 10, and maybe 100 times bigger than that. People learned the lesson from Delphi. Furthermore, it'd be very unusual for banks to have a huge net position in CDS, with the possible exception being their proprietary desks and funds. Again, the most likely suspects are AIG and hedge funds.
Now you know what the government bailout of AIG is for - the initial $85B and then the additional $37.8B (suspiciously precise isn't it?). Don't be surprised if the number goes up again before 10/21. Will tax-payers get the money back after 10/21? Fat chance. Is the money really for saving AIG, or making sure others who bought CDS on Lehman will get their windfall? Take your pick.
On to the hedge funds. They knew how much they would need to pay since Lehman's bankruptcy. Reportedly JPM, GS, and MS have issued massive margin calls to their hedge fund clients, which is consistent with their sell requests (except JPM who, being the clearing bank for Lehman, may have bought protection) at the ISDA auction and my suspicion is that a big part of their requests are on behalf of their clients. Some hedge funds are being forced to cash out. And since Thursday some apparently went shorting in desperation, trying to make a quick buck before the doomsday. The 900 point surge Friday at 3 p.m. in half an hour showed how nervous and desperate they are.
In the meantime, of course, hedge fund investors must be withdrawing as fast as they possibly could, adding to their misery. Bankruptcy law will be the golden profession for many years to come.
WaMu CDS settle on Nov 7. Their impact is expected to be much smaller, although nobody can be sure, as is the case with all CDS. We may get some rough idea on its auction date, 10/23. If there are high-profile bankruptcies on 10/21 (banks, AIG), then markets will be spooked and all eyes would then turn to WaMu; otherwise it'd likely be a non-event in comparison.
If there were bankruptcies of anything other than hedge funds on 10/21 (or 11/7, though less likely), then we could be in a serious chain reaction. But governments all over the world would band together to stop it. Governments may be stupid and inept, but they're not suicidal. The Fed's discount window will stay open late on 10/21. For banks (or AIG) who cannot post enough collateral, Paulson will be ready to buy stocks in a heartbeat. If the initial $250 billion runs out that day, they can let foreign sovereign funds buy preferred stocks. It's a wonderful world.
Moreover, I suspect the pending doomsday is a big reason why banks have shied away from lending to each other over the past few weeks. Nobody knows how much anybody else owes on that day. Coming 10/22, assuming no banks fail, it'd be a huge cloud gone. Back to business as usual, or as usual as it gets nowadays.
Hedge funds' fire-sale exit may be creating a very rare buying opportunity in many financial markets (stocks, bonds, commodities, maybe even dreaded CDOs and mortgages). A few days ago I wondered if the bottom was near. Now I'm convinced the bottom will be around 10/21, if not earlier. The way back up may be painfully fast or painfully slow. But the crisis is essentially over unless we let the chain reaction take place.
Then we'll only have to deal with the massive debt, recession, and inflation. Piece of cake.
Disclosure: None
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The Free Market works but the Capitalistic power brokers are bothered by that. Consequently, we will get SociObamism and we won't have a free market as the will control the Treasury, Military, Courts, Media (superfluous?) all without firing a bullet.
The Lehman CDS settlement on Oct 21st will be one of the biggest coming out events ever witnessed because of the scale of the numbers. Mr. Peng cites $100-$400 billion, while I think I saw the New York Times estimate the range at as much as $400-$600 billiion in an article at the end of last week.
Think of these numbers -- $100-$600 billion on a single company's default (i.e., Lehman) relative to the US industry wide $750 billion rescue plan, or the Treasury backing of AIG to the tune of $85 billion.
Yes, this single company CDS settlement on Oct 21st of $100-$600 billion is part of the $56-$58 trillion estimate of the global CDS market currently outstanding. Happily, Lehman is the only super scale level bankruptcy thus far.
AIG and hedge funds seem to be the prime suspects for having to face the Oct 21 Lehman CDS settlement pay-out. Who else will take a big hit, we do not know. To further illustrate why Oct 21st becomes so important, just suppose the Lehman CDS exposure is concentrated in a single additional firm such as Bear Stearns, now inside JPM, or an RBS or DB?
While European, Asian and American banks have stepped up to be commited to their respective large banks, if the CDS exposure is concentrated, the scale of the CDS settlement payout's impact on a bank's capital base could be mind numbing.
No wonder interbank lending has virtually ground to a halt. No wonder LIBOR, as the best barometer, is nearly 5%. No wonder, as Mr. Peng explains so well, the banks were calling hedge fund debt last week, which in turn was a significant contributor to the scale of last week's equity market rout.
In a nutshell, US housing price declines over the last two years, are the source of subprime mortgage problems, and in turn, mortgage back securities problems, which with asset liability gap mis-management and an inherent degree of high leverage, led to large bank losses and capital problems.
But the big kahouna looming in 2008 has been the CDS settlement risk faced by CDS issuers in the event of a large scale bankruptcy (i.e., Lehman), and that day of reckoning comes on Oct 21, as pointed out and explained so well by Mr. Peng.
As a credibility check on Mr. Peng's article, I checked the "Oct 21" web link at the outset of his article, which leads to the ISDA web site. To see the Oct 21 date, one has to click on "Lehman Brothers" at the top of the ISDA page, then click on the link next to "Protocol", and then click on "Plain English Summary".
We're not out of the woods yet (as of today, Oct 13). Hopefully, the concentration of Lehman CDS issuer risk will not be too great. We will find out in little more than a week.
Love the pic also... heeeeyah!
Also, PrudentMan, a term more appropriate for the power brokers would be cronyistic. Capitilistic=free market,
online.wsj.com/article...
"The actual cash payments that sellers have to make in the coming days will be significantly lower, because many firms had already posted cash or collateral to their counterparties on the contracts prior to last week's auction. In addition, most banks and financial institutions had both bought and sold swaps on Lehman's debt, so some of their profits and losses would offset each other."
I do agree with you that the total amount will be well over the $6B cited by DTCC. However, note this article:
seekingalpha.com/artic...
My original title was "10/21: The Bottom". Maybe the editor(s) thought it was too provocative? ;>
Zulu, I think it's sure the world will wake up on 10/22 with fewer hedge funds. But the one thing nobody seems to know is whether some failure could trigger a chain reaction through some derivatives-based amplifier link that nobody has thought of. It's the classical unknown unknown. I just hope somebody with access to more info and in position of power has given this some serious thoughts...
amarksp, no CDS seller ever has the expected loss fully collateralized. It would kill any economic incentive to sell it, or otherwise the premium would be so high nobody would buy them. Furthermore, the loss on Lehman CDS turned out to be much higher than "expected".
I would expect that it is standard procedure at AIG to have reinsured a substantial portion of its CDS exposure, of course that just muddies the waters more. In that event AIG may pay out substantial sums but recover similarly substantial sums from reinsurers on a different time schedule.
A wise man once told me that a coconut couldn't fall on a car in Tahiti without the reinsurance market feeling the impact.
"While European, Asian and American governments have stepped up to be commited to their respective large banks, if the CDS exposure is concentrated, the scale of the CDS settlement payout's impact on a bank's capital base could be mind numbing."
Tim Butler
source: www.dtcc.com/news/pres...
This is hugely overblown.
On September 23 the New York Insurance Department issued new guidelines that, for the first time, establish that some credit swaps are insurance and therefore subject to state regulation.
So called ‘naked swaps’ are not insurance and cannot be regulated by the State. The State urged the US Government to cover the gap. SEC Chairman Cox recently proposed to Congress that it enact legislation giving the SEC authority to initiate such regulation.
While AIG had many regulatory reasons to avoid calling CDS insurance, I believe they still could have handled their risk management in a manner that would have provided protection for these exposures. I have discovered that the basic re-insurance contract contains a specific exclusion for this type of risk but separate re-insurance markets are available to obtain coverage. I have no idea whether or not AIG made use of these markets. The fact that they have been silent on this matter would lead one to believe thay had no additional protection.