Lehman's Loss: More Than $200 Billion

“Lehman CDS auction went smoothly, ISDA CEO says” (article by Alistair Barr, Oct. 10, 2008, on MarketWatch).

“Smoothly? Death by lethal injection can go smoothly as well, I suppose.”
(Comment posted by bubblybubbles).

At this point, we can conclude that letting Lehman (LEHMQ.PK) fail when it did (by which I mean letting it slide into bankruptcy instead of an assisted fire sale, à la Bear, or a nationalization, à la AIG (AIG)) was in all likelihood a very costly mistake. Whatever long-term gains on moral hazard may be achieved presently seem to pale in comparison to the financial tsunami that has ensued; right now, any concerns about moral hazard (or inflation as well, by the way) have been thrown out the window. Clearly, as can be seen in the charts below, both the money-market seizure (as evidenced by the jump in the 30-day LIBOR rates) and the equity markets collapse (which has wiped about 3.7 billion in three weeks) started on September 15, after the bankruptcy filing of Lehman Bros.

By allowing Lehman to fail before a clearinghouse for credit default swaps was put in place, the authorities took a gamble, and it has turned out, it seems, to be a losing one. To be fair, it may well be that saving Lehman would only have postponed the collapse rather than avoid it, and I’m certainly not criticizing the decision, just analyzing it with the benefit of hindsight.

The CDS mess

For the purposes of settling CDS contracts on Lehman, the value of Lehman bonds was set last Friday, 10/10/08, at 8.625 (meaning buyers of CDS’s are due 91.375) cents on the dollar, and the contracts are to settle Oct. 21. In the MarketWatch article mentioned above, ISDA chief executive Robert Pickel observes, “Traders and other participants in the credit default swap market marked the fair value of their exposures to market and posted more collateral as Lehman's troubles increased. This discipline means that sellers of protection should not have trouble paying to settle the contracts related to Lehman.”
We will find that out on Oct. 21, but judging by the lack of reaction in the money markets, it seems doubtful that that is the case. In reality, Lehman CDS spreads (see chart below) remained remarkably low (five-year senior was below 300) until the last week before the collapse; in all likelihood, this means there was limited time to ask for more collateral.

A stab at the loss toll

Lehman had about $613 billion in liabilities, the majority of which was secured and should have minimal losses, and $158 billion in outstanding unsecured debt ($138 billion in senior loans, $17 billion in subordinated loans, and $3 billion in bank loans). Taking into account where the bonds are trading and the results of the CDS auction, the best guess for losses on these may be 80-90 cents on the dollar, or about $135 billion total; losses for secured creditors are usually nil but given the market dislocations and Lehman investment grade ratings up until its collapse one would not be surprised with, say 3-5% losses or around $20 billion.

Assuming there are $400 billion worth of CDS’s on Lehman’s senior notes, this results in $365 billion of money changing hands, making it very hard to figure out how much actual net losses (and corresponding net gains) may be realized. If a substantial portion of the buyers of CDS’s are bondholders hedging their exposure, then this is just a transfer of the cash market losses, and in this case, no additional damage to the system is done by the CDS market. Some sellers of CDS’s may have been shorting the equity (betting in a Bear-type scenario); in this case, those sellers would use the gains from their equity shorts to cover their losses on the CDS’s and should have no problems coming up with the cash.

Let us assume that:

• half ($200 billion) of the transactions are by market makers who sell and buy CDS’s and have no net exposure,
• half of the bond holders bought CDS protection worth $80 billion (so there are $80 billion of losses being transferred from bondholders to the sellers of CDS’s),
• of the remaining $120 billion half was sold by equity shorters, so only the remaining ($60B x $0.915 = $55B) are additional unhedged losses (and have corresponding gains to the buyers of CDS’s, so these are not losses to the “system” to the extent that CDS sellers can honor their obligations; but they still matter, as Bill Gross argued a few months ago on one of his investment outlooks).

$55 billion is a lot, but is not unmanageable; however, I think that one does need to consider also the gross amount of $365 billion that is changing hands as having had a major impact on liquidity and on hoarding of liquidity by the banks and others.

In addition, there should be more losses arising from Lehman’s counterparty default in the over-the-counter derivatives market where Lehman was a big player. In all likelihood, collateral posted for the interest rate and currency derivative markets should be enough to cover losses. (The U.S. Bankruptcy Code does not place an automatic stay on the seizing of collateral used in these instruments. Normally, creditors owed money for loans or bonds are prohibited from immediately seizing collateral when a company files for bankruptcy.)

However, this is probably not the case in the CDS market, where Lehman may have been a counterparty for about $1 trillion worth of contracts; estimates here are that losses could range from $25-50 billion. For example, if half of the CDS positions were losing money for Lehman, and the average loss was 10%, this would result in $50 billion; however, some of these should have had some cash or acceptable collateral posted against them.

So, in total, Lehman should take a toll of over $200 billion in direct losses, this staggering amount is more than half of all new equity raised by financials since the start of the credit crunch. The additional impact of the hoarding of liquidity to satisfy $365 billion in gross payments in the CDS market and the loss of confidence that ensued the banks failure had probably an even higher though hard to quantify impact. Equity markets have lost $3.7 billion since 9/15.

Comments

[AnonymousAlso:]

How often are CDS marked to market? Every day? Every week? Every month? How often are payments exchanged? Only at settlement? That is in this case 10/21? Or have payments been exchanged thru the lifetimes of the contracts at periodic points?

The CME's CDS exchange marks to market twice a day?

2008 Oct 13 08:02 AM

[Charlie Bottle:]

CDS are markerd to market daily, however it really up to each buyer of CDS to request for additional collateral. I'm not aware of any guidelines by ISDA (although there may be and still be looselly applied by participants). So in a situtation like lehman where the credit spreads ramin tide until a few days before BK, the chances are that collateral posted is quite short.

2008 Oct 13 05:57 PM

[Amicus:]

Lehman had about $613 billion in liabilities, the majority of which was secured and should have minimal losses, ...
====
At what price are Lehman's (defaulted) senior bonds trading? Last week's CDS auction suggested that the recovery rate on Lehman "bonds" was not nearly as high as suggested here. That discrepancy could be explainable.

Separately:

"Losses" in your terminology perhaps should be refined. Here's what I have in mind.

True or false: the net economic losses from any defaulted set of bonds is limited to the par-value of the bonds, at the time of default.

Derivatives, such as CDS, are essentially risk-transfers. As such, they net to zero. Put another way, my loss is always someone else's gain.

If Lehman was running a perfectly hedged book of CDS, at the time of bankruptcy, then a netting of the "long" claims against Lehman with the "short" claims, coupled with any cash positions used for hedging or collateral, ought to net zero residual claim.

As you may recall, ISDA held and extra-ordinary derivatives trading session on the Sunday before Lehman went under.

The net results of that, in terms of plucking an incompletely hedged book out of the chain of dominoes, ... is not public, so far as I know.

www.isda.org/press/pre...

2008 Oct 13 10:10 PM

[Amicus:]

the teaser from the ISDA press release (they traded everything, it appears):

"The special trading session is taking place on Sunday September 14 for OTC derivatives. The purpose of the session is to permit parties to reduce their market risk associated with a potential Lehman Brothers Holding Inc. bankruptcy filing, by entering into transactions with other participants that would fully or partially offset OTC derivatives positions that they have with Lehman. Product classes involved are credit, equity, rates, FX and commodity derivatives."

2008 Oct 13 10:12 PM