Lehman CDS Net Settlement Only $6B: What Does It Mean? 14 comments
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The whole world financial market has been in cryogenesis for weeks due to the known unknown of Lehman (LEHMQ.PK) CDS settlement on 10/21. But Saturday DTCC came out with a bombshell revelation: The settlement will net to a measly $6B.
Well, according to "calculations so far performed by the DTCC", that is. Anybody care to hint how far this "so far" is? 10%? 50%? 90%?
Secondly, the overall net is meaingless. Let's say A owes B $600B and B owes C $540B. The net is $6B. A still fails, which may trigger another round of CDS settlement. Let's say that one nets to precisely $0. Are we supposed to be suckers again and take comfort on that?
Thirdly, the settlement on 10/21 includes virtually all credit derivatives involving Lehman -- CMCDS, fixed recovery CDS, Nth to Default, CDX, CDO.
There're many other reasons why the DTCC announcement cannot be taken at the face value. But the above are the most important ones and I'll stop here.
The important thing is for the government and the market not to be fooled into a false sense of complacency by this press release. The logjam in worldwide financial markets for the past few weeks is because of the Lehman CDS settlement. Banks know how much they're liable for. But they don't know how much others are, including their hedge fund clients.
Unless government forces disclosure on Lehman settlement exposure, we can only assume the worst -- another bank or two going down and propagating the chain reaction. The opacity has been the single most important reason why the inter-bank market has seized up and hedge funds have been forced to liquidate by the double whammy of prime brokerage margin calls and investor withdrawal.
Government must take the pending storm seriously and force all financial institutes to disclose their net liability or windfall on 10/21. For those with huge liability and whose failures are likely to cause chain reaction, the government must provide immediate backing -- buy preferred stock or force debt-to-equity conversion -- so that it's clear to everyone that the chain reaction will be stopped.
The CDS settlement is a zero-sum game. However big the total payout may be, somebody else will get exactly equally big windfall. So there's no reason for the world to go down on 10/21. However, if left unforced, narrow self-interest, greed, and distrust will make people choose certain demise. We need full disclosure, now.
At a time opacity is causing and fanning panic and distrust, the DTCC press release is not helpful. It merely adds smoke to the scene.
Stock position: None.
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This article has 14 comments:
In your simple two-dealer example, no one delivers $600 billion. All that is deliverable is $6 billion, in cash, from A to B.
The most that could "fail' is the net amount(s).
Six billion is still a lot of cash, but it's not ... fantastically large.
Preferred, Lehman's debt holders haven't even begun recovering their claims. Derivatives counterparties can go thought bankruptcy protection and force liquidation.
The settlement system, via the CLS Bank that is used, is very much developed. It is used for the settlement of F/X, where the notional values soar as high as any in the history of the world ...
I found this primer to share:
www.bis.org/publ/qtrpd...
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It's not clear (to me) how many will.
see here:
www.isda.org/press/pre...
I'm not a settlements expert, but you may have calculated the "net" wrong in your example (not just the math).
If A owes B $600 billion and B owes C $540 billion, then the net settlement, I'd *guess* is $600 billion, with $60 paid from A to B and $540 paid from A to C.
There isn't too much evidence to suggest that there was a player out there who wrote up to $600 billion in unhedged CDS, on any one name. So far, it seems only AIG had large, unhedged positions (why else would they suddenly need $85 billion dollars).
The DTC calcualtion *suggests* that, after all the back-and-forth, the net settlement will be a lot smaller than our illustration.
For instance:
C is "flat" as follows:
C owes $8 biliion to B and C is owed $8 billion from A
A is a net payor
A owes $120b to B and B owes $115b to A (net 5 A to B); and
D, a customer, has protection from C
C owes D $1 billion
I'd *guess* that the net settlement, here is $6 billion, with $5 from A-to-B and $1 from C to D.
With luck, A was hedged, so they don't have to come up with $5 billion, but some lesser amount, because of the performance of their hedge.
I wish I had more confidence, but I think that is the right interpretation of the DTC's figure. They list a phone number on their press release. We should call them...
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It does seem that some are speculating that "A", in this example, might collectively be "lotsa hedge funds", who may not have had sufficient hedges, and consequently, not have the money ...
I'd speculate - not even guess, speculate - that the clearing firms would be on the hook to complete the settlement(s) if their clients fail.
That could be just totally wrong.
Whatever the case, it is unlikely that there will be another auction, since those are geared toward setting a settlement price, not who owes what...
If some hedge funds fail on 10/21, their prime brokerages would be left holding the collateral. Whatever shortfall they have, they'll need to recover in bankruptcy court. This is consistent with the reported massive margin calls all big prime brokerages have issued recently.
From the DTC's note, it appears that their contract registry covers all the major dealers. It doesn't appear to cover any hedge-fund to hedge-fund trading, if there is much volume to that.
Also, from what I could tell, most of the major banks (and by extension, their clients) are covered under the CLS settlement protocol. I did not see AIG on the list .... They are suggesting that "all major institutional players" will be 'on the list' by end of 2009, which, of course, is an ocean of time, with today's worried markets.
www.cls-group.com/Abou...
Hedge Funds: The Credit Market’s New Paradigm, June, 2007 (last year)
www.rgemonitor.com/blo...
if A owes B $600B and B owes C $540B,
The Net for B is $60B,
but someone still has to give C his $540 - looks like A is on the hook for that too in the net settlement process.
How are you coming up with an overall net of $60B?
That would only happen if C or someone else owed A $540.
It looks to me like the issue is whether some players have large unhedged positions, and what happens when they don't have the funds to pay - triggers another round of CDS settlement that may take more unhedged players out etc.