Bo Peng

Lehman's CDS Mess: Who's on the Hook?

Marley & User 283188, this article is not about AIG, or any other particular stock for that matter. My original title was "10/21: The Bottom" which is what the article says, if you care to read it in its entirety. If AIG only has $6.2M exposure as you claim, we'll find out tomorrow and the stock would reflect it.

No retraction necessary.

Lehman's CDS Mess: Who's on the Hook?

Marley, where did you get those numbers about AIG? I'd like to see for myself. I based my guess purely on what I read about how AIG is the biggest net CDS seller, plus the timing of AIG bailout vs Lehman bankruptcy -- within days.

I agree with you that the settlement will probably not affect the senior and super-senior tranches of most CDOs. Some CDXs will be affected, but not nearly as much as single-name CDS. If AIG didn't sell much single-name CDS on Lehman and mostly sold CDS on super-senior tranche CDOs, then good for them. I'm just saying it's unlikely judging from known facts so far -- why did they need bailout then?

But even if they do have a huge exposure, the government would have no choice but to pop them up, which is my point.

Lehman's CDS Mess: Who's on the Hook?

Yes, tekram, government (the court, rather) can forfeit private contracts but in the case of CDS, since the contracted asset is legal, prosecution would have prove intend to defraud. That's next to impossible to do on CDS since

1. It's based on market price.
2. Its payout depends on projection of future, low-probability events.

The impact would be incalculable. Banks signed on to Basel II depend on CDS to maintain their capital adequacy (Basel II is total crap but that's a different story). If all CDSs are canceled, you're talking about all European banks and most of US big banks going insolvent overnight.

In addition, there ARE legitimate use of CDS as a hedging tool. Let's say company A takes delivery on your products/service but has a deferred payment agreement of some sort. Until you get paid, you're exposed to its credit risk. You could buy CDS on it to hedge the risk. It won't be exact or perfect, but it does offer protection. When you get paid, you unwind the trade and move on.

Canceling CDS is not even close to the realm of reason. But there're much better alternatives. I have a proposal for one.

Lehman's CDS Mess: Who's on the Hook?

tekram, I don't think the government has the right to cancel private contracts unless there're "greater" causes such as national security.

Now we're talking philosophy: are we ready for totalitarianism? Paulson's bank rescue may have come close to it. But which way would you rather go, further or get back?

Lehman's CDS Mess: Who's on the Hook?

spragus, I doubt DTCC knows the complete picture. Registration at DTCC is voluntary. Many buyers and sellers would rather remain anonymous.

Lehman's CDS Mess: Who's on the Hook?

Kinabalu, if AIG had treated CDS as insurance, then you'd be right, they may have insured part of it. But as it was (and still is), it's not insurance. It's well known that they're by far the biggest net CDS seller.

Lehman's CDS Mess: Who's on the Hook?

ddavid, if your friend has Lehman bonds, I'm afraid it's not good news. I don't want to cause any misconception or false hope. Those who will be made whole are those who hold the bonds AND bought the CDS protection. If you just have the bonds, you can only get around 10 cents on the dollar back now. I don't know what to say...I just hope Lehman bonds are a small part of her holdings...

Lehman's CDS Mess: Who's on the Hook?

Thanks for your generous comments, TimButler.

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".

Lehman's CDS Mess: Who's on the Hook?

Haha, very insightful, Keith.