Amicus

Lehman CDS Net Settlement Only $6B: What Does It Mean?

More (read it and weep?):

Hedge Funds: The Credit Market’s New Paradigm, June, 2007 (last year)
www.rgemonitor.com/blo...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

Updating:

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...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

With luck, A was hedged, ...
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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...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

you are right, so let me revise and extend my remarks.

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...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

Derivatives counterparties can go thought bankruptcy protection and force liquidation.
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It's not clear (to me) how many will.

see here:
www.isda.org/press/pre...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

2 dealers, 3 dealers, it matters, but not the way you may think. They use a multi-lateral netting process.

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...

Lehman's Loss: More Than $200 Billion

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."

Lehman's Loss: More Than $200 Billion

Lehman had about $613 billion in liabilities, the majority of which was secured and should have minimal losses, ...
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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...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

Bo, luckily the settlement for these things is net. Even a "fail" is a net fail, I believe.

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.

Settlement Auction for Lehman CDS: Surprises Behind

Also, DTC has released this important note about settlement:

www.dtcc.com/news/pres...

Settlement Auction for Lehman CDS: Surprises Behind

It is interesting, to note, also, that the bid-offer spread in the first part of the auction went way up, from the Fannie/Feddire to the Lehman auctions, from an average of circa 2% to one circa 20%.

One wonders if this isn't partly related to the $640,000 quasi-penalty Goldman paid in "adjustments" in the last round (the inside market quote size also was cut in half). If so, this might explain Barclay's bid at 8 that I wondered about aloud above.

Whidbey, I'm certainly not an expert, as some of my questions probably show.

At this time, it's not clear to me how or why the valuation of CDS would be affected by the success or failure of these auctions - don't we theoretically like the price of credit to the probability of default, not to potential recovery rates? Obviously, I need to hit the books.

As for the auction itself, I've been through MarkIt's Auction Primer, to the point that I think I understand the calculations, but not the rationals (except at the big picture level of trying to set a settlement price).

For instance, when I first looked it through, I thought that the approach for any one firm would be to try to "win" in the limit phase about the same face value that was indicated to create the 'open interest' in via the first phase.

In that vein, I'm not sure, right now, what it "means" to offer $141m, but then end up with "winning" bids for $670m. Client orders? Why wouldn't they be part of the initial request, so that the total 'open interest' was larger?

I'm sure there is a logical explanation and it's just too late a night for me to figure it out. G'nite and g'luck.

Settlement Auction for Lehman CDS: Surprises Behind

Michael, great write-up. Thanks!

After looking over the Freddie/Fannie anomaly and reading through this, I have an alternative conjecture for your thesis about the "split result" in the last auction, in which the stop in one part of that auction trailed out at 99-something.

Could it be that the derivatives people participating in these auctions are simply ... not as skilled and used to running them as are, say, the primary dealers' desk?

While not inconsistent, per se, they look ... incomplete, in a technical sense of the term. I mean, look at Barclay's bids. Under what theory would bids peter out with *declining* price? Ditto Merrill Lynch. Compare that the Bank of America - their desk are willing to take the same amount of bonds at almost any price - with a bidding strategy like that, one imagines that ISDA should create a sidecar category for "non-compete" bids...

To be charitable, maybe it has to do with the structure of the auctions or the structure of the markets (can't treasury dealers go short in advance of auctions, in order to protect themselves?).

Last, keying off your insight about the impact that the net open interest might have on auction results, can we suggest that the reason that the reason the mid-market average came in below the pre-auction trading prices is that the net open interest was to sell bonds? Just under 60% of the satisfied limit orders were from three firms..

Last, I don't understand the Barclay's limit bids, in relation to the size of their physical settlement request. They put in a physical settlement request of $130m to buy, with a dealer bid at 8, then "won" $1,080m - almost 10x - with a weighted average bid of 9.47 in the limit order.