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.