TimButler

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

I think Mr. Bo Peng's article is one of the very best, and most insightful articles I have ever read on Seeking Alpha. It goes to the heart of where we are in the global financial crisis.

The Lehman CDS settlement on Oct 21st will be one of the biggest coming out events ever witnessed because of the scale of the numbers. Mr. Peng cites $100-$400 billion, while I think I saw the New York Times estimate the range at as much as $400-$600 billiion in an article at the end of last week.

Think of these numbers -- $100-$600 billion on a single company's default (i.e., Lehman) relative to the US industry wide $750 billion rescue plan, or the Treasury backing of AIG to the tune of $85 billion.

Yes, this single company CDS settlement on Oct 21st of $100-$600 billion is part of the $56-$58 trillion estimate of the global CDS market currently outstanding. Happily, Lehman is the only super scale level bankruptcy thus far.

AIG and hedge funds seem to be the prime suspects for having to face the Oct 21 Lehman CDS settlement pay-out. Who else will take a big hit, we do not know. To further illustrate why Oct 21st becomes so important, just suppose the Lehman CDS exposure is concentrated in a single additional firm such as Bear Stearns, now inside JPM, or an RBS or DB?

While European, Asian and American banks have stepped up to be commited to their respective large banks, if the CDS exposure is concentrated, the scale of the CDS settlement payout's impact on a bank's capital base could be mind numbing.

No wonder interbank lending has virtually ground to a halt. No wonder LIBOR, as the best barometer, is nearly 5%. No wonder, as Mr. Peng explains so well, the banks were calling hedge fund debt last week, which in turn was a significant contributor to the scale of last week's equity market rout.

In a nutshell, US housing price declines over the last two years, are the source of subprime mortgage problems, and in turn, mortgage back securities problems, which with asset liability gap mis-management and an inherent degree of high leverage, led to large bank losses and capital problems.

But the big kahouna looming in 2008 has been the CDS settlement risk faced by CDS issuers in the event of a large scale bankruptcy (i.e., Lehman), and that day of reckoning comes on Oct 21, as pointed out and explained so well by Mr. Peng.

As a credibility check on Mr. Peng's article, I checked the "Oct 21" web link at the outset of his article, which leads to the ISDA web site. To see the Oct 21 date, one has to click on "Lehman Brothers" at the top of the ISDA page, then click on the link next to "Protocol", and then click on "Plain English Summary".

We're not out of the woods yet (as of today, Oct 13). Hopefully, the concentration of Lehman CDS issuer risk will not be too great. We will find out in little more than a week.