Settlement Auction for Lehman CDS: Surprises Behind

by: Michael K. Edwards

The surprise: no price support at pre-auction bond prices. (No inside bid exceeded 10%, and the inside market midpoint was 9.75%.) The relief: despite a substantial net open interest to sell bonds for physical settlement, barely half of which would have cleared at the inside market midpoint price, the excess supply was soaked up by limit order bids within the inside market's spread, resulting in a final price of 8.625%. There was ample additional demand at slightly lower prices, implying that at least some dealers' bids during the inside market phase really reflected a willingness to purchase plenty of bonds at their bid price.

(See previous article: "Settlement Auction for Lehman CDS: Surprises Ahead?")

A closer look at the limit order phase shows us who is starving for liquidity and who thinks there is money to be made by buying and holding these bonds. Here are the net trades resulting from the auction, ordered from most bonds sold to most bought. (Keep in mind that many of these bids and offers were placed by dealers on behalf of their customers, so they don't entirely reflect the trading strategies of the dealers themselves.) All volumes are notional. Net sellers first:

Deutsche Bank sold $870m. They didn't place a single limit bid above 8.5, and would have been net sellers at any price above 6. They would have been happy to take plenty at 4 or 5, though.

Credit Suisse sold $705m. This is net of $50m for which they (or more likely one of their customers) were willing to pay the top price possible (10.75) in the limit order phase. Otherwise they didn't have any interest above 8.5, and would also have been net sellers at any price above 6 (at which they were willing to soak up over a billion dollars' worth!).

Morgan Stanley sold $430m, similarly net of $50m of bids at 10.75. They wouldn't have been net buyers at any price above the absolute minimum possible bid (0.125), suggesting that their bid of 8 during the inside market phase was more or less a sham. The interpretation that comes to mind - about which I have no inside information whatsoever, mind you - is that they simply don't have the liquidity to play the "investment bank" game any longer.

Goldman Sachs sold $376m or so; they got there by offering to sell $1470m and then buying up over $1 billion of that ($150m effectively bid at "any price from the 10.75 maximum down", $675m via limit orders at the price set by inside market fixing, and the rest farther down the limit bid sequence). This seems to reflect their huge role as a dealer rather than any great appetite on their own behalf; they would have been net buyers at 8, but the bid that looks to me like Goldman's "we'll take it if no one else wants it" backstop is at 1.25. That isn't the derisory bid that Morgan put in, but it doesn't reflect a lot of willingness to scoop up a chunk of the ultimate Lehman liquidation either.

BNP Paribas sold $370m; their inside market bid of 9 wasn't backed up by any real participation in the limit order phase. They or a customer would have gone long at 2.125, and taken some more at 0.25, and that's it. They mostly just wanted to unload the stuff.

HSBC sold $157m (net of $30m bid at the inside market fixing). Otherwise they didn't bid at all. Some market maker - especially since they were the highest bidder in the inside market phase.

UBS sold about $83m; they would have been a much bigger seller at any price above 9, and would have been neutral at 8.5, substantial buyers at 8, and massive buyers at 6.

Banc of America sold just under $78m. They were clearly in no position to backstop the market but did bid for another $15m at each price point all the way down to 4 (resulting in a crossover to being a net buyer at 7.875). They don't have a lot of cash to play with, but at least they're playing like they believe in the game.

RBS sold $31m (after $160m of buy-back, probably mostly on a customer's behalf); despite having bid on the high side at 9.25 during the inside market phase, they wouldn't have taken any more back at any price. Another sham bid, if you ask me; but no surprise given that they seem to be on the verge of semi-nationalization.

Citigroup sold $24m, net of a couple of small purchases and a big $500m bid (possibly on their own behalf) just below their inside market bid. They would have taken another $500m at 8.375 and kept on buying all the way down (with a real monster bid at 6.625). Who knows where they think they would get the cash; maybe someone is bidding through them on a disproportionate scale.

And now the net buyers:

Dresdner bought $75m, probably on others' behalf; although they were one of only three bidders offering to buy during the initial physical settlement, the quantity was small at $30m and the bid was low at 8. However, they were willing to soak up supply if others were to have dropped out, starting just below that bid of 8 and continuing down to their big backstop at 1.375.

Merrill Lynch bought $529m; they were the only dealer to end up on the opposite side from where they started (having offered $141m in the initial physical settlement), thanks to a $670m bid at 10.25. (Presumably that's not their own trade, as they were among the bottom bidders at 8 during the inside market phase!) They would have bought more at 8.5 or below, but didn't even bother to put in a shoot-the-moon bid near zero.

Barclays bought $1210m, most of it with bids at the the price set by inside market fixing. They (or their customers) would have taken some more at lower prices, but their bid volumes peter out on the way down; they don't seem to have been interested in mopping up a potential excess.

That leaves JPMorgan Chase, the biggest buyer at over $1310m. They were by far the biggest bidder ($612m) in the initial physical settlement, and just kept on soaking it up; their bid for $500m at 8.625 wound up setting the final price. They were the one net buyer who would have kept on buying and buying and buying at prices not much lower than this - although there was plenty of other demand in this price bracket and, as previously mentioned, UBS would have started stepping in for real at 8. Doubtless there were lots of outside bidders using JPMorgan as their dealer, but evidently Chase trades heavily enough that they could have made this whole market themselves.

In short, this auction was basically successful at clearing the market for physical settlement at a credible price (contrary to outsider expectations though it might have been). However, without Barclays (NYSE:BCS) (the purchaser of Lehman's assets) and JPMorgan Chase (NYSE:JPM) (the Treasury's agent in winding down Lehman's trades), it would have been a very different story. (I wonder what combination of them has inherited trusteeship for all of the Lehman-created structured vehicles that issued CDS on Lehman itself?) The auction also seems to have provided a rare view into the actual trading behavior of the top broker/dealers, including apparent confirmation that Morgan (NYSE:MS) and Goldman (NYSE:GS) (not to mention RBS (NYSE:RBS)) are seriously starving for cash.

Disclosure: none