$400 Billion Lehman CDS Unwind?
I've heard concerns from various traders and hedge fund managers over the past few weeks that the Lehamn Brothers (LEH) derivatives unwind has been what's roiling markets.
Early October, Citi (C) credit analyst Michael Hampden-Turner estimated there is $400bn of Lehman credit derivatives that will be settled on Friday
Hence, some recent fear can now be attributed in part to jumbo losses caused by Lehman's derivative unwind . . . with JPMorgan (JPM) being the biggest potential collateral damage . JPM has the biggest derivative exposure on the Street (I have no opinion on how this impacts them or on their derivative exposure).
Here is the FT:
"At the moment, participants can't just extinguish credit derivatives contracts with Lehman, they can only offset them. That, in turn, puts pressure on some participants to buy more credit insurance and the cost of such contracts is rising.
Moreover, many counterparties to Lehman who believe it owes them money have joined the ranks of unsecured creditors. This increases the number of claimants and reduces the money available to bondholders and other creditors.
The exact amount of any claim is determined by the difference between the value of the collateral and the cost of replacing the contract. The cost has risen in line with fears about the health of financial institutions and the creditworthiness of counterparties."
While Fannie and Freddie CDS settled at between 91.5 and 99.9 cents on the dollar., expectations are for Lehman to settle at 10 cent on the dollar -- causing a few $100 billion in losses. The unwind comes Friday.
More details after the jump . . .
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UPDATE: Octoer 9, 2008 11:08am
Wow, that was quick -- the Dow flipped from plus 150 to minus 150 rather fast. . .
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Source:
Lehman exposes faults in credit default swaps
By Henny Sender in New York
FT, October 7 2008 03:00 | Last updated: October 7 2008 03:00
http://www.ft.com/cms/s/0/04733ac8-9408-11dd-b277-0000779fd18c.html
Banks prepare for CDS pay-outs:
Banks are hoarding cash in expectation of pay-outs on up to $400bn of defaulted credit derivatives linked to Lehman Brothers and other institutions, according to analysts and -dealers.
This added pressure on the frozen financial system comes as authorities prepare to meet participants in the so-far unregulated $54,000bn credit derivatives market to speed up plans for the creation of a central clearing house.
The Federal Reserve will meet dealers, investors and exchange executives in New York today. Although big dealers had committed to setting up a central counterparty by the end of the year, urgency has increased in light of the collapse of banks around the world and as company bankruptcies loom.
"The New York Fed will hold a meeting [today] with a small number of banks and buyside firms to discuss the progress being made toward the creation of a central counterparty for credit default swaps," said a Fed official, adding that this would "help reduce systemic risk associated with counterparty credit exposure and improve how the failure of a major participant would be addressed".
Reuters explains how the process will work:
Twenty-two dealers will participate in the auctions, which will determine how much protection sellers will recover after paying out the insurance. The timeline for the auctions follows, according to JPMorgan.
9:45 a.m.-10 a.m. Auction participants will submit bids and offers for the debt backing the credit default swaps, which will be used to determine the initial recovery rate of the swaps.
10:30 a.m. Auction administrators Creditex and Markit will publish the initial recovery price and the open interest for the contracts will be published. The open interest reflects the amount of bids and offers that have been made, and will show if there are more buyers than sellers, or vice versa.
12:45 p.m. -1 p.m. Participating dealers will submit limit orders for the debt on behalf of themselves and their clients to fill the open interest
2 p.m. The final price of the auction will be published.
Other Sources:
Banks prepare for CDS pay-outs
By Aline van Duyn in New York and Hal Weitzman in Chicago
FT, October 7 2008 03:00
http://www.ft.com/cms/s/5911e2d8-9407-11dd-b277-0000779fd18c.html
FACTBOX-Lehman CDS settlement auction timeline
Karen Brettell
Reuters Oct 8, 2008 4:16pm EDT
http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSN0841811720081008
Credit market to price $500bn in bad deals
Aline van Duyn
FT, October 5 2008 18:55
http://www.ft.com/cms/s/0/339dd2c2-9304-11dd-98b5-0000779fd18c.html
Thursday, October 09, 2008 | 09:54 AM | Permalink
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Barry, Barry, Barry....
You just had the wrong fairy tales read to you as a child...in real life the grasshoppers win, and the ants just keep on working through the winter....
Posted by: Bruce in Tennessee | Oct 9, 2008 10:03:58 AM
You know the markets have been tough when I need to look at my intraday charts in log scale.
Posted by: Freddie | Oct 9, 2008 10:05:30 AM
FYI. George Washington's Blog had a good post yesterday on which institutions have the biggest derivatives exposure...
http://georgewashington2.blogspot.com/2008/10/whos-got-biggest-derivatives-exposure.html
Posted by: Boom2Bust.com | Oct 9, 2008 10:09:51 AM
Kind of makes sense, $700B balance sheet thrust into the market at once as a massive delevering slug is bound to roil things. With GS and MS converting to holding companies, they will at least get more time to delever in an orderly fashion. I think we all agree the LEH experiement was an utter failure for Hank and Ben.
Posted by: Scott | Oct 9, 2008 10:11:05 AM
Should be absolutely fascinating to see what valuation basis unsecured creditors use in bankruptcy court.
Here's an easy call: the Lehman Brothers bankruptcy litigation will yield no fewer than three U.S. Supreme Court decisions.
The plate tectonics have only begun to rumble...
Posted by: Ratso | Oct 9, 2008 10:29:31 AM
market ticker got this too...looks like a very ineresting day tomorow...
http://market-ticker.denninger.net/archives/603-What-The-Media-Didnt-Cover.html
Posted by: peterthepainter | Oct 9, 2008 10:32:20 AM
This auction is for Lehman CDSs only? Cross party derivative risk is where? I'm curious why anyone would want to fulfill these insurance contracts? I presume in the fine print, of these insurance pay outs, the owner of these insurance instruments own something real. What is that real item?
Posted by: Greg0658 | Oct 9, 2008 10:33:59 AM
I don't know that the LEH experiment was a failure. As Barry has repeatedly said, the problem is housing and credit. This blow-up was going to happen. There is no way to avoid it. If letting LEH blow up causes consequential damage so severe that it forces the ECB to cut rates, after hiking them in July, then so be it. If the damage is so severe that it forces the FDIC to arrange marriages, so be it. If the damage is so severe that it forces the governments to inject capital into the banking system, so be it.
The flawed "experiment" wasn't letting LEH fail. The flawed experiment was letting derivatives trade without proper clearing and margining. The flawed experiment was the Maestro's belief that the system was invulnerable to shocks! The flawed experiment was the belief that liars would pay back loans.
This was going to happen one way or the other. You want it quick, or do you want it to take 20 years?
Posted by: Don | Oct 9, 2008 10:38:40 AM
Help me out here...couldn't the auction tomorrow turn out to be negative for the markets? I mean, if nobody really participates tomorrow, nobody wants these Lehman dregs...then couldn't the markets take this as a sign that the taxpayer is going to wind up owing most if not all of the bailout package? You do have to find a handle, absolutely, but wouldn't waiting a few days or weeks be prudent? Does anyone else see this as a gamble that someone is going to bid??
Posted by: Bruce in Tennessee | Oct 9, 2008 10:50:21 AM
BR - You think that this may be one of the reasons AIG went back to the Feds for another 38 billion?
Posted by: Don | Oct 9, 2008 10:51:04 AM
100 point Dow moves look like blips on my charts now...it could easily rise or fall 1000 in a day (I'm betting fall)
Posted by: Steve Barry | Oct 9, 2008 11:16:32 AM
Man, I remember reading you months ago and thinking this financial crisis was only about as big as, comparatively, Enron, WorldCom, and the others crashing and burning ... with a smattering of dot com implosion built in. I thought Roubini was a borderline crackpot who, none the less, had a few decent predictions under his belt. I thought easy credit would re-emerge somewhere and the world would inflate it's way out of this mess.
Nope, this is LTCM to the tenth power, multiplied by a couple of continents and a lot of crooks.
Now I'm starting to think you're a little soft on the potential endgame, whatever that may be. Any suggestions? Anyone who asked for this to happen as a cleansing economic activity couldn't have possibly known how bad it will ultimately be before the markets bottom. I guess we've all been a little naive.
This might be good for an open thread.
"What's next? What's left?, When Will It End? How will it End? What after that?" And, most importantly, "how can I make some money out of this"?
On the dark side, I think the US might start a carry trade to counteract an eventual deflation that won't end until a new economy based on things and actual work emerges.
Posted by: dead hobo | Oct 9, 2008 11:29:27 AM
"Now I'm starting to think you're a little soft on the potential endgame, whatever that may be. Any suggestions? Anyone who asked for this to happen as a cleansing economic activity couldn't have possibly known how bad it will ultimately be before the markets bottom. I guess we've all been a little naive."
I would argue the the actions by the Fed and Congress have made matters worse. Their addiction to low taxes subsidized by foreign investment and a desire to maintain business as usual is postponing the inevitable, the complete collapse of the investment banks that facilitated this bubble. It is like trying to bail out Enron, so that they can continue to manipulate the energy markets.
In my opinion, the correct course of action would be to get off of the credit addiction, raise rates, let the CDS default, burn the bondholders, balance the budget, raise taxes, evict homeowners who took out bad mortgages and get back to some semblance of fiscal responsibility.
Very painful, yes. But, the sooner this happens, the shorter the recession/depression. We need to take our medicine.
Posted by: Blackhalo | Oct 9, 2008 11:43:28 AM
it is a Chain of risk based on multiple counterparties. Here is a graphic depiction.
http://nickgogerty.typepad.com/designing_better_futures/2008/09/cds-and-systemic-risk-a-primer-about-chain-settlement-risk.html
Posted by: nickgogerty | Oct 9, 2008 11:47:03 AM
Barry:
Your target of 975 seems to be holding up. Is there any other new info that might not be discounted? It is a well known fact that several banks will fail; if you go with Roubini's estimate we have 900 more to go! When people like Jim Cramer starts talking about similarities to '87 crash, i wonder if we have a tradable bottom here.
Any comments would be appreciated.
Balu
Posted by: Balu Nischal | Oct 9, 2008 11:55:32 AM
Just a couple itty-bitty concerns with the "take our medicine" argument:
Maybe we should also look at the likely impact of a global Depression -- I'll say it -- on some OTHER national economies like, oh, say, China and Russia. Catch my drift?
Remember the old "civilization is always a few meals away from anarchy" thing?
With U.S. consumer spending down -- and likely to stay down/tank through the holidays -- China's real economy is already taking a big hit. Many earlier posts here and elsewhere have touched on China's investment in the U.S. debt.
And Russia's reverting back to xenophobic/autocratic ways. Everyone who has faith in the Russian government's ability to successfully manage its own banking crisis please raise your hands.
Here's hoping the joint U.S./European rate reduction is a sign of bigger and better things to come.
Posted by: Transor Z | Oct 9, 2008 12:01:43 PM
Declare all CDS instruments void and non-negotiable. The Fed and SEC can do this with a little know financial administrative called, "Tough Titty."
The Tough Titty invocation was jsut recently used to spew out the 700 (nee 880) billion dollar bailout, where the Treasury and Fed basically said, "Tough Titty", to the taxpayers.
So, for the CDS unwind, I advocate that the Tough Titty rule be invoked.
Posted by: Alan Wilensky | Oct 9, 2008 12:06:14 PM
hobo - ""What's next? What's left?, When Will It End? How will it End? What after that?" And, most importantly, "how can I make some money out of this"?""
me - maybe this is a psychology experiment to get folks to stop trade'g for a living (or 2nd income) and create companys?
Posted by: Greg0658 | Oct 9, 2008 12:11:37 PM
Acc to nakedcapitalism the unwind is today?
http://www.nakedcapitalism.com/2008/10/money-markets-still-frozen-dollar-libor.html
Posted by: AA | Oct 9, 2008 12:15:06 PM
I agree with Alan. The CDS bogeyman is behind a lot of the uncertainty plaguing the credit markets. Nobody wants to think that they are on the hook for $5 trillion before the close tomorrow.
Can the entire swap market and a few entities will get hurt but the rest of us can get back to a normal existence as we get back to thinking about liabilities in the good old billions.
The lawyers can fight over the scraps.
Posted by: leftback | Oct 9, 2008 12:16:44 PM
The decision to let Lehman fail continues to look worse and worse as time goes on. I'm not for government intervention in the markets, but we never had a true free market to begin with. Some people say "look at what these financial companies did in the unregulated derivatives market. That's even more reason for intervention and further regulation." But this misses the point. This gigantic derivatives market was built on the basis of expanding home values due to artificially low interest rates brought about by the Fed. The market was simply responding to the distortion created by this quasi-governmental banking cartel.
The Truth Shall Set You Free - Sign of the Times
Posted by: Truth08 | Oct 9, 2008 12:59:34 PM
Let's think about this implications of this...
Will the necessary cash for paying the CDS be raised by Friday, ending the selling pressure on one hand, and creating liquidity on the other?
Or, will the payout of the CDS wipe-out a new big player and create a whole new round of panic?
Comments?
Posted by: Cheiro | Oct 9, 2008 1:03:15 PM
@Alan - yes: Solution: Declare All Credit Default Swaps Null And Void
There is Supreme Court precedence for this from the Roosevelt time.
A simple step that would take a lot of systemic risk away.
Posted by: b | Oct 9, 2008 1:11:57 PM
@ Cheiro:
"Will the necessary cash for paying the CDS be raised by Friday, ending the selling pressure on one hand, and creating liquidity on the other?
Or, will the payout of the CDS wipe-out a new big player and create a whole new round of panic?
Comments?"
We won't know the answers until it is history, which, of course explains the volatility...
"He who knows, does not speak. He who speaks, does not know." ~ Lau tzu (600BC - 531BC)
"When the mind is in a state of uncertainty the smallest impulse directs it to either side." ~ Terence (c.185BC – 159BC)
Posted by: The Financial Philosopher | Oct 9, 2008 1:26:31 PM
Looking at the table of derivatives exposure that Boom2Bust offered up a ways back in this thread, it strikes me as passin' strange that the CDS exposure for the top 3 banks (JPM, BoA, Citi) is so outsized in comparison to their other derivatives exposure.
Almost as if they knew that a big chunk of the CDS they had purchased were vaporous, and had over-committed to compensate for it -- if so, imagine their surprise when so much (all?) of the swaps turned out to be toxic! -- it would have been interesting to also see the CDO exposure for each of these fellas, as I really doubt that they had purchased/sold over a hundred trillion dollars worth of CDOs between the three of them.
It would be nice to see a competent panel of inquisitors (time to bring back the Spanish Inquisition?) grill the managements about this, and if it turned out that yes, they did over-commit because they were suspicious of the quality, then maybe we can find a better use for Gitmo than whatever we are currently using it for.
Or perhaps I am clueless here (there seems to be a lot of that going around recently), and there is a perfectly reasonable explanation for such outsized allocations of CDS that would fall within the envelope of legitimate business practices. If so, would some tolerant and knowledgeable soul please 'splain it to me?
Posted by: constantnormal | Oct 9, 2008 3:08:34 PM
