Loading...
Symbols:
Authors:

Lehman CDS Datapoint of the Day

by: Felix Salmon October 13, 2008 | about stocks: LEH    
Felix Salmon

Felix Salmon

About this author:
Become a Contributor Submit an Article
  • Font Size:
  • Print

The DTCC is a reliable source, and it says the Lehman CDS settlement flows on October 21 are going to be small:

In November 2006, The Depository Trust and Clearing Corporation (DTCC) established its automated Trade Information Warehouse as the electronic central registry for credit default swaps. Since that time, the vast majority of credit default swaps traded have been registered in the Warehouse...

The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range (in U.S. dollar equivalents).

This is massive-sigh-of-relief good news. The widely-cited $400 billion number was, as far as I could make out, pulled largely out of thin air, while this is concrete stuff. If net funds transfers are only about $6 billion, that's not enough to bankrupt any systemically-important institution.

While I'm on the subject, I spoke to Creditex today about the way that the CDS auctions work. (I really should have done this before the Lehman CDS auction, but I was, um, distracted.)

In its simplified basics, it's a two-part process: In the first part, a bunch of dealers are canvassed to give bid and offer prices on the cheapest-to-deliver bonds of the entity which has just gone bust. From those prices you get something called an "indicative inside market midpoint". That's the level at which the CDS should, by rights, cash-settle.

But the problem is that there are also CDS which people want to physically settle. Some people need to deliver physical bonds -- so they're putting in bids, and need to buy them -- and some people are going to be receiving physical bonds they don't particularly want, and they'll be putting in offers, wanting to sell them.

If the difference between the buy interest and the sell interest is zero, then the indicative inside market midpoint is the final price. Otherwise, there's a second part to the auction, where the price is adjusted so that there's equilibrium between buyers and sellers. That's how the Lehman CDS cash-settlement price ended up falling from 9.75 cents on the dollar to 8.625 cents on the dollar: At 9.75 cents, there were more sellers of bonds than buyers.

Back in the bad old days of the Delphi CDS auction, single-name CDS had to be physically settled, which meant there was an enormous number of protection buyers all needing to come up with physical bonds. The result was a ridiculously high cash settlement price of 63.375 cents on the dollar -- much more than any reasonable recovery value on the bonds.

Today, however, single-name CDS not only can be cash-settled, but usually are cash-settled. Which means that Delphi-like discrepancies are much less likely to occur.

What DTCC said yesterday is that even at 8.625 cents on the dollar, which means that sellers of protection have to cough up 91.375 cents for every dollar they insured, total payments aren't going to go much over $6 billion. I can't imagine why they would say that if it wasn't true, so I believe them. Which means that one massive potential source of tail risk is not nearly as big as most people thought it was.

(Via Alea)

Related Articles

This article has 3 comments:

  •  
    Oct 13 12:02 PM
    This is interesting, i just read another comment that Oct. 21 is the "armageddon date" where 100's billions of CDS is going to be physically settled and major funds/banks are going to fail. Shouldn't the government come out and clarify this? The CDS market is so opaque, a quick resolution to clear up the total liabilities and who're the major losers (I'd think these are the institutional investors like asset managers and hedge funds) and who are the winners.
    Reply
  •  
    Oct 13 02:26 PM
    This is amazing.

    Bo Peng says that: "On Oct 21, somebody [group A] will have to pay somebody else [group B] billions in cash to settle Credit Default Swaps (CDS) on Lehman. Estimates on what this entails range from $100 billion to as much as $400 billion.".

    Felix Salmon has $6 billion net pay out.

    Michael Edwards is very satisfied that it all worked out right but does not say what the net pay out is according to him.

    The head of the German Financial Regulators said in a Reuters story today that "We're still licking the wounds of Lehman," said Jochen Sanio, president of the German Federal Financial Supervisory Authority, at an international banking conference. "It caused international damage of $300 billion outside the U.S."

    Is the panic injection of equity by OECD member countries is based on the hard reality of a $300-400 bn cash payout (according to Bo Peng) or may be a misunderstanding (possible inference from Felix Salmon) ?

    One thing is clear. Don't let rocket scientists anywhere close to where their bets co-mingle with normal fund flow ! Merriwether, Salomon, LTCM and now everybody has made the grievous error !



    I have never seen estimates that are that much in variance --- from $6 billion to $400 billion.

    So what is the correct take on this.


    Reply
  •  
    Oct 14 11:07 AM
    If what you say is true, a little common sense says that if only $6 bil was paid out by protection sellers, and they had to pay 92% of the value of the bonds, doesn't this impply that Lehman defaulted on only $6.5 bil of bonds? Seems awfully low to me so something is rotten in Denmark.
    Reply
More Comments on LEH ยป
More by Felix Salmon

Investment Resources
Money Management 

Research 

Seeking Alpha provides these ads as a service to its leading contributors
Articles on related themes
Consumer Credit 

Insurance 

Investment Banks 

Major & Intl. Banks