$400 Billion Lehman CDS Unwind?
Thursday, October 09, 2008 | 09:54 AM
in Credit | Derivatives | Trading
What is roiling the markets...
so we should look forward to to a lot more than this in the near future.
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.
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.
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