Lehman Credit-Default Swap Payout Could Climb as High as $365 Billion

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Lehman Credit-Default Swap Payout Could Climb as High as $365 Billion (or $600 Billion)

By Heather Landy
Special to The Washington Post
Saturday, October 11, 2008; Page D03

NEW YORK, Oct. 10 -- In what may shape up to be the most expensive payout ever in the credit-default swap market, sellers of insurance against a debt default by Lehman Brothers will have to pay 91.375 cents on the dollar to settle the contracts.

The results of a settlement auction held Friday imply that banks, hedge funds, insurance companies and other writers of the insurance-like swaps would have to come up with as much as $365 billion for buyers of the protection. But many of the firms on the hook may have taken steps to offset their obligations, which could minimize the blow, industry experts said.

Swaps are basically insurance policies bought by investors to protect against an investment such as a corporate bond losing all value if the company falls apart. The unregulated nature of the market, in which investors essentially bet on the likelihood of a default by a bond issuer, makes it impossible to say who owes how much to whom. But it is safe to say that selling default protection through the swaps turned out to be costlier than anticipated.

The price of the Lehman bonds underlying the swaps was settled at auction at 8.625 cents on the dollar, which is subtracted from 100 to get the payout ratio for the swaps. Bond traders had recently quoted Lehman's debt at about 13 cents on the dollar, which protection sellers might have been using as a proxy before the auction to estimate how much they owed their counter-parties.
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"For all the people who are sellers of protection who didn't have hedges themselves, they're paying more than they thought they were going to pay," said Joel Telpner, an attorney at Mayer Brown in New York who specializes in credit derivatives transactions.

Credit-default swaps, initially used by bondholders that wanted to offset the risk of their investments, evolved in recent years into a $55 trillion market that frequently attracted speculators who simply placed bets on the derivatives' value, and never actually owned the debt underlying the contracts.

The swaps were at the center of the government's bailout of AIG, which needed a loan to meet collateral calls on credit derivatives.

Last month's bankruptcy by Lehman, which had been the nation's fourth-largest securities firm, has raised concern that firms might not be able to cover credit-default swaps written on about $400 billion of Lehman bonds. But firms with exposure to swaps frequently hedge their bets to limit their risks.

"If we see defaults from the standpoint that protection sellers don't pay up, then we're going to have a huge problem in the market," Telpner said. "But we don't have any explicit evidence indicating that sellers ultimately are not going to be able to pay the amounts owed to buyers."

Auctions earlier this month to unwind Fannie Mae and Freddie Mac credit derivatives resulted in much lower settlement amounts, south of 10 cents on the dollar. That's because a government bailout of the mortgage-finance companies helped preserve the value of their bonds, making default protection less valuable.

The International Swaps and Derivatives, a private industry group, has overseen more than a dozen auctions to unwind credit-default swap contracts when "triggering events" have occurred. Several more auctions are on tap as investors try to unwind swaps involving Washington Mutual and several Icelandic banks caught up in their country's credit crisis.

The brief history of credit derivative settlement auctions has primarily involved swaps related to bond issuers that needed to restructure themselves. The Lehman auction represented a new frontier for the market because the securities firm is not reorganizing -- it is liquidating.

The auction-settled price of 8.625 cents on the dollar for Lehman's bonds is not necessarily indicative of the recovery amounts that bondholders can expect in Lehman's bankruptcy proceedings.

More than 350 firms signed up to participate in the Lehman auction, which was run by Creditex Group and Markit Group.

http://www.washingtonpost.com/wp-dyn/co ... 03050.html


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 'Firms may have to pay $600 bn for Lehman debts'
Financial companies and investment funds have to shell out up to $600 billion in claims for the insurance policies on Lehman Brothers' debts, which may worsen the ongoing credit crisis.According to the New York Times, whether those claims can or will ... [10/11/2008 - Yahoo! India]
Entities: Credit Default Swaps, Lehman Brothers, Settlement Date, Markit Group Ltd, York Financial Corp

http://www.silobreaker.com/DocumentClus ... =11_263738


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10/10/2008 - Market Pipeline
Lehman Credit-Swap Auction Sets Payout of 91.38 Cents on Dollar
(Bloomberg) Sellers of credit-default protection on bankrupt Lehman Brothers Holdings Inc.

will have to pay holders 91.375 cents on the dollar, setting up the biggest-ever payout in the $55 trillion market.

An auction to determine the size of the settlement on Lehman credit-default swaps set a value of 8.625 cents on the dollar for the debt, according to Creditfixings.com, a Web site run by auction administrators Creditex Group Inc. and Markit Group Ltd.

Based on the results, sellers of protection may need to make cash payments of more than $270 billion, BNP Paribas SA strategist Andrea Cicione in London said. The potential payout is higher than the 90.25 cents indicated by initial results from the auction earlier today. Lehman bonds traded yesterday at 13 cents on the dollar, suggesting a payout of about 87 cents was expected.

No one knows exactly how much is at stake because there's no central exchange or system for reporting trades. It's that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market. More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman.

Pimco, Citadel

The list of participants includes Newport Beach, California-based Pacific Investment Management Co., manager of the world's largest bond fund, Chicago-based hedge fund manager Citadel Investment Group LLC and American International Group Inc., the New York-based insurer taken over by the government, according to the International Swaps and Derivatives Association in New York.

Hedge funds, insurance companies and banks typically buy and sell credit protection, which is used either to insure a bond against default or as a bet against the company's ability to pay its debt.

Banks and investors typically make offsetting trades to hedge their positions, and likely have already posted collateral as the market-value of the contracts fall, so the actual amount they need to come up with will be much less, Bank of America Corp. credit strategist Jeffrey Rosenberg said in a note to clients today.

Fears `Overblown'

``Fears surrounding the Lehman auction settlement are overblown,'' Rosenberg said. ``The economic impact of the Lehman bankruptcy through CDS contracts has for the most part already occurred.''

Some funds may be forced to dump assets to meet the payment demands if they haven't hedged, BNP Paribas's Cicione said.

``Banks can go to the Federal Reserve, or use the commercial paper market where it is still functioning'' to meet protection payments, said Cicione, who said a 9.75 cent recovery rate would lead to payments of about $270 billion. ``But fund managers or hedge funds, once they've used their cash, have only one option: to sell assets.''

The failures of Lehman, once the fourth-largest securities firm, and Seattle-based Washington Mutual Inc. as well as the government takeovers of Fannie Mae, Freddie Mac and Iceland's biggest banks have provided the 10-year-old credit-default swaps market with its biggest test to date. The use of credit derivatives has grown more than 100-fold in the past seven years as investors began using the swaps to bet on companies' creditworthiness.

Fed Meeting

The Federal Reserve Bank of New York is meeting with credit swap dealers and exchanges today to expedite efforts for a market clearinghouse that would reduce risks and absorb counterparty losses resulting from the failure of market makers such as Lehman.

Credit-default swap indexes around the world soared today on concern the deepening credit crisis will trigger company and bank failures. The Markit CDX North America Investment Grade index, linked to 125 companies in the U.S. and Canada, jumped 17 basis points to 215 basis points as of 12:54 p.m. in New York, according to Barclays Capital.

Credit-default swaps are financial instruments that can be based on bonds and loans. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Five-year credit-default swaps on Lehman rose as high as 790 basis points before the firm filed for bankruptcy, according to Phoenix Partners Group., a New York-based inter-dealer broker. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Fannie, Freddie

Dealers earlier this week set values for bonds of Washington-based Fannie Mae and Freddie Mac of McLean, Virginia. Sellers who signed up for the auction will pay 8.5 cents on the dollar at most because the government is backing the debt of the two largest mortgage-finance companies.

The Pimco Total Return Fund, with about $130 billion under management, has written protection on $105.4 million face amount of Lehman debt as of June 30, according to regulatory filings. Pimco spokesman Mark Porterfield didn't immediately return a call seeking comment.

A unit of Primus Guaranty Ltd., a Bermuda-based company that has sold more than $24 billion in credit-default swaps, said last month it guaranteed $80 million of Lehman debt. The firm sold protection on $215 million of Fannie and Freddie debt and $16.1 million on WaMu. Yesterday, it said it also had made bets of $68.2 million on Kaupthing Bank hf, which the Icelandic government seized.

Primus

Primus said last week it had $820 million in cash and liquid investments to meet claims on the contracts. The stock was halted from trading on the New York Stock Exchange yesterday after falling to 99 cents. The shares fell 10 cents, or 11 percent, to 80 cents at 1:33 p.m.

Collateralized debt obligations that sold credit-default protection may lose money as defaults erode their ability to withstand losses, said Byron Douglass, a strategist at Credit Derivatives Research LLC in Walnut Creek, California. He follows the market for CDOs that sold protection on Lehman debt.

The CDOs pool the swaps and then sell off pieces with varying risk.

Standard & Poor's has ratings on 1,889 CDOs that sold credit-default swap protection on Lehman, the New York-based ratings firm said last month. Pieces of 1,526 CDOs sold protection on Washington Mutual, S&P said. More than 1,200 made bets on both Fannie and Freddie.

The Icelandic banks that failed this week were also often included in CDOs created during 2006 and 2007, according to Sivan Mahadevan, a New York-based Morgan Stanley strategist.