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Thursday, October 09, 2008

More on Lehman CDS auction

There's very little information on the web about this. Elizabeth McDonald at Fox Business:

...A key driver behind the market plunge has been the tremendous demand for cash from counterparties related to the CDS (credit default swap) payouts on these recent major credit events.

It’s all happening now.

This past Monday: An estimated $200 bn to more than $1 tn in CDS written on Fannie and Freddie’s debt, the two companies’ senior and subordinated debt, were auctioned on Monday.

Reports indicate that protection sellers on the mortgage giants’ subordinated debt won big time here, with contracts on Fannie Mae’s subordinated debt recovering 99.9% of the sum insured, and swaps on Freddie Mac’s subordinated debt recovering 98%, reports auction administrators Creditex and Markit.

However, CDSs on the senior debt got less, with Fannie Mae’s senior swaps recovering 91.5% the sum insured and Freddie Mac’s senior swaps recovering 94%. CDS sellers’ losses less than expected being felt here, because Fannie and Freddie debt have rallied since the two were placed under conservatorship;

This Friday, October 10th: When the Lehman deals get unwound. Potentially $400 bn in payouts. Lehman debt now trading between 15 cents and 19 cents on the dollar, with imputed losses of 81 cents and 85 cents on the dollar.

Felix Salmon has a nice discussion, and a news search brings up this schedule for the auction. My CDS posts here.

Salmon: ...Now there are people who made money betting against Lehman Brothers by buying default protection. And since the CDS market is a zero-sum game, there must therefore be people who lost money by selling that protection. The $400 billion question is whether they have the wherewithal to make good on their obligation. (And remember that $400 billion is a gross number: the net exposure -- the total amount that some people made and others lost -- is much smaller.)

I'm optimistic on that front: I think the answer is yes, although it might well involve selling collateral and other securities in order to come up with the cash. So there could be some nasty liquidation events on or around October 10. But I suspect that a lot of the exposure to Lehman came from synthetic bonds, CDOs of CDSs, and that kind of thing -- in other words, it resides on the buy-side, not on the sell-side.

It's always possible that some hedge fund somewhere will find itself going bust as a result of writing protection on Lehman -- but so far the big hedge-fund returns on CDS have been positive (Paulson, Lahde) and not negative. I'm holding out hope that the same will hold true on October 10.

This just up from Barry Ritholtz. Today (Thursday) looks like a very bad day for equities... suspicious. Tomorrow could be worse?

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.

This picture may tell all, once the dust settles. Either I am overly focused on the role of CDS, or the financial press and academic economists are totally missing one of the biggest drivers of systemic risk and current volatility. Here is a post I wrote in 2005 linking CDS strategies to equity vol. At the time, over half of all CDS volume involved hedge funds. In the end I think we're going to see some big hedge funds wiped out from selling naked or poorly hedged CDS insurance.

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