CDS dealers honour trades to cut Lehman risk

LONDON, Sept 15 Mon Sep 15, 2008 11:53am EDT

LONDON, Sept 15 (Reuters) - Credit derivatives dealers are agreeing between themselves to honour trades made at a special session on Sunday to replace Lehman Brothers as a counterparty, even though the trades technically became invalid on Monday.

The International Swaps and Derivatives Association (ISDA) organised a four-hour session for dealers in credit default swaps and other types of derivatives to make offsetting trades that would cut out Lehman LEH.N and thus reduce counterparty risk in the entire over-the-counter market.

But the trades were contingent on a Lehman bankruptcy filing by 2359 New York time on Sunday. They ceased to exist when Lehman missed that deadline and filed for Chapter 11 early on Monday.

One London trader said his bank and another major dealer on Monday between them had agreed to stand by the offsetting trades they had made on Sunday.

"As far as I know, all dealers are honouring these trades in the spirit of things. The orders will stand," the trader said.

An ISDA notice on Monday said: "Under the terms of the Protocol Agreement published yesterday, trades done pursuant to the protocol have not come into effect as the filing occurred after 11:59 pm, New York time Sunday."

But it added: "If parties wish to give effect to those trades (at the relevant price agreed in yesterday's trading session), they may do so by renewing the Protocol Agreement with a revised expiration date and expiration time."

In offsetting trades, every contract to buy by one dealer with another is simultaneously matched with a contract to sell the same asset to that same counterparty. The net effect is that neither side makes a gain or loss.

TOO EARLY TO TELL

Traders and analysts, meanwhile, said it was too early to tell what effect Lehman's bankruptcy filing would have on systemic counterparty risk.

"Counterparty risk is going to be major," said one analyst. He estimated the number of trades with Lehman as a counterparty in the tens of thousands but would not estimate the value of those trades.

"Each one of these trades has to be novated, rehedged, unwound. From an operational viewpoint, this could take a long time," he added. In novation, a counterparty does a subsequent trade to pass on credit risk to another dealer.

Trading volumes were relatively modest in Europe on Monday, traders said, as most investors assessed their exposure to Lehman as a counterparty and their risks rather than rushing to get out of their contracts and rehedge with another dealer.

Credit derivatives indexes gapped wider in early morning trade and then recovered part of those losses. The investment-grade Markit iTraxx Europe index ITEEU5Y=GF was at 125.5 basis points at 1426 GMT, 22.5 basis points wider on the day but down from 136 basis points in earlier trade.

"It has been pretty orderly to tell you the truth. Lehman is not that big a counterparty," the trader said. "So far there is no panic yet."

A fund of hedge funds manager, who declined to be named, said he expected the effect on hedge funds to be limited.

"It (counterparty risk with Lehman) is obviously now something that everyone is reviewing ... A lot of people have seen this coming and I'm sure have ... reduced exposure," he said.

Most counterparties, including hedge funds, would have required Lehman to post collateral to cover changes in market value of trades. Collateral is adjusted only on a daily basis, however, and would not cover their losses from Monday's market drop.

"A number of contracts, like exchange-traded futures, will settle profits and losses on a daily or weekly basis. You have cash flows depending on how the trade is moving on a daily or weekly basis. It's based on a margin system ... My impression is that it (the effect) is fairly limited,"

"What most people seem to be doing at the moment is sitting on their hands," another trader said. (Additional reporting by Laurence Fletcher and Maya Thatcher; Editing by Paul Bolding)