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LONDON, Oct 17 (Reuters) - Investors who bought protection against a Lehman Brothers default in the credit default swaps market have little to worry about getting paid on Tuesday, when an estimated $8 billion in cash payments on Lehman CDS come due.
While these payments may push a few fragile hedge funds over the edge, analysts say, stringent collateral requirements mean most protection buyers will not be out of pocket.
Comment has circulated in the markets and in the media that CDS counterparties may not be able to come up with the cash.
"The big issue is whether they (CDS) will be settled successfully," wrote ING rate strategist Padraic Garvey on Friday. "The talk is that hedge funds sold protection on Lehman ... well now they will have to cough up."
Analysts at Citigroup and Barclays Capital said market fears about the Oct. 21 date have been overstated.
"This is more of a slow process, and people will have had to come up with the money long before the settlement date," said Michael Hampden-Turner, a Citigroup credit strategist.
The standard practice in the CDS market is that hedge funds and other counterparties must adjust collateral on a daily basis as the value of a contract changes.
As Lehman CDS fell in value, before and after it filed for bankruptcy, protection sellers would have had to provide increasing amounts of Treasury bonds or other cash-like investments as collateral for those contracts.
"The mark-to-market on the CDS is margined daily as a credit event draws near, and that mitigates a large, lumpy payment at the end," said Peter Goves, another Citigroup strategist.
In the Lehman case, the largest collateral payments would have been required in the four or five days following the bankruptcy filing in mid-September, when spreads on senior debt widened from around 700 basis points on the five-year contract to around 7,000 basis points, based on the then market view of an estimated 30 percent recovery, Hampden-Turner said.
The cash settlement CDS auction on Oct. 10 set final recovery on the CDS at an even lower 8.625 percent.
But by that time, market expectations had already fallen to close to that level, around 10 cents on the dollar.
"The auction was not a huge surprise, worse than expected but only slightly," said Puneet Sharma, a credit strategist at Barclays Capital. "If you are a solvent institution or a counterparty to a solvent institution, then you would already have collateral close to that amount."
For a few hedge funds or other leveraged investors who sold protection on Lehman LEHMQ.PK, however, Tuesday could prove to be a strain.
Funds typically use leverage to obtain the collateral they provide on CDS contracts.
So while the CDS counterparty is already holding collateral to cover his payment, other lenders to the hedge fund may end up the losers.
If the only event in the market were the Lehman failure and the resulting payment of $8 billion on its CDS, that alone would probably not be enough to cause any funds to collapse, Barcap's Sharma said.
But in the current environment, "the stresses that hedge funds are facing because of volatility are unprecedented," he said. "The number of margin calls from the commodity, equity, credit, volatility and other positions are going to be enormous."
For some investors, Tuesday's payment "could be the final straw", he said. (Editing by Paul Bolding)