(Updates price, rewrites throughout)
NEW YORK, Oct 10 (Reuters) - Banks, hedge funds and other sellers of protection on Lehman Brothers LEH.N LEHMQ.PK are facing losses of 91.375 percent of the insurance they sold, after an auction was held on Friday to determine the value of the credit default swaps.
The settlement of Lehman’s credit default swaps is one of the largest in the $55 trillion market to date, with around $400 billion in contract volumes estimated on Lehman’s debt.
Based on those estimates, the amount of insurance paid out would equal $365.5 billion, CreditSights analyst Brian Yelvington said in a report. However, “net positions are likely to be much lower,” he said.
The auction was widely watched as some investors had feared that large losses by protection sellers may be concentrated at one institution, such as a bank.
Derivatives practitioners, however, argue this is unlikely as protection sellers will have already written down the loss in the market value of the contracts, and so extra losses should be negligible.
The auction, “in and of itself, should not be the downfall of an entity since (Lehman’s) bonds have been trading in the low teens for weeks and the difference in the auction and yesterday’s price is only $4.375,” Yelvington said.
Large counterparties, such as dealers, would also have a number of offsetting trades where they may have bought and sold protection, and much of this will be canceled out.
Bob Pickel, chief executive at the International Swaps and Derivatives Association, a trade group, said payouts after netting these exposures would likely be nearer 2 percent of the volumes outstanding. This means $8 billion in protection would need to be paid out.
There were more sellers than buyers of the debt in the auction, which led the final recovery of 8.625 percent to below the 12-to-13-cent area some had expected based on the trading level of Lehman’s bonds on Thursday.
This is likely due to more protection sellers choosing to settle the contracts in the auction, compared with protection buyers who settled by physically delivering the defaulted debt to the seller.
When a borrower defaults on their debt, sellers of protection pay buyers the full sum insured, and in return receive the defaulted debt or a cash payment, which is determined by the auction.
In spite of the imbalance “the auction went very smoothly, with the slightly lower-than-expected final price reflecting a bias towards sellers,” said Simon Moore, credit strategist at credit Suisse in New York.
“You don’t know who’s going to cash settle or physically settle until the auction and even amongst the people who physically settle you don’t know what the ratio will be,” he added. (Reporting by Karen Brettell; Editing by Jonathan Oatis)