(Adds comment from ISDA in paragraphs 15-16)
By Karen Brettell
NEW YORK, Oct 21 (Reuters) - Tuesday’s deadline to settle an estimated $400 billion in credit default swaps on Lehman Brothers failed to trigger feared havoc in the market, and derivatives analysts said the concerns had reflected misunderstandings about the process.
Tuesday is the final day that credit default swaps on Lehman’s LEH.NLEHMQ.PK debt can be paid out.
“It seems like a non-event,” said Tim Backshall, chief strategist at Credit Derivatives Research in Walnut Creek, California. “There’s a couple of hedge fund rumors, but I am sure they are more general redemption issues than Lehman specific.”
Speculation had mounted in recent sessions that banks, hedge funds and other sellers had been hoarding cash to pay out a massive 91 percent loss on the contracts.
But experts say the fears were exaggerated and in any case, losses may not be made public until companies post their next quarterly earnings in the months to come.
“There’s been a lot of talk about this, but I don’t think it’s that material, there has been a lot of misunderstanding,” said Sivan Mahadevan, head of credit derivative and structured credit research at Morgan Stanley in New York. “I think it’s been overdone.”
Credit default swaps are insurance-like securities that protect against the risk of a borrower defaulting on debt.
The $55 trillion market has created concerns that it may pose systemic risks as its private nature makes it impossible to know who holds what risk, and the size of any exposures.
Part of the worry about the Lehman swaps is the $400 billion in insurance outstanding, although the figure overstates the amount of money that will actually be transferred.
The Depository Trust and Clearing Corporation, which clears the vast majority of trades in the over-the-counter market, said this month only $6 billion may actually change hands.
This is because large players in the market, such as dealers and some hedge funds, have both bought and sold protection, subsequently taking both gains and losses on Lehman’s default that will offset each other.
For companies with net exposure to pay out protection, much of the pain of settling the swaps has already been taken.
“If you were the seller of protection, you had to pay collateral and that collateral was changed on a daily basis, based on where Lehman’s bonds were trading,” Mahadevan said.
“The money’s already in the system. The loss is already in the system. I don’t think of it as a big deal in terms of losses exchanging hands,” he added.
The International Swaps and Derivatives Association, or ISDA, a derivatives trade group, declared the settlement of trades on Lehman’s debt a success for the industry.
“Today’s settlement demonstrates that the industry infrastructure for CDS clearly works,” Robert Pickel, chief executive of ISDA, said in a release. “The Lehman default and settlement have not created the financial disruption that critics of the CDS business have claimed.”
The price of Lehman’s bonds dropped to about 12 or 13 cents on the dollar after the investment bank filed for bankruptcy in September, meaning sellers of protection needed to post collateral to cover a loss of 87 percent to 88 percent on the contracts at the time.
Some buyers of protection would have used these bonds to settle their contracts. Others participated in an auction on Oct. 10 to determine the value of the contracts.
When a borrower defaults on 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 auction.
The Oct. 10 auction involved 358 market players and determined the swaps were worth just 8.625 cents on the dollar, meaning sellers needed to pay out 91.375 cents on every dollar of insurance sold.
“The auction for Lehman CDS was successful and the amount that was paid out on this credit event is significantly lower than what has been mentioned in the press,” analysts at Barclays said in a report.
An auction to settle credit default swaps on Washington Mutual’s (WM.N)WAMUQ.PK debt is scheduled for Thursday, with payments on those contracts due by Nov. 7.
Analysts expect that WaMu’s swaps will recover a high value, leading to fewer losses by protection sellers than those seen on Lehman.
Meanwhile, of the companies that have so far announced exposures to Lehman’s default swaps, none has indicated any threat to the viability of the firm.
Genworth Financial (GNW.N), for example, said it had only $5.4 million in credit default swap exposure to Lehman credit default swaps, and Hartford Financial Service Group (HIG.N) said it had $30 million in exposure to Lehman’s swaps. (Reporting by Karen Brettell; Editing by Leslie Adler and Jan Paschal)