NEW YORK, Oct 9 (Reuters) - Banks, hedge funds and other sellers of protection on Lehman Brothers’ (LEN.N) LEHMQ.PK debt are facing losses in the area of 90 percent the insurance sold when the value of the failed bank’s credit default swaps are settled in an auction on Friday.
If sellers of protection outweigh buyers in the auction, as some analysts expect, losses may be even higher.
Lehman’s bankruptcy filing last month sent its bond values plunging as the majority of the investment banking assets that had supported the debt were purchased by Barclays Bank, leaving debt holders at the abandoned holding company with little to reclaim.
The auction to settle credit default swaps protecting the debt will be one of the largest settlements of contracts in the $55 trillion market, with around $400 billion in contract volumes estimated on Lehman’s debt.
Fannie Mae FNM.N and Freddie Mac’s FRE.N credit default swap settlements on Monday were the largest to date. But unlike swaps on the agency debt, which recovered more than 90 percent of their value, Lehman’s protection sellers face the possibility of being virtually wiped out.
When a borrower defaults on their debt, sellers of protection pay buyers the full sum insured, and in return receive the defaulted debt or cash equivalents.
To determine the cash value of the default swaps, protection buyers choosing to settle the contracts in an auction will deliver the cheapest debt that qualifies in the contracts.
The majority of Lehman’s bonds are trading in the area of 12 to 13 cents on the dollar, according to MarketAxess, indicating the swaps will only recover in that area.
But there is a risk they could recover even less.
If more protection sellers than buyers choose to use the auction to settle the contracts, there will be a net open interest to sell bonds, which can push down the recovery.
“With so much uncertainty over currency, coupon and maturity, we feel most protection sellers will opt for cash settlement,” said Tim Backshall, chief strategist at Credit Derivatives Research in Walnut Creek, California.
“We also feel that protection buyers are probably dominated by traditional managers who owned the bonds but bought some protection at the end to hedge,” he said. And these investors are likely to choose to settle the contracts by physically delivering the bonds, instead of using the auction, he added.
This could send recovery levels down even lower than currently expected.
“This will leave the auction with a net open interest of bond sellers putting some downward pressure on physical bonds, and potentially leading to a lower recovery rate,” Backshall said. (Reporting by Karen Brettell; Editing by James Dalgleish)