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Fears about Lehman CDS deadline seen as overstated
October 21, 2008 / 5:10 AM / 9 years ago

Fears about Lehman CDS deadline seen as overstated

NEW YORK (Reuters) - Tuesday’s deadline to settle an estimated $400 billion in credit default swaps on debt in failed investment bank Lehman Brothers is unlikely to trigger new havoc in the market, derivatives analysts said.

<p>People look out of the window at the Lehman Brothers Holdings Inc building in New York September 15, 2008. REUTERS/Joshua Lott</p>

Tuesday is the final day credit default swaps on Lehman’s LEH.NLEHMQ.PK debt can be paid out.

Speculation has mounted that banks and other sellers have been hoarding cash to pay out a massive 91 percent loss on the contracts.

Some analysts on Monday attributed gains in the U.S. dollar to demand for dollars needed to pay the insurance.

But experts say the fears are 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 the private nature of the market makes it impossible to know who holds what risk, and how large any exposures are.

Part of the worry about the Lehman swaps is the $400 billion in insurance outstanding, although this number 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 also 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 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 October 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 October 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.

Meanwhile, of the companies that have so far announced exposures to Lehman’s default swaps, none have 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 Jan Paschal

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