September 15, 2008 / 12:22 AM / 11 years ago

Derivatives market trades on Sunday to cut Lehman risk

NEW YORK (Reuters) - Major players in the $455 trillion global derivatives market rushed Sunday to scale back exposure to a potential bankruptcy filing by investment bank Lehman Brothers in a rare emergency trading session.

The Lehman Brothers headquarters in New York is seen September 10, 2008. REUTERS/Brendan McDermid

Trading took place as U.S. regulators and bankers were making last-ditch efforts to prevent toxic assets from ailing Lehman Brothers spilling into global markets and rupturing investor faith in the international financial system. For details see

“This is an extremely, and I stress extremely, rare event. It also speaks to the more general notion that, in today’s highly disrupted financial markets, the unthinkable is thinkable,” said Mohamed El-Erian, the chief executive of Pimco, the world’s biggest bond fund, based in Newport Beach, California.

The session opened at 2 p.m. New York time and was due to run until 4 p.m. (1800 to 2000 GMT), according to the International Swaps and Derivatives Association. ISDA later extended it for another two hours and some banks continued to offset their Lehman exposure even after the official session ended, according to a market source.

Trading involved credit, equity, rates, foreign exchange and commodity derivatives. ISDA estimates the OTC derivatives market excluding commodities has a value of $455 trillion.

Market sources said the special session was initiated by the Federal Reserve.

The aim is to reduce risk associated with a potential bankruptcy filing by Lehman Brothers Holdings Inc.

“Trades are contingent on a bankruptcy filing at or before 11:59 p.m. New York time Sunday (0359 GMT),” said the statement. “If there is no filing, the trades cease to exist.”

LEHMAN DEAL HOPES FADE

Britain’s Barclays Plc, which had appeared to be the frontrunner to take over Lehman — excluding its bad mortgage-related assets — pulled out of the bidding early in the afternoon, according to a person familiar with the matter.

Bank of America, the other party named as a potential acquirer, also turned away and had instead hammered out an agreement to buy Merrill Lynch & Co Inc for roughly $29 a share, or $44 billion by Sunday evening, the Wall Street Journal reported.

Merrill Chief Executive John Thain and Bank of America Chief Executive Kenneth Lewis were present at weekend talks on the future of Lehman.

Fading hopes for a Lehman deal raised the risk the firm may file for bankruptcy. Lehman hired law firm Weil Gotshal & Manges to prepare a potential bankruptcy filing, the Wall Street Journal reported on Saturday in its online edition, citing a person familiar with the matter.

The head of bond fund Pimco, Bill Gross, said a Lehman bankruptcy risks an “immediate tsunami” because of the unwinding of derivative and credit swap-related positions worldwide in the dealer, hedge fund and buyside universe.

The trading session “saw very little trading — perhaps $1 billion total — but at much wider spread levels for corporate bonds,” he said.

Mark Grant, managing director of structured finance at Southwest Securities, based in Dallas, said the lack of transparency in the credit derivatives market is a problem.

“No one has any idea about the credit quality of the assets in Lehman’s portfolio and no one has a handle about the size of the CDS contracts,” he said.

“The market is going to be spooked. People will be fearful and no one outside a very small group of people knows what Lehman going into liquidation will mean.”

If there is a forced sale or liquidation, “this could set off another round of writedowns globally.”

The benchmark U.S. investment grade derivative index jumped 23 percent late Sunday. The index weakened to 187.5 basis points from 151.56 basis points at Friday’s close, according to Markit Intraday.

COUNTERPARTY RISK

If Lehman were to file for bankruptcy, credit spreads for all corporates are expected to widen dramatically, causing large losses to investors, including those without any direct exposure to Lehman.

Barclays credit analysts said earlier this year that CDS counterparty failure could amount to $47 billion in losses.

“Our analysis shows that the failure of a major counterparty which had $2 trillion outstanding in OTC credit derivatives, could result in losses of $36-47 billion in the financial system solely due to the immediate re-pricing of credit risk due to a counterparty default,” Barclays said in a February 2008 report.

Against this background, the U.S. stock market appeared set for a sharply weaker open Monday. Stock index futures tumbled on opening with Dow futures falling more than 300 points before paring their losses. Futures on the S&P 500 were down about 28 points after earlier falling 40 points, reflecting investor jitters about the health of the financial sector.

The dollar weakened against major rivals, while gold futures rose. U.S. Treasury yields fell sharply in early Asian trade.

(Reporting by Karen Brettell, Jennifer Ablan and Walden Siew)

Writing by Ciara Linnane and Chris Sanders

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