Pay-up time for Lehman swaps (today)

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http://www.atimes.com/atimes/Global_Economy/JJ22Dj03.html


This Tuesday will be the first really interesting day in the financial markets since the day last week when US Treasury Secretary Paulson partially nationalized the nine largest US banks. October 21 sees the settlement of the credit default swaps (CDS) issued on Lehman Brothers debt.

First the facts. A CDS, or credit default swap, is essentially an insurance against losses if an issuer of debt goes bankrupt and cannot honor its obligations. Those who have sold the protection will then compensate the loss to those who have bought the protection. Estimates say that Lehman debt amounts to some US$150 billion. Other estimates say that Tuesday will see settlement of about $360 billion worth of nominal CDS contracts.

Sounds fishy? Insured debt of $360 billion while the total outstanding of Lehman debt amounts to only $150 billion? The explanation is a simple one, that the CDS are not necessarily linked to the buyer of the credit insurance in fact holding any Lehman debt. To put it in different terms: a CDS is the financial market equivalent of being able to take out an insurance that will pay out money to you in case your neighbor's house burns down.

This situation is indicative of something that ought to have everybody hold their breath for a second. CDS were originally meant as insurance for holders of debt. But in absence of rules, oversight and regulation CDS became instruments of speculation, where the buyer and the seller took bets on Lehman's future. If the above estimates are true, and if we make the friendly assumption that $150 billion worth of nominal contracts are indeed bought by the actual holders of Lehman's debt, no less than $210 billion worth of speculative bets will have to be settled on Tuesday. <1>

If the recent prices of Lehman debt is anything to go by (between eight cents and nine cents in the dollar), this settlement will lead to some $190 billion changing hands - from sellers to buyers of "default protection".

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But it is almost certain that hedge funds are among the big holders of speculative default protection. If the settlement of Lehman CDS gives rise to any glitches, the huge CDS market will be shaken and it is likely we will see a scramble for the exit as holders of "protection" realize that they may not be protected at all.

Readers will recall the ancient Chinese curse: May you live in interesting times! Sometimes a bit of boredom should be welcomed.
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