Lehman exposes credit default swap faults
By Henny Sender in New York

Published: October 6 2008 22:21 | Last updated: October 6 2008 22:21

The failure of Lehman Brothers has exposed new fault lines in the credit default swap market, with the bank's absence putting pressure on its counterparties to buy more credit insurance just as confidence in the market is waning.

"It is a cannibalistic frenzy," says one lawyer representing some of the Lehman counterparties in disputes with the failed investment bank. "The credit default swap market has taken on a life of its own. There are huge exposures out there."

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Lehman's mid-September bankruptcy is the largest in the US and recoveries for unsecured creditors might be as low as 11 cents on the dollar.

"Many investors had long and short CDS positions with Lehman which are terminated post Lehman's default," said a recent report from JPMorgan Securities. "This leaves investors suddenly long or short on credit risk. Investors need to reset these positions with other counterparties, sometimes at a loss."

In other words, at the moment, participants can't just extinguish credit derivatives contracts with Lehman, they can only offset them. That, in turn, puts pressure on some participants to buy more credit insurance and the cost of such contracts is rising.

Moreover, many counterparties to Lehman who believe it owes them money have joined the ranks of unsecured creditors. This increases the number of claimants and reduces the money available to bondholders and other creditors.

"The impact of a default far outweighs the economic impact of just the debt and equity a company has issued," says Gregg Berman, co-head of the risk business at RiskMetrics. "When you write derivatives to take exposure and have more people betting, you magnify the impact of a default".

The exact amount of any claim is determined by the difference between the value of the collateral and the cost of replacing the contract. The cost has risen in line with fears about the health of financial institutions and the creditworthiness of counterparties.

Theoretically, claims against Lehman should be offset by claims on Lehman's part. But those who believe Lehman owes them money are pressing their claims, and those who owe money to Lehman "basically say come and get me", the lawyer adds.

● Nomura continued its rescue of Lehman on Monday after the Japanese bank said it would hire 150 fixed-income staff from the US banks' European operations. Nomura also said that the conditions to closing the acquisition of Lehman's European and investment banking and equities division had been met and that a significant number of the 2,500 staff employed in that unit had been retained.

Copyright The Financial Times Limited 2008

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Banks prepare for CDS pay-outs
By Aline van Duyn in New York and Hal Weitzman in Chicago

Published: October 7 2008 03:00 | Last updated: October 7 2008 03:00



Banks are hoarding cash in expectation of pay-outs on up to $400bn (£230bn) of defaulted credit derivatives linked to Lehman Brothers and other institutions, according to analysts and -dealers.

This added pressure on the frozen financial system comes as officials prepare to meet participants in the so-far unregulated $54,000bn credit derivatives market to speed up plans for the creation of a central clearing house.


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The Federal Reserve will meet dealers, investors and exchange executives in New York on Tuesday. Although big dealers had committed to setting up a central counterparty by the end of the year, urgency has increased in light of the collapse of banks around the world and as company bankruptcies loom.

"The New York Fed will hold a meeting [today] with a small number of banks and buyside firms to discuss the progress being made toward the creation of a central counterparty for credit default swaps," said a Fed official, adding that this would "help reduce systemic risk associated with counterparty credit exposure and improve how the failure of a major participant would be addressed".

Credit default swaps, a form of insurance against bond defaults, are the most common type of credit derivative. The default of up to $500bn in derivative contracts linked to Fannie Mae and Freddie Mac was settled on Monday, the biggest such exercise ever carried out.

The Fannie and Freddie CDS settled at between 91.5 and 99.9 cents on the dollar, reflecting the fact its underlying debt is not in default after the mortgage groups were seized by the US government. The seizure did trigger defaults on derivatives, however.

The next test will be the unwinding of CDS linked to Lehman, which filed for bankruptcy three weeks ago. Michael Hampden-Turner, a credit strategist at Citi, estimates that there could be $400bn of credit derivatives referenced to Lehman.

These contracts will be settled on Friday, and with the recovery value on Lehman bonds currently estimated at about 10 cents on the dollar, the pay-out by banks and other sellers of credit protection on Lehman could reach a gross $360bn.

The Fed meeting is expected to include executives from exchanges such as the CME Group and Intercontinental Exchange, which are vying with The Clearing Corporation, a consortium of investment banks and dealers that has vowed to establish a central counterparty clearing house by the end of the year.

Copyright The Financial Times Limited 2008