Protection sellers face high payouts in Lehman CDS auction


Louise Bowman
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The long-anticipated ISDA auction settlement of Lehman CDS trades took place October 10 amid heightened nervousness in the market about what the impact of the final settlement price will be. The key issue in the Lehman auction is the net open interest (buyers versus sellers) for the contracts – which initially shows US$4.92 billion to sell.

In the recent Fannie Mae and Freddie Mac CDS auction the net position was bid – there were more buyers than sellers – which led to the perverse result that the final price for subordinated paper was higher than that for senior. In Lehman’s case there are US$138 billion senior bonds and US$17 billion subordinated bonds outstanding (but many of these are non-deliverable under the ISDA protocol) and CDS exposure widely reported as being around US$400 billion. Lehman bonds were trading in the mid-teens prior to the auction which would indicate that protection sellers face a significant payout. However, these positions are collateralized and the extraordinary trading session on Sunday 14th September (the day before the bankruptcy was announced) allowed those with exposure to Lehman to net off their positions. The initial results of the auction revealed a net open interest of US$4.92 billion to sell and an inside market midpoint 9.75. The final price of the auction was 8.625%. This means that protection sellers have to pay out 91.375c on the dollar.

But no matter how efficient the ISDA auction protocol system is, it was never designed to deal with a succession of defaults on this scale. And concern about the wider impact of CDS settlement has rattled markets and regulators alike. Indeed, the credit default swap market now seems to be facing a regulatory backlash so severe that the future viability of the industry as a whole is in question. The market’s frantic efforts to reduce notional outstandings might simply be too little too late, as its image as a hotbed of speculative trading and market manipulation becomes cemented in politicians’ minds. The compression initiatives now under way will certainly reduce the contracts outstanding by a significant amount: Isda has confirmed that volumes decreased from $62.2 trillion to $54.6 trillion in the first half of this year – before the recent events at Fannie, Freddie, Lehman et al even took place. In normal times, a market that shrinks by $7.6 trillion in six months would be remarkable. In these times, however, no one cares. In the public’s mind the CDS market is volatile, opaque, unregulated and out of control – and the regulators are determined to do something about it.

Are credit derivatives guilty as charged? Volatile? Certainly. Following Lehman’s default on September 15, Goldman CDS jumped 150 basis points to 347.5bp, Morgan Stanley 203bp to 479bp, and AIG 820bp to 1,722bp. And the recent behaviour of CDS spreads on insurance companies amply illustrates how these instruments can amplify nervousness to a worrying degree.

Opaque? That depends on who you are. The small number of large CDS dealers that dominate have invested heavily in pricing infrastructure, hardly surprising when you consider the extent to which they dominate the whole market (Lehman was referenced in 70% of all CDS reference portfolios when it collapsed). But for smaller, second-tier players and buy-siders that do not reconcile their positions every day it is a very different story. The rush to establish central clearing for CDS is to counter this charge of lack of transparency.

Unregulated? Not entirely – but certainly not regulated enough. And out of control? Considering the scale of the credit events that have taken place, the market seems to be functioning reasonably well.

Many thought that the default of one big counterparty – let alone three, Fannie, Freddie and Lehman – would result in utter chaos, and that has not happened. How the Isda auction processes play out will be a vital test – but it is something that Isda has again spent a lot of time working on. Under the terms of the cash settlement protocol, a dealer poll is undertaken to establish the clearing price of the distressed asset and then the contracts are settled at this market consensus price. The bankruptcy of Canadian forest products company Tembec Industries earlier this year gave Isda the chance to run the system nine separate times before the Lehman bankruptcy occurred. However, the counterintuitive result of the Fannie Mae and Freddie Mac auction highlights cracks in the market infrastructure that has been so painstakingly constructed.

But no matter how quickly the tear-up processes reduce the size of this market, and no matter how quickly central clearing is established to assuage concerns over counterparty risk and no matter how many initiatives are set in place to improve transparency, the market that emerges will be a shadow of its former self. There is simply too much political capital to be made by enacting new regulation for an industry now inexorably associated in the public’s mind with excess.