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     Oct 22, 2008
Pay-up time for Lehman swaps
By Kim Asger Olsen

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".

To get the order of magnitude right: the amount changing hands corresponds to nearly three months of US current account deficit.

A gain of 91 cents or so for each underlying of $1 is not a bad return on a few minutes work. In other words, those who speculated on Lehman's collapse are looking forward to a huge pay day. Or are they?

Certainly, some of the biggest players, such as the fully nationalized AIG and the nine partly nationalized banks, are big players in this game. It is inconceivable that some of them are not on the underwriting side and have sold the protection, irrespective of whether the buyer actually held Lehman debt or was just another gambler in the market. Now an interesting new dilemma is appearing: will the US Treasury accept that potentially huge sums of taxpayer money be used to pay speculators who were right in guessing that the US Treasury would allow Lehman to fail.
It is known in the market that AIG has asked the US Treasury for some $20 billion-plus on top of the bailout package of $85 billion agreed three weeks ago. It is also widely guessed in the market that that $20 billion is earmarked to meet AIG's obligations related to Lehman debt. We have not started to talk about other defunct debt issuers yet - notably Bear Stearns or Washington Mutual.

Being among those who have to shell out $190 billion is enough to give other institutions a powerful push in the direction of insolvency. For this reason alone, the US Treasury is facing a serious choice: use taxpayer money to reward speculators or try to limit the damage. One possible avenue would be to demand that those who have bought protection actually prove that they held Lehman debt, and pay them, but refuse to pay those who had speculated. This could be a politically attractive way out of an interesting moral dilemma.

Morals are always interesting to discuss. For our purposes it is, however, more relevant to look at the potential impact on the CDS market. It is estimated that CDS to the value of $55,000 billion or $55 trillion have been sold in relation to corporate debt. Given that the CDS market is unregulated, it is at this point in unknown how many of those "protection" contracts are purely speculative, as are about two-thirds of the Lehman contracts. It is unknown who issued them and we do not know the buyers. What we do know is that the settlement of the Lehman CDS will be an important indicator for whether this market will be the next to melt down as the subprime market has already done.

Probably, most of the CDS are issued on non-financial companies, and some even on sovereign issuers. This could indicate that we are not heading for a total meltdown, as the rate of corporate bankruptcies obviously will not go through the roof (unless we really are heading for a depression ... an interesting thought).

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.

1. The Depository Trust and Clearing Corporation, which clears the vast majority of trades in the US over-the-counter market, said this month only $6 billion may actually change hands, Reuters reported early on Tuesday. 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, the report said.

Kim Asger Olsen trained as an economist in Denmark, Italy and France. He has worked as an investment strategist, chief investment officer and a managing director in the European financial sector for more than 20 years.

(Copyright 2008 Kim Asger Olsen.)

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