Unforeseen Side-Effects of Lehman Bankruptcy

Apparently there may be up to $360B dollars in losses tomorrow as the auction for the Lehman CDS contracts are settled according to this Reuters article: Lehman CDS sellers face massive losses in auction

Banks, hedge funds and other sellers of protection on Lehman Brothers’ debt are facing losses in the area of 90 percent the insurance sold when the value of the failed bank’s credit default swaps are settled in an auction on Friday.
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The auction to settle credit default swaps protecting the debt will be one of the largest settlements of contracts in the $55 trillion market, with around $400 billion in contract volumes estimated on Lehman’s debt.

Fannie Mae and Freddie Mac’s credit default swap settlements on Monday were the largest to date. But unlike swaps on the agency debt, which recovered more than 90 percent of their value, Lehman’s protection sellers face the possibility of being virtually wiped out.

This component of the Lehman bankruptcy highlights some of the unforeseen repercussions of their filing that are causing ripples throughout the financial markets.

It also highlights the magnitude of the $60 Trillion notional value CDS market. One way to think about this is that there is somewhere between $15 and 20 Trillion of face value between MBS, CMBS, and Corporate bonds. The CDS market thus represents 3-4x the total amount of credit outstanding in the economy.

Thus, whenever corporate defaults happen, the losses associated with these failures can be much larger than the “balance sheet” of the failing company. Given the fact that there are people on both sides of these CDS transactions, this arguably should not be a net loss to the economy (i.e. there are both winners and losers).

However, when losses come in spikes like this, it can clearly threaten the viability of individual firms, forcing them to sell other securities, which exacerbates the pressure of normal losses.

Furthermore, given the already strained nature of a number of these firms, it is clear that continued losses like this will cause failures.

As we are in the midst of the turn of a credit cycle, losses are inevitable and part of a slowing economy. The problem this time around is that institutions are highly levered and losses are being felt in ways that were unforeseen…causing more firms to lose money, sell assets, and creating further downward pressure on asset classes globally.

All of this adds to the fear and uncertainty that you are feeling and seeing in the markets right now.

Things are looking bad. Things will probably get worse.

BUT, don’t forget, things are also very good. There are a lot of phenomenal companies that are going down with those that are challenged, and particularly in technology, these companies will be making money for years to come.

I am convinced our best days are ahead of us…we just may have a few more bad ones in between now and then.

UPDATE: Last night’s estimates were accurate. According to this arcticle, losses will be upwards of $360B: Lehman Debt Protection Cost Set at Auction

Issuers of unregulated derivatives promising a payout in the event of a Lehman Brothers default will pay more than 91 cents on the dollar to settle credit default swaps related to the bankrupt company.

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