From BreakingViews via the New York Times:
A Day of Reckoning
Wall Street and its regulators are gnawing their fingernails. Financial firms are about to learn how much they stand to gain — or lose — on derivatives linked to Lehman Brothers’ credit.
Banks, hedge funds and others use the credit-default swap market to sell and buy protection against borrowers’ defaults. Protection sellers agree to pay buyers the difference between the face value of the debt, usually 100 cents on the dollar, and what investors expect to recover through the bankruptcy process.
Lehman, which filed for bankruptcy last month, has about $113 billion of bonds outstanding, according to Reuters Knowledge. It’s impossible to know how much protection has been written on that debt, because credit derivatives are privately negotiated and not all buyers of protection hold the underlying debt....MORE (scroll down)
Lehman to Spark Record Payout for Credit Swap Sellers
The collapse of Lehman Brothers Holdings Inc. may force Pacific Investment Management Co. and other sellers of credit-default swaps to make the biggest-ever payout in the $55 trillion market.
An auction to be held today will determine the size of the payments buyers of default protection can claim after New York- based Lehman filed for the largest bankruptcy with $618 billion in debt. Lehman's $128 billion of bonds were trading yesterday at an average of 13 cents on the dollar, indicating credit swap sellers may have to pay 87 cents.
``That's a big hit,'' said Byron Douglass, a strategist at Credit Derivatives Research LLC in Walnut Creek, California. He follows the market for collateralized debt obligations that sold protection on Lehman debt. The payment compares with a typical bond recovery of about 40 cents on the dollar and a payout closer to 60 cents, Douglass said.
More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman. No one knows exactly how much is at stake because there's no central exchange or system for reporting trades. It's that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market...MORE