Friday, October 10, 2008

Lehman CDS: It Won't Be Over Today

To answer an emailers question on why the emphasis on the Lehman CDS today, there are dozens of implications for the markets and the economy. Here are three:
1) Part of the reason banks slowed their overnight lending even further this week is that to the extent they are on the insurer side of the swap, they had to hoard cash to make the payoffs.

2) The auction is setting a transparent price for Lehman's debt and it is not pretty.

3) Some of the secondary players in the swaps market are hedge funds that were out and out gambling that they would never have to pay a claim. Being hedgies they are so leveraged that the only way they can meet their obligations is to sell everything, stocks, bonds, derivatives, their souls (well, technically that would be a naked short or fraudulent double pledging of the same collateral).

One of the reasons pros were looking for an immediate term bottom today is that they thought this mandated selling would stop (for now. I'll be back with the problems the hedgies are going to cause us in the next couple months, when things cool down a bit)

From Market Movers:
Vipal Monga today mentions something I was unaware of: the Lehman CDS auction today is not the end of the story when it comes to settling those trades. All it does is set the price: settlement doesn't happen until October 21, the week after next. In other words, to the degree that there's nervousness over counterparties being unable to meet their CDS obligations, it's going to remain through not only this weekend but also the weekend afterwards.

In fact, the actual settlement price is one of the few things we already know, more or less: it's going to come in somewhere between 10 cents and 20 cents on the dollar. The huge list of things we don't know, by contrast, is going to remain unknown until after October 21. Michael Edwards has a good column up at Seeking Alpha today:

CDS pricing is even less transparent than it seems at first glance. Setting aside the counterparty risk, the liquidity risk, and the litigation risk (due to absurdly complex CDS contracts)...MORE