Friday, October 17, 2008

Lehman CDS Payout On October 21: $360bn or $6bn?

From RGE Monitor:

The publicly reported facts so far are the following:

1) the gross notional volume of CDS contracts written on Lehman is around $400bn.

2) At the October 10 auction organized by the ISDA defaulted Lehman bonds secured a recovery value of 8.7 cents on the dollar. CDS protection sellers are thus called to pay out 91.3 cents of the insured face value to the protection buyers on October 21.

3) In dollar terms, protection buyers are called to pay out a gross amount of around $270-360bn as widely reported by observers.

4) The The Depository Trust and Clearing Corporation (DTCC) argues that the gross amount ignores bilateral trades among counterparties that cancel out. The net payout will only be in the range of $6bn instead of the average $300bn reported in the press (i.e. divided by a factor of 50)

5) ISDA CEO Robert Pickel in January 2008 notes in a response to Bill Gross’ (PIMCO) “Pyramids Crumbling” that, based on a recent Fitch study for the year 2006, the difference between gross and net CDS exposure is a factor of 50 and that the total CDS market exposure is not the notional $50 trillion but just $1 trillion.

Who is correct?

The first thing to note is that the CDS market is as safe as its counterparties. CDS contracts are not exchange-traded with strict margin requirements or a central clearinghouse. A CDS contract among two parties therefore introduces counterparty risk, or the risk that the protection seller e.g. will not be able to perform when called upon. From SeekingAlpha: “Those who bought naked CDS on Lehman [i.e. speculators that bet on Lehman default without owning the underlying bonds] will have a HUGE windfall -- for every dollar notional, they'll get over 91 cents. If they can collect, that is.“ [bold added]

The question about potential losses in the system depends crucially on the soundness of counterparty risk management in the over the counter CDS market. In a recent paper, the ISDA notes that “counterparty risk management begins with 1) ISDA or other relevant transaction documentation, followed by 2) measurement of both current exposure and potential loss if default were to occur in the future, and 3) by collateralization of net exposures.”

Let’s look at these elements in turn....MORE (including some pretty sharp comments)