Ghosts of Lehman’s Debt

Story Highlights:

• Lehman's failure proved to be a huge test to the financial system, specifically to the $55 trillion credit default swap (CDS) market.
• Serious concerns loomed over the ability of contract sellers to cover the estimated $400 billion of Lehman CDSs outstanding.
• The result of final prices set last Friday means contract sellers must pay 91.375 cents on the dollar to contract holders. This is a large amount, but not unexpected, and helped clear many uncertainties hanging over the markets.
• Forced sales of liquid assets leading up to Lehman's CDS settlement auction could explain some of the extreme negative volatility of last week.

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It's not yet Halloween, but old ghosts are coming back to haunt.

About a month ago (yes, only a month ago, though by now it feels like ages), the US government chose not to save Lehman Brothers from failure—perhaps believing its failure wouldn't cause as much systemic damage to the financial system as other "too big to fail" institutions (dubious, but possible). Ironically, Lehman's failure proved to be a huge test to the financial system, specifically to the $55 trillion credit default swap (CDS) market. (Recall: This is precisely the market many believed sunk AIG in the first place.)

CDS contracts are purchased by holders of debt to insure against the event of that debt defaulting. Dealers selling the contracts agree to pay the buyer the face value of the debt security if default occurs. When Lehman failed (thus making the default event a reality), serious concerns grew over the ability of contract sellers—such as Morgan Stanley and Citigroup—to cover the estimated $400 billion of Lehman CDSs outstanding. More worrisome, there was no visibility—let alone certainty—as to who was exposed or to what extent to Lehman CDSs. Any massive net exposure was feared to possibly trigger systematic collapse of the financial systems (or at least of many major players).

Last Friday, 22 major CDS dealers in conjunction with the International Swaps and Derivatives Association, Inc. (ISDA) participated in an auction to settle prices on Lehman's CDS contracts. The final recovery rate on Lehman's senior debt was set at 8.625 cents on the dollar, meaning contract sellers must pay the remaining 91.375 cents to contract holders. Holders of Lehman's debt include big banks such as Goldman Sachs and JP Morgan.

The final price for Lehman's debt is slightly lower than some initial estimates, but it wasn't significantly different from dealers' expectations. Many sellers expected to be liable for 90% of the value of the debt, and a number of financial institutions have presumably been forced over the last month to raise cash, including selling stocks, to prepare to pay CDS buyers.

During much of Friday's session, global stock markets sold off ferociously, but upon completion of the auction, the ISDA declared that not only was a worst case scenario averted, but the actual outstanding cash settlements of all the Lehman CDS was a tiny amount. This was a result of many participants holding offsetting positions (i.e., having both long and short positions on Lehman CDSs) and the previous posting of collateral. Rather than the estimated $400 billion of counterparty risk, ISDA noted that the actual exchange of additional money needed to settle Lehman CDSs will be an amount closer to 2% of the gross outstanding or $8 billion. The S&P 500 skyrocketed more than 10% in the 45 minutes that followed. (We can't easily identify that big a move in the stock market in that short a time ever occurring.)

If the system proves able to withstand what qualified as one of the most expensive payouts in the history of the CDS market (and of derivatives in general), equity markets could move from panic to relief—though it is far too soon to say as much. This is, at the very least, a plausible explanation for the extreme negative volatility of the last several trading sessions.