Fears of Lehman's CDS derivatives haunt markets

By Ambrose Evans-Pritchard
The Telegraph, London
Friday, October 17, 2008

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/321164...

It is a full week after bankers gathered in New York to start sorting out the derivatives mess left by the bankruptcy of Lehman Brothers. We still do not know who is on the hook for some $360 billion of default insurance, or how much they will have to pay.

Ominous talk of big names and big sums continues to haunt global markets, thwarting efforts by the US and European authorities to unlock inter-bank lending. Traders have noted with acute interest that insurer AIG -- now nationalised -- says it will need another $38 billion from the US government, on top of the $85 billion bailout it has already received. AIG is the world's biggest underwriter of credit protection.

Those on the wrong side of these Lehman debt contracts -- known as credit default swaps (CDS) -- must come up with the money by Tuesday, the next D-Day in the ever-fraught calendar of the credit markets. There has been a deafening silence so far.

There is no easy way of finding out who they are, so every bank and insurer is suspect. The $55,000 billion CDS market is "completely lacking in transparency and completely unregulated," in the words of Chris Cox, the chairman of the US Securities and Exchange Commission.

The settlement auction on Lehman CDS contracts last week was in itself a bombshell. Creditors retrieved just nine cents on the dollar from the Lehman wreckage. As Naked Capitalism put it, the bank had "vaporised". The biggest players at the auction were Goldman Sachs and Deutsche Bank but they were almost certainly transacting for clients.

The insurers of the debt -- a third are hedge funds -- will have to pay 91 percent of the $400 billion in contracts.

The Depository Trust and Clearing Corp. says the risks have been exaggerated in headline scare stories, insisting that the total sum to be paid will be closer to $6 billion. It says most positions are "netted out."

"That's not credible," says Andrea Cicione, credit chief at BNP Paribas.

"They keep coming up with these number by 'netting' but we think the amount is going to anywhere from $220 billion to $270 billion. The chain broke in the CDS market when Lehman Brothers went down. We may now see other counterparties defaulting," he said.

With hindsight, it is now clear the decision to let Lehman Brothers go bankrupt set off a meltdown of the world financial system, forcing North America, Britain, Europe, Australia, and now parts of Asia to rescue their banks. "A dramatic error," said Christine Lagarde, France's finance minister.

US Federal Reserve chair Ben Bernanke said this week that Washington lacked the legal power to take on the vast liabilties stemming from a Lehman rescue.

"A public-sector solution for Lehman proved infeasible, as the firm could not post sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve would be repaid, and the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman's acquisition by another firm. Consequently, little could be done," he said. The new legislation passed by Congress "will give us better choices."

In truth, both Congress and the US public wanted a scalp. Treasury Secretary Hank Paulson had to bide his time until it was clear to almost everybody that a domino collapse of the US banking system would lead to catastrophe. The Lehman collapse did the trick.

The list of companies admitting to losses on Lehman investments reveals the global extent of the damage. Dexia held E500 million of bonds, which may have caused its own need for a Franco-Belgian rescue days later.

Among the others with declared exposure: Swedbank $1.2 billion; Freddie Mac $1.2 billion; State Street $1 billion; Allianz E400 millio; BNP Paribas E400 million; AXA E300 million; Intesa Sanpaolo E260 million; Raffeissen Bank E252 million; Unicredit E120 million; ING E0100 million; Danske Bank $100 million; Aviva L270 million; Australia and New Zealand Bank $120 million; Mistubishi $235 million; China Citic Bank $76 million; China Construction Bank $191 million, Industrial Commercial Bank of China $152 million; and Bank of China $76 million. Ultimately, some money may be recovered.

These losses are out in the open, but the CDS shoe has yet to drop. Perversely the insured volume is greater than the $150 billion total of Lehman debt. Some $400 billion of CDS contracts were sold. Many were used by hedge funds to take "short" bets on the fate of the bank. The contracts nevertheless have to be honoured.

Chris Whalen, head of Institutional Risk Analytics, says this creates a huge moral dilemna. Why should taxpayers now responsible for AIG foot the bill for huge windfall transfers to hedge funds?

"We need to shut this whole thing down. The people who don't own the underlying collateral and were just betting should be flushed away. It would be grotesque if the US authorities were now to subsidize speculators. The US political class is waking up to this," he said.

If so, the winners may have more trouble than they realize collecting their prize.

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