Lehman CDS Auction Settlement: Credit Markets Take a Deep Breath
By Anthony R.G. Nolan and Gordon F. Peery
When Lehman Brothers Holdings Inc. ("Lehman") filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code on September 15, 2008, a credit event occurred on over $400 billion notional amount of credit default swaps (“CDS”) referencing Lehman obligations. The notional amount of CDS referencing Lehman was high because two distinct categories of players had bought protection on Lehman. The first category consisted of traders who used CDS to speculate on Lehman’s credit spreads and the likelihood of becoming a debtor in a bankruptcy case. The second category consisted of counterparties to financial contracts with Lehman or its subsidiaries, which entered into CDS as a hedge against the risk that Lehman would not be able to perform on obligations owing to them. Protection sellers in CDS referencing Lehman Brothers were, generally, insurers, including monoline insurance companies, hedge funds and special purpose entities engaged in structured financings.
As with settlement of other CDS where the notional amount exceeded the amount of deliverable obligations that could readily be delivered in physical settlement, the International Swaps and Derivatives Association, Inc. (“ISDA”) established an auction protocol (the “Protocol”) to offer market participants an efficient way to address the settlement issues relating to credit derivative transactions referencing Lehman. The Protocol offered institutions the ability to amend their documentation for various credit derivatives transactions in order to utilize an auction that took place on October 10, 2008 to determine the final price for certain CDS and other credit derivatives referencing Lehman. Derivatives coming within the Protocol are those transactions that were entered into on or prior to September 15, 2008, terminate on or after September 15, 2008, have a trade date on or prior to October 10, 2008 and remain outstanding as of October 21, 2008.
The auction that took place on October 10, 2008 created some consternation because the market value of the deliverable obligations was valued at approximately 9 percent of par, meaning that protection sellers would realize a loss of approximately 91 percent of the notional amount of CDS, or over $364 billion in gross terms. In light of the large notional amount of transactions to be settled, the market looked forward with trepidation to October 21, 2008, the date on which buyers of credit protection against Lehman were to receive payments from protection sellers. News reports indicated that banks may have been hoarding cash in recent weeks to be in a position to make payments. There was also speculation that significant settlement failures by protection sellers could have a potentially disastrous effect on market stability, possibly resulting in other significant challenges to the $55 trillion CDS market.
Credit market participants breathed a collective sigh of relief when October 21, 2008 passed without undue strain in the markets, as it turned out that the $400 billion notional amount of Lehman CDS was well in excess of the actual $6 billion of net Lehman CDS settlement proceeds that changed hands on October 21, 2008. The relatively small net amount reflected the fact that many protection sellers had been required to post collateral to secure their payment obligations. As CDS referencing Lehman fell in value, parties buying protection from protection sellers made collateral calls, and protection sellers had to post increasing amounts of collateral, effectively meaning that assets to satisfy a large portion of the settlement obligations had already been segregated and made available to cover Lehman CDS. It may have also reflected the fact that many large institutions and hedge funds were on both sides of Lehman CDS trades and were able to net amounts owing to each other on Lehman CDS.
While the netting of positions and the offsetting of amounts owed by posted collateral minimized the market impact of the October 21, 2008 Lehman CDS settlement under the terms of the Protocol, it may be too early to break out the champagne because the full effect of the $6 billion payday may not be known until quarterly results are released. The net Lehman CDS payout may very well still result in the failure of many Lehman CDS protection sellers which used leverage to fulfill their collateral posting obligations. This is particularly true in the market for synthetic collateralized debt obligations (“CDOs”), where investors will bear losses for many transactions that had significant exposure to Lehman. Even though the obligations of synthetic CDO issuers to their CDS counterparties are supported by collateral, the market value loss of the CDS is reflected in and borne by investors in the CDOs through writedowns of principal. This may lead to an expansion of the stresses recently seen in the asset-backed CDO market to the corporate CDO market, which until now has been relatively unscathed. It is probable that the fallout of the Lehman settlement will add to the pressure that has been growing in Washington and in parts of Wall Street for more effective regulation of the CDS market.
