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Bracing for Impact: Lehman Swaps Set to Unwind Tuesday

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October 20, 2008 – Comments (4)

Could be a dramatic week, folks... hold onto your Foolish jester caps.

Markets hold breath as $360bn Lehman swaps unwind The $54trillion credit derivatives market faces a delicate test as $360bn worth of contracts on now-defaulted derivatives on Lehman Brothers are due to be settled on Tuesday.

By Louise Armitstead and Peter Koenig
Last Updated: 7:47PM BST 18 Oct 2008

Due to the opacity of the market, which is one of the most complex, least regulated and least understood in the global financial system, it is still not clear how many contracts have to be settled or which institutions will take the ultimate hits once the billions of dollars worth of contracts have been unravelled. The collapse of Lehman Brothers, is expected to trigger credit default swap (CDS) protection pay-outs of about $400bn but because the contracts were sold many times through different counterparties it is not yet known who will be liable.

One commentator said: “This will be the greatest illustration of the follies of Wall Street and how unnecessarily complicated the wild off-track betting became in the past few years.”

Five years ago Warren Buffett, the iconic American investor, warned that the chaotic profusion of derivatives used by companies and hedge funds to fund financial growth were “financial weapons of mass destruction.’’

Bankers in the City and on Wall Street are bracing for yet another round of turbulence as the contracts are unwound.

The Bank of England and the Federal Reserve in America have said they will keep their special liquidity windows open late on Tuesday night to allow the contracts to settle.

“We’re in unchartered waters here and it may all prove an anti-climax,” said a senior City banker on Friday, “but everyone will be watching the situation and wondering what’s going to happen.”

An earlier auction of Lehman-related derivatives on October 10 prompted early fears that banks and investors could lose $400 billion. In the event, the discounts on the Lehman-related paper that day realised losses of only $6 billion.

At the core of Tuesday’s cash exchange between banks stands a quasi-insurance product, the credit default swaps. Investors buy CDS’s to protect themselves against the possibility of default on securities issues by firms such as Lehman. During the boom years, banks’ insurers and hedge funds created and sold CDS’s to raise what appeared to be risk-free cash in the form of premium payments.

On September 16, Lehman filed for bankruptcy, leaving them obliged to payout on CDS’s written to protect investors against the possibility of a default on Lehman paper.

City bankers say that Lehman also holds a portfolio of CDS’s written to protect against other institutions defaulting and these, too, could get caught up in Tuesday’s action.

“This will arguably be the biggest cash-exchange day and somebody will fail,” one analyst warned last week.

 

 

4 Comments – Post Your Own

#1) On October 20, 2008 at 11:38 AM, Tastylunch (29.48) wrote:

should be fun....

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#2) On October 20, 2008 at 12:17 PM, anchak (99.85) wrote:

This one is a big test ........Hopefully that extra day of trading ( Sunday) before the LEH bankruptcy - should have been sopme lead time to unwind any ridiculous bets people had - in theory if these are hedges - they should not pose any risk. But I think Dinello was saying - 50%+ of these are - as usual - BETS

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#3) On October 20, 2008 at 4:44 PM, angusthermopylae (40.73) wrote:

I think I understand (as much as any lay-mortal can) the conecpt behind these derivatives...but my question is this:  Is Lehman the only bank going to "unwind" on Tuesday?  Or are there others whose values will "come due" on Tuesday?

Then, the question becomes, "When do these other banks' derivatives come due?"

From my armchair quarterback position (probably the safest one around), I'm betting that this/these day(s) of "reckoning" are going to feel like an axe to a tree-house tree...little tremors at first, then worse and worse as they continue.

(Not to push the metaphor too far, but it could be argued that the woosdman :-) is ready to yell "Timber!" already.  Of course, then everyone argues what a falling financial tree sounds like when it hits the ground.)

(Wow...I've got to get my metaphors under control...)

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#4) On November 02, 2008 at 12:08 PM, jgseattle (29.60) wrote:

CDS do not protect a loss of value, only if the underlying security actually defaults.  Is that correct?

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