CDS auction monday: look out below

[yoganmahew]

nakedcapitalism.com/2008/10/ … g-big.html

…it turns out there may be a specific reason that the banks are hanging on to cash for dear life. Reader Glen pointed to a Financial Times piece that discusses the upcoming settlement of credit default swap payouts triggered by recent defaults. The banks apparently lack a good estimate of their exposures (settlement prices are to be set by auction). And banks that don’t have enough to meet their obligations may fail. And more failures would trigger more credit default swap settlements, which could trigger more failures…

From the FT:

The $54,000bn credit derivatives market faces its biggest test this month as billions of dollars worth of contracts on now-defaulted derivatives on Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual are settled.

Because of the opacity of this market, it is still not clear how many contracts have to be settled and whether payouts on the defaulted contracts, which could reach billions of dollars, are concentrated with any particular institutions.

According to dealers, insurance companies and investors such as sovereign wealth funds, which are widely believed to have written large amounts of credit protection through credit default swaps on financial institutions, could have to pay out huge amounts…

The “auction season” starts tomorrow, when the International Swaps and Derivatives Association has scheduled an auction for Tembec, a Canadian forest products company. This is followed by Fannie Mae and Freddie Mac auctions on October 6. Then, Lehman is settled on October 10, and Washington Mutual is scheduled for October 23.

Even though it is possible that some participants in the credit derivatives market will have to make large payouts, the flipside is there could also be big winners. For every loss in credit derivatives, there is a gain.

The amount of contracts outstanding that reference Fannie Mae and Freddie Mac alone is estimated to be up to $500bn. The default was triggered under the terms of derivatives contracts by the US government’s seizure of the mortgage groups, even though the underlying debt is strong after the explicit government guarantee.

The CDS contract settlement could result in billions of dollars of losses for insurance companies and banks that offered credit insurance in recent months. The recovery value will be set by auction. Usually, the bond that is eligible for the auction that trades at the lowest price - the so-called cheapest-to-deliver - is the one that sets the overall recovery value for the credit derivatives.

In the Lehman case, numerous banks and investors have already made losses due to exposure to Lehman as a counterparty on numerous derivatives trades. The auctions next week are for credit derivatives which have Lehman as a reference entity. There are likely to be fewer contracts outstanding than for Fannie Mae and Freddie Mac because Lehman was not included in many of the benchmark credit derivatives. However, exposure remains unclear, which is one concern that regulators now have about the credit derivatives market.

Lehman’s bonds have been trading between 15 and 19 cents on the dollar, meaning investors who wrote protection on a Lehman default will have to pay out between 81 and 85 cents on the dollar, a relatively high pay-out.

The previous biggest default in credit derivatives was for Delphi, the US car parts maker that went bankrupt in 2005 and which had about $25bn of CDS.

Update from the Independent:

The “auctions” to decide the value of bonds in default and the amounts the derivative insurance will have to pay out on them are organised by theInternational Swaps and Derivatives Association (ISDA), based in New York. ISDA has held only nine auctions since 2005, but this month will see five that will include many of the former giants of the US financial scene. The CDS market is opaque because contracts are only registered between the buyer and seller of the insurance, with no central record of the value or whereabouts of outstanding contracts…

The auctions will also be a big test of investment banks’ procedures when the authorities are scrutinising certain securities firms for lapses.

“It is significant because it is probably going to be a good opportunity for investment banks to prove to regulators that they have their house in order. Any big investment bank will want to make sure that nothing is dropped on the floor,” said an analyst at oneinvestment bank.

A record 409 firms had alreadyregistered for the Fannie and Freddie auction yesterday, with 300 having signed up in the previous 24 hours and hundreds more in the pipeline. The value of derivatives contracts covering the two US mortgage finance agencies, which were effectively nationalised last month, is estimated at between $400bn and $600bn.

The size of the Fannie and Freddie auction dwarfs the previous biggestdefault in credit derivative markets, which was for Delphi, the US car-parts producer that went bankrupt in 2005.

The auction system was put in place seven years ago to centralise agreement of the recovery rate on company bonds in default.

ISDA calculates an average value for the underlying bonds from varioussubmissions by market makers. If the average is 40 per cent, for example, then the issuer of the protection pays the “lost” 60 per cent to the CDS buyer.

Before the system was brought in, the buyer of protection had to physically find some bonds and present them to the insurer in return for the payment. The insurer then had to get back as much as possible from the defaulting company. The system has become increasingly important because, as the CDS market has grown, for many companies the value of outstanding CDS contracts vastly exceeds the value of the actual bonds issued.

In theory these auctions should be damp squibs, because the CDS should cancel each other out. But the suspicion is that it doesn’t really work like that. The suspicion is that many companies did an AIG on it and sold CDS that they didn’t offset completely and so they are carrying the can. There is also a suspicion that naked purchases took place, that is, purchases where there was no underlying asset to protect - these companies will be big winners. Where there are big winners, there are either big losers or lots of small losers.

Despite reading the auction process above a few times, I don’t really understand how it works, so if anyone clever can tell me, I’d be delighted

[yoganmahew]

From Dhalc2 on tickerforum:

FYI This is broadly how the CDS auction procedure works:

Say the buyer of protection has entered into a CDS with a seller of protection, referencing, for example, a notional $10,000,000 of Freddie Mac bonds (the buyer is not required to actually hold such bonds).
The buyer pays quarterly premiums of, say, 125bps = $125,000, to the seller of protection. The buyer stops paying protection on the occurrence of a credit event.

On the auction date, firm bids will be requested from a consortium of Wall Street banks on a certain notional amount of Freddie Mac bonds and then the recovery rate on those bonds will be calculated. Because firm bids are requested from the banks, the hope is that the prices they receive will be prices the other party is actually willing to pay for these bonds.

The articles indicate that the recovery rate will be high (i.e. the bonds have not dropped much in value). For most of the credit events I have seen, the recovery rate has been in the 30%-50% range (and it is likely that the Lehman and WM CDSs may have even lower recovery rates).

As the recovery rate is high, the sellers of protection are going to have to make smaller payouts in comparison to other credit events. Additionally, the purpose of the auction procedure is that all the amounts owed by sellers will be netted off against each other where possible (i.e. if bank A owes bank B $100, and bank B owes bank A $60, bank A pays over $40), reducing the amount of $$$ that will have to be paid. On the other hand, as the outstanding notional amount of CDS on Freddie and Fannie is so large (and since Settlement Amount payable by seller = Recovery Rate * CDS Notional Amount), it is therefore possible that even with the high recovery rate, the settlement amounts will wipe out many sellers of protection.

From the ISDA website, it looks like the cash settlement date will be Oct 15 2008, so the sellers have until then to come up with the cash.

One other important point is that these Fannie and Freddie CDSs were put into synthetic CDOs. The investors in those CDOs (hedge funds, insurance companies, banks etc.) are effectively sellers of protection, so those investors stand to lose $$$, depending on how leveraged those CDOs were. Therefore it is not just the banks which wrote CDS contracts that lose $$$ here, but many investors who invested in synthetic structured finance instruments.

As the FNM and FRE bonds are government guaranteed, it is likely there will not be much of a problem with them. The real problem will come with the Lehman’s auction on 10 October. This in turn, if it turns bad, could turn the WaMu and AIG auctions into bigger events (although in theory both are guaranteed by their new owners). Pabloescobar, another poster on tickerforum, believes this is the real motivation behind the Fed/Treasury needing 700 bn in cash to buy distressed assets - they need to pump money into the losers of these CDS unwinds.

[Green_Bear]

The Looming Lehman CDS Unwind
blogs.wsj.com/marketbeat/2008/10 … ds-unwind/

Geoffrey Rogow reports:
On the heels of similar auction processes for Fannie Mae, Freddie Mac and Washington Mutual late last month will be the expected Friday settlement for buyers of about $400 billion of protection on Lehman Brothers debt.

For now, traders in the equity market are concerned about the prospects for the settlement, adding that its uncertainty is casting a dark cloud over the most likely holders of the debt — big banks such as Morgan Stanley, Goldman Sachs and J.P. Morgan Chase.

This Lehman credit default swaps settlement auction will likely be one of the most expensive payouts in the history of that market, something the government is certainly keeping an eye on.

The Fed has called a second meeting to discuss the settlement of Lehman CDSs, among other issues, on Friday. “They think there is still counterparty risk out there. But, if we get through that hurdle without too many issues then you will see a more stable market into next week,” said John O’Donoghue, head of equities for Cowen & Co.

O’Donoghue said the Fed is trying to make sure there is a “smooth” settlement process where that agency can then move towards making the settlement process a more government-regulated, centralized market.

[yoganmahew]

nakedcapitalism.com/2008/10/ … ts-on.html

Those who wrote $400 billion plus of protection on Lehman’s credit default swaps had been expected to make a substantial payout in the 80% to 85% of face value range, but the preliminary auction showed even worse results.

How the SEC and Treasury had so little clue that Lehman was in such bad shape is beyond me. The vagaries of permitting Level 3 accounting.

From Bloomberg:

-Sellers of credit-default protection on bankrupt Lehman Brothers Holdings Inc. would be forced to pay holders 90.25 cents on the dollar under initial results of an auction today, setting up the biggest-ever payout in the $55 trillion market.

Preliminary results of the auction to determine the size of the settlement on Lehman credit-default swaps set an initial value of 9.75 cents on the dollar for the debt, according to Creditfixings.com, a Web site run by auction administrators Creditex Group Inc. and Markit Group Ltd. A final price is scheduled to be announced at 2 p.m. New York time.

The payment would be higher than indicated by trading in Lehman's $128 billion of bonds yesterday. The debt was trading at an average of 13 cents on the dollar, indicating credit swap sellers would have to pay 87 cents.

More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman. No one knows exactly how much is at stake because there's no central exchange or system for reporting trades. It's that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market.

The list of participants includes Newport Beach, California-based Pacific Investment Management Co., manager of the world's largest bond fund, Chicago-based hedge fund manager Citadel Investment Group LLC, and American International Group Inc., the New York-based insurer taken over by the government, according to the International Swaps and Derivatives Association in New York.....

BNP Paribas SA strategist Andrea Cicione in London estimated earlier today that a 20 cent recovery rate would lead to sellers paying out as much as $220 billion.

``Banks can go to the Federal Reserve, or use the commercial paper market where it is still functioning'' to meet protection payments, said Cicione. ``But fund managers or hedge funds, once they've used their cash, have only one option, to sell assets."

Defenders of CDS had long argued that the guarantees were hedged with offsetting swaps. We are about to find out whether that true.

[superman]

@yoganmahew

We are about to find out whether that true.

F!CK - when does this hit the fan exactly?
Also how much more of this is there?

[yoganmahew]

@superman

@yoganmahew

We are about to find out whether that true.

F!CK - when does this hit the fan exactly?
Also how much more of this is there?

There’s still AIG to do, but I don’t expect that to cost that much as it is nationalised and it’s bonds are worth something (about 85 cents on the dollar?). Still, don’t know how much is outstanding on AIG.

The next biggies, which will be 30 days after the confirmed ‘event of default’ will be the Icelandic banks. There’s been speculation about them for months (far longer than about Lehmans), so I expect there will be a fair amount written on them. Prices were high for the CDS, so maybe it won’t be too bad?

edit: sorry - Diet on godlikeproductions.com/forum … 632616/pg1 believes his kabalism and says either 2:07 eastern or 3:11 eastern (19:07 or 20:11). I presume he knowns when the announcement will be made and assets will be dumped? Or that margin calls will start being made based on the downturn in the market caused by Lehmans CDS auction or he’s got a hotline to Opiuchi and the voices are telling him…

[2Pack]

bloomberg.com/apps/news?pid= … refer=home

Fears `Overblown’
**
Fears surrounding the Lehman auction settlement are overblown,'' Rosenberg said. The economic impact of the Lehman bankruptcy through CDS contracts has for the most part already occurred.‘’
**

Oct. 10 (Bloomberg) – Sellers of credit-default protection on bankrupt Lehman Brothers Holdings Inc. will have to pay holders 91.375 cents on the dollar, setting up the biggest-ever payout in the $55 trillion market.

An auction to determine the size of the settlement on Lehman credit-default swaps set a value of 8.625 cents on the dollar for the debt, according to Creditfixings.com, a Web site run by auction administrators Creditex Group Inc. and Markit Group Ltd.

Based on the results, sellers of protection may need to make cash payments of more than $270 billion, BNP Paribas SA strategist Andrea Cicione in London said. The potential payout is higher than the 90.25 cents indicated by initial results from the auction earlier today. Lehman bonds traded yesterday at 13 cents on the dollar, suggesting a payout of about 87 cents was expected.

No one knows exactly how much is at stake because there’s no central exchange or system for reporting trades. It’s that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market. More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman.

Pimco, Citadel

The list of participants includes Newport Beach, California-based Pacific Investment Management Co., manager of the world’s largest bond fund, Chicago-based hedge fund manager Citadel Investment Group LLC and American International Group Inc., the New York-based insurer taken over by the government, according to the International Swaps and Derivatives Association in New York.

Hedge funds, insurance companies and banks typically buy and sell credit protection, which is used either to insure a bond against default or as a bet against the company’s ability to pay its debt.

Banks and investors typically make offsetting trades to hedge their positions, and likely have already posted collateral as the market-value of the contracts fall, so the actual amount they need to come up with will be much less, Bank of America Corp. credit strategist Jeffrey Rosenberg said in a note to clients today.

[yoganmahew]

I hope he’s wrong. Otherwise I can’t see a reason for the waves of selling other than, er, selling…

[yoganmahew]

Guess the kabala is busted…

[Green_Bear]

creditfixings.com/informatio … primer.pdf

When credit default swaps (CDS) were first developed, the intended use was to hedge cash debt positions with the derivative. With that in mind, the settlement method developed to settle credit events was what is known as ‘physical settlement’. After a default, the protection buyer delivers the defaulted asset and receives in return the due amount outstanding from the defaulted entity.

As time passed, CDS became the tool of choice to take a view on credit. This was facilitated by derivatives trading not being limited by supply (all you need is a willing counterparty) and market standardization - instead of having to pick from hundreds of Ford bonds, you had one CDS curve traded across the market.

As the CDS market developed into a primary indicator of an entity’s creditworthiness, default swaps evolved from being a hedging tool to the primary credit trading tool. As a result, at some point early this decade, the volume of CDS trades began to outstrip the volume of bonds outstanding - there were more CDS traded on a credit than the outstanding bond issuance of that credit.