POST MORTEM – Lehman CDS Settlement: $360bn or $6bn?

As a premise, the counterparty risk in the over-the-counter market and in the entire shadow banking system is real. It lies at the heart of the financial crisis that has cost banks globally over $650bn in writedowns already, and trillions in taxpayer money around the world. The focus of this debate is to understand the dynamics at work in order to improve the system. It is neither about fear-mongering nor about denial.

With respect to Lehman’s CDS payout on October 22, the DTCC released the following statement:

DTCC Trade Information Warehouse Completes Credit Event Processing for Lehman Brothers [bold added]

New York, October 22, 2008 – The Depository Trust & Clearing Corporation (DTCC) announced that its Trade Information Warehouse (Warehouse) successfully completed the automated credit event processing and settlement of over-the-counter (OTC) credit default swap (CDS) contracts related to the Lehman Brothers Holdings Inc. (Lehman) credit event. This processing resulted in approximately US$5.2 billion in net funds transfers from net sellers of protection to net buyers of protection. The portion of this net funds settlement allocable to trades between major dealers was settled through the normal settlement procedures of CLS Bank (the world's central settlement bank for foreign exchange, and the central settlement provider to the Warehouse) for Tuesday, October 21 without incident.

In November 2006, The Depository Trust and Clearing Corporation (DTCC) established its automated Trade Information Warehouse as the electronic central registry for credit default swaps. With a client base that includes virtually all global derivatives dealers and more than 1100 buy-side firms in 31 countries, the vast majority of credit default swaps traded have been registered in the Warehouse. In addition, all of the major global credit default swap dealers have registered in the Warehouse the vast majority all contracts executed among each other before the Warehouse’s November 2006 launch. At the time of the bankruptcy of Lehman Brothers Inc., approximately $72 billion in credit default swaps written on Lehman Brothers were registered in the Warehouse.

One of the many central servicing functions of the Trade Information Warehouse is to calculate payments due on registered contracts, including cash payments due upon the occurrence of the insolvency of any company on which the contracts are written. Calculated amounts are netted on a bilateral basis, and then, for firms electing to use the service, transmitted to CLS Bank where they are combined with foreign exchange settlement obligations and settled on a multi-lateral net basis. Currently all major global credit default swap dealers use CLS Bank to settle obligations under credit default swaps. It is expected that all major institutional players in the credit default swap market will use the same process for settlement by the end of 2009. For Lehman Brothers Holdings Inc. the calculated amounts netted in the Warehouse on a bilateral basis amounted to approximately $21 billion. The $5.2 billion net funds transfer represents the net of these nets.

About DTCC

DTCC, through its subsidiaries, provides clearance, settlement and information services for equities, corporate and municipal bonds, government and mortgage-backed securities, money market instruments and over-the-counter derivatives. In addition, DTCC is a leading processor of mutual funds and insurance transactions, linking funds and carriers with their distribution networks. …”

First, as emerges from the statement, the DTCC clears and settles (voluntarily) registered trades. As the statement says, the registered notional amounts to $72bn out of the total $400bn (total outstanding acknowledged in ISDA’s CEO Robert Pickel statement on October 21).

--> I haven’t read anything about the remaining $330bn notional. Any hints are welcome. Will those players that want to be hedged use the clearing platform while those that want to take an open position won’t? Any hints are welcome.

Second and related, as emerges from the statement the DTCC is mainly a venue for large dealer banks to clear their interdealer positions in the OTC market. Large dealer banks usually offer their customers tailored counterparty services and then hedge this position in the interdealer market. As pointed out in my previous post: “Large global banks themselves have gone from being hedged players to taking on net credit risk exposure in the wake of securitization and structured finance but they at least have access to unlimited Fed liquidity.”

--> If the DTCC indeed clears mainly interdealer positions, their largely hedged positions as well as the successful completion of any outstanding claims does not come as a surprise. Again, if somebody has any specifics on this they are welcome.

Third, as mentioned in my previous post, the counterparty risk argument applies especially to net protection sellers, i.e the ultimate credit risk takers by choice:

“Other net protection sellers in general include insurers [such as AIG], monolines, SPV specialized in structured products. Neither of these are known for their strong capital bases. Neither are hedge funds who are facing margin calls on a large scale in the aftermath of Lehman’s default and who are strongly suspected to be driving the global stock market selloff.”

--> Don’t just take my word for it but look at what has been happening in the markets in the past 2 days alone:

AIG's Liddy Says $122.8 Billion U.S. Loan `May Not Be Enough'

Bond insurers seek to tap into $700bn plan

CDO Cuts Show $1 Trillion Corporate-Debt Bets Toxic

Fitch Comments on Derivative Product Companies

The Hedge Fund Contagion

Peterffy Says CME Group Credit Swap Plan Puts Billions at Risk

Greenspan Concedes to `Flaw' in His Market Ideology

…

The following paper gives a useful overview of the risks in the CDS market:

Michael Gibson (2007); Credit Derivatives and Risk Management; Fed Board

Abstract: “The striking growth of credit derivatives suggests that market participants find them to be useful tools for risk management. However, credit derivatives pose risk management challenges of their own. I discuss five of these challenges. Credit derivatives can transform credit risk in intricate ways that may not be easy to understand. They can create counterparty credit risk that itself must be managed. Complex credit derivatives rely on complex models, leading to model risk. Credit rating agencies interpret this complexity for investors, but their ratings can be misunderstood, creating rating agency risk. The settlement of a credit derivative contract following a default can have its own complications, creating settlement risk. For the credit derivatives market to continue its rapid growth, market participants must meet these risk management challenges.”

I look forward to any constructive comments on the three main points raised.