Lehman Credit-Default Swap Payout Could Climb as High as $365 Billion

By Heather Landy
Special to The Washington Post
Saturday, October 11, 2008

NEW YORK, Oct. 10 -- In what may shape up to be the most expensive payout ever in the credit-default swap market, sellers of insurance against a debt default by Lehman Brothers will have to pay 91.375 cents on the dollar to settle the contracts.

The results of a settlement auction held Friday imply that banks, hedge funds, insurance companies and other writers of the insurance-like swaps would have to come up with as much as $365 billion for buyers of the protection. But many of the firms on the hook may have taken steps to offset their obligations, which could minimize the blow, industry experts said.

Swaps are basically insurance policies bought by investors to protect against an investment such as a corporate bond losing all value if the company falls apart. The unregulated nature of the market, in which investors essentially bet on the likelihood of a default by a bond issuer, makes it impossible to say who owes how much to whom. But it is safe to say that selling default protection through the swaps turned out to be costlier than anticipated.

The price of the Lehman bonds underlying the swaps was settled at auction at 8.625 cents on the dollar, which is subtracted from 100 to get the payout ratio for the swaps. Bond traders had recently quoted Lehman's debt at about 13 cents on the dollar, which protection sellers might have been using as a proxy before the auction to estimate how much they owed their counter-parties.

"For all the people who are sellers of protection who didn't have hedges themselves, they're paying more than they thought they were going to pay," said Joel Telpner, an attorney at Mayer Brown in New York who specializes in credit derivatives transactions.

Credit-default swaps, initially used by bondholders that wanted to offset the risk of their investments, evolved in recent years into a $55 trillion market that frequently attracted speculators who simply placed bets on the derivatives' value, and never actually owned the debt underlying the contracts.

The swaps were at the center of the government's bailout of AIG, which needed a loan to meet collateral calls on credit derivatives.

Last month's bankruptcy by Lehman, which had been the nation's fourth-largest securities firm, has raised concern that firms might not be able to cover credit-default swaps written on about $400 billion of Lehman bonds. But firms with exposure to swaps frequently hedge their bets to limit their risks.

"If we see defaults from the standpoint that protection sellers don't pay up, then we're going to have a huge problem in the market," Telpner said. "But we don't have any explicit evidence indicating that sellers ultimately are not going to be able to pay the amounts owed to buyers."

Auctions earlier this month to unwind Fannie Mae and Freddie Mac credit derivatives resulted in much lower settlement amounts, south of 10 cents on the dollar. That's because a government bailout of the mortgage-finance companies helped preserve the value of their bonds, making default protection less valuable.

The International Swaps and Derivatives, a private industry group, has overseen more than a dozen auctions to unwind credit-default swap contracts when "triggering events" have occurred. Several more auctions are on tap as investors try to unwind swaps involving Washington Mutual and several Icelandic banks caught up in their country's credit crisis.

The brief history of credit derivative settlement auctions has primarily involved swaps related to bond issuers that needed to restructure themselves. The Lehman auction represented a new frontier for the market because the securities firm is not reorganizing -- it is liquidating.

The auction-settled price of 8.625 cents on the dollar for Lehman's bonds is not necessarily indicative of the recovery amounts that bondholders can expect in Lehman's bankruptcy proceedings.

More than 350 firms signed up to participate in the Lehman auction, which was run by Creditex Group and Markit Group.

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