Lehman Fallout

A major factor behind today's plunging stock markets is anxiety before a settlement pricing tonight for an estimated $440bn of credit derivatives linked to failed US investment bank Lehman Brothers.

Analysts have predicted the Lehman settlement will trigger gross payouts of $350bn to $400bn. Meanwhile, the recent rash of Icelandic banking failures could bring further derivative payouts estimated at $200bn in the coming weeks.

No one is sure where the heaviest losses will be felt — and net losses are expected to be much lower than the headline payout estimates — but there remain fears the recent run of large-scale defaults may leave many hedge funds with payout demands they cannot meet. This, in turn, will force writedowns for those failing to receive payouts, many of them major banks.

Sandy Chen, a banking analyst at Panmure Gordon, this morning described the prospect of mass payment failures as "key drivers of the current apocalypse". He pointed to Barclays and Royal Bank of Scotland as being most exposed among the UK banks to the credit derivative market. Both have bought and sold, in roughly equal measure, £2.4tn of such contracts.

An explosion in the largely unregulated credit derivatives market in recent years has seen potential payouts balloon to levels that far outstrip the potential losses from the underlying bonds they reference.

Lehman had $110bn of senior bonds outstanding before filing for bankruptcy last month. Since default, those bonds have been trading between 15 cents and 20 cents in the dollar. Analysts estimate there are $440bn of credit default swaps (CDS) outstanding in relation to Lehman senior bonds.

In theory, a CDS is a contract in which a bondholder buys insurance — known as protection — against that bond defaulting. In practice, however, CDSs have become hugely popular among investors trading on the likelihood of a bond default without holding the underlying bond. The market has proved particularly popular with hedge funds, in part because it offers an opportunity to "short sell" bonds.

Derivatives specialists insist it is impossible to predict which investors will be hit hardest by the losses on Lehman CDSs, which are spread far and wide, as Lehman was one of the most actively traded credit default swaps.

Chen believes Barclays and Royal Bank of Scotland are likely to be prominent among those required to pay out on Lehman CDSs. Meanwhile, counterparties failing to meet their CDS obligations to the two banks could lead to significant writedowns. "Against this, tangible shareholders' equity bases of £20bn to £30bn seem like cloth tents in a hurricane," said Chen.

Source - Guardian