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By Pat Dorsey, CFA | 10-10-2008 05:25 PM

Risk from Lehman CDS Settlement Lessens

Friday's settlement helped clarify an opaque credit default swap market. (10/10/08)

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Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar. Well, the settlement of Lehman's credit default swaps occurred on Friday. It was an event that market was waiting for. We have the results in.

There was a conference call on Friday to kind of discuss what happened. Market actually rallied quite a bit off the news, so it was fairly positive.

This is a reminder for those of you who haven't been following this story. A credit default swap is basically an unregulated insurance contract on a bond, essentially. Basically it's someone betting that a bond will have a higher chance of default or not getting paid back or will actually default itself.

Lehman had a lot of bonds out before it went under and many people had made bets that Lehman would default. Of course, someone had to sell that insurance to them. In this very unregulated credit default swap market, there was the possibility that some of the people, who had sold that insurance, might not have the cash to pay up.

That was the worry that was permeating the market for some time. We have a lot more clarity on it right now. I'm lucky to have with me Matt Warren, our associate director for financial services to give us some clarity.

He was on the call and he can tell us exactly what happened. Thanks for joining me Matt.

Matt Warren: Good to be here.

Dorsey: So, initially it looked like the big question was going to be, at what price do these credit default swap settle? What will people have to payout? But as it turned out, that really wasn't the big news that came out of the call.

Warren: Yes, it looks like they settled that $0.08 in change. So, the people that wrote the insurance are going to pay up north of $0.90 on the dollar to settle the contracts.

But I think in my mind that the better part of the call was that they made it a little bit more clearer to people that don't play in this market on a day to day basis, what some of the mechanics are in the marketplace.

Dorsey: That sort of calmed the market's fears. What do you think it was? The market is still a little opaque, but what do you think that clarity was that perhaps gave people some more comfort that this wasn't going to be a source of a black hole?

Warren: Sure. They didn't disagree with the fact that it might be about $400 billion or so in terms of notional value of contracts related to Lehman.

But they did suggest that the--a lot of the participants in the auction are investment banks and other financial institutions that have a matchbook within their own business of buyers and sellers that they put together.

Dorsey: Meaning if they had sold one of these insurance contracts to someone, they'd probably bought one from somebody else. So, their exposure to Lehman going under would net zero.

Warren: Yes. They have both sides of the trade, and then the net amount was like less than 10% of the notional amount, is what's represented at this auction.

Dorsey: Less than 10% or less than 2%?

Warren: Less than 10%. Well less than 10. So, it gives you the impression that the i-banks had relatively matchbooks. The other thing they got into that I thought was really important, was the cash collateral posting.

We've known this. We know that the i-banks have asked for cash collateral posting as these things move. Some times these move dramatically when you get towards the actual event of bankruptcy.

So, we don't actually see those companies posting the cash collateral. The i-banks are seeing that, and they are the ones seeing if there are any actual problems among their client base.

On average, you hope that it's all working out as it aggregates up to the i-bank level, and then as it aggregates up to this auction level. But we won't know until the cash settlement from this auction will come, and it's about a week and a half or so. That will be the final tally on this.

Dorsey: So, the bottom line is that we could have a few hedge funds fail over this. Perhaps people who had sold these insurance contracts don't have the cash to back it up, didn't have the kind of a matched book at an investment bank. That could still come out in the wash, but the likelihood of sort of a huge ripple effect seems to have been diminished.

Warren: Yes, I think so. I think there could have been people that wrote insurance on these contracts and then when their investment bank already asked them to post collateral, they might have already done some forced sales.

It wouldn't be shocking given the markets that we have been seeing. Perhaps they didn't have enough cash and they couldn't fully support their promise of the investment bank, and perhaps the investment bank made up the difference for whatever amount of customers couldn't fully support their deal.

At the system wide level, it appears that a lot of it might have netted out and everybody is posting cash collateral, except perhaps a few AAA-rated, that's where there is kind of one idiosyncrasy.

Dorsey: There is nobody left. Last time I checked, Johnson & Johnson isn't selling credit default swaps.

Warren: Let's hope not.

Dorsey: So, well that's good. I mean not an all clear signal, but perhaps with saying a big test for the market, a big source of uncertainty that now seems to have been diminished somewhat.

Warren: Yeah, absolutely. I'd be even more comfortable if this were on an exchange and it was all that much more visible. But it looks like they have it operating relatively smoothly considering how spread out the market is.

Dorsey: We are moving towards that. I mean I believe the Chicago Mercantile Exchange is talking about trying to bring the CDS market onto the exchange. Is that correct?

Warren: That's right. There are a couple of different players trying to get this business. The market participants in general and the regulators will love to see it in a more organized fashion with better information sharing and more transparent posting of collateral would be even better.

So, there is much room for improvement, but it looks like this one might have gone off OK. We'll know for sure in a couple of weeks.

Dorsey: We'll hope the markets learned the lesson that a multi-trillion dollar unregulated derivatives market is generally speaking not a great idea.

Warren: Fair enough.

Dorsey: I'm Pat Dorsey and thanks for watching.

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