Market's Next Test: Lehman CDS Settlement

Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar. Given that we are sailing in pretty uncharted waters in both the credit and equity markets right now, so I was just trying to look a little bit further ahead and sort of see what the next shoals or rocks might be that we could run into.

There's a very interesting event coming up this coming Friday that hasn't received a lot of attention yet. I thought it would be worth talking about a little bit. That's the auction to settle the credit default swaps on the bonds of now defunct Lehman Brothers.

Now, we'll explain what all that means and why it's something you ought to be paying attention to, with Matt Warren, who is our associate director for financial services. Thanks for joining me Matt.

Matt Warren: Good to be here.

Dorsey: OK, so first of all, let's just back up and talk about what is a credit default swap or a CDS?

Warren: Sure, so basically credit default swap is an insurance contract.

Dorsey: On a bond basically.

Warren: On a bond, on Lehman's bonds outstanding. The original purpose was, if you own one of the bonds, but you're nervous about the credit risk, you can buy the insurance, still collect the coupon and be protected against the event of defaults.

You have to pay the insurance premium, and this is what protects you from that. So, that's the original understanding.

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Dorsey: So, they've invented a sort of a very dull, plain vanilla security for bondholders, for people who own big portfolios of bonds, and said, "If I'm a little bit nervous about the ability of some of these folks to pay me back, I'm going to buy some insurance on that. In the same way I might be nervous about my vacation home in Florida, if it's in the path of a hurricane and I buy a little insurance on that."

Warren: Exactly. It was a way of separating the coupon from the credit risk. So, it was an attempt to make the market more efficient and the ability to spread out risk. From there, it's grown tremendously.

Dorsey: Into a market that's been highly speculative over the past couple of years, with people basically betting for or against the survival of failure of various entities.

Warren: Yeah, it's my understanding that the credit default swap market, the notional amounts,i's an enormous amount, it's $50 to $60 trillion is what people are saying in terms of notional exposure. The actual value of those is a fraction of that, but it's still not a small number.

Dorsey: That's simply because you can right at this point, you don't need to own the bond to take the insurance policy. I don't know if right.

Warren: That's right.

Dorsey: It will be a little bit like me saying, I want to take out an insurance policy against somebody else's vacation home in Florida, so that if it gets blown over in a hurricane, I get paid the insurance.

Warren: Exactly. You have what amounts to a lot of side debts, the credit quality of all these different companies with bonds outstanding. So, it's a way to wager the day to day, week to week, month to month market's perception of the credit risk around a company.

I think the liquidity that you're seeing, and the activity and the growth and the notional amount of understanding, outstanding, it's pretty clear that there's a lot of pretty active bets going on. You might imagine some hedge funds are pretty highly involved.

Dorsey: Right. So, earlier this year, people started making bets that Lehman Brothers might default. So, if the Lehman Brothers did go under, people will have to pay out the entire face value of those bonds.

The folks of course selling them their insurance were thinking, "There is no way Lehman could ever go under. I'll never have to pay out this much money."

Warren: Yes. I wouldn't make that bet. I would never make that bet myself, but I am sympathetic to that logic that you watched Bear Stearns, where the bondholders were saved there by the governments.

Lehman is a bigger institution. I was surprised that the government allowed the bondholders to take a hit at Lehman Brothers. So, I think that bankruptcy very well could have caught a lot of market players off sides.

A lot of people might have though they were taking in free money, writing insurance for an event that was never going to happen, sure enough.

Dorsey: There it happened. Of course, a key part of this credit default swap market is that it's a very--it's as if it's an unregulated insurance market.

Basically you can sell someone insurance without having to have the reserves on your balance sheet to pay for that policy. It's as if all state could sell me an insurance policy without having to have money on its balance sheet in case I hit them up with a claim.

Warren: That's right. So, it's all kind of controlled by the i-bank oligopoly globally with each individual i-bank making individual decisions with each side of the trade. It's my understanding there is some posting of cash collateral as these things move, but it's not centralized, the information isn't shared. Let's just say for example…

Dorsey: There is no regulated exchange in other words. We don't have a Chicago Mercantile Exchange on NYSE for these CDS in Stearns.

Warren: Yes, and that's how it has been, although you're starting to see that crop up now, but you can have a hedge fund. Let's say a hedge fund was down 15% earlier this year. It was already having a horrendous year; they're on their way out.

Let's say you're trying to gamble for redemption. They could have been writing contracts insuring against the Lehman default. They could have gone to one i-bank and written that contract. They could have gone to another i-bank, written the same contract. I'm not even sure all the players would know how much was written.

Dorsey: Right, and those i-banks were basically selling them the insurance, thinking that we are never going to be able to pay off the full face value of this, perhaps we might need to pay a slightly higher price if Lehman becomes more riskier in the future than it was at the point they wrote the contract.

But nobody was expecting to pay off the full amount of all of Lehman's bonds. That's what will be decided on Friday, right?

Warren: On Friday, they are going to have the auction to actually settle. The company went bankrupt, they are going to have the auction to determine what the actual payout is on the bonds.

It's my understanding that it's going to be north of $0.80 that gets paid out on the dollar. This could be the biggest test of this market today. Fannie and Freddie already happened, but the payout was much smaller.

Dorsey: $0.05 on the dollar.

Warren: Even if there might have been more bonds outstanding. With Lehman, you have a lot of bonds outstanding, you have a big payout. This is where the tide goes out and we see who wrote insurance and actually had the money standing behind those contracts and who didn't.

From there, we are going to see some people that wrote the insurance go bust. We are going to see people that were counting on the insurance and have it marked on their books that way, that insurance might not work out what they expected.

Dorsey: They simply may not get paid, because the folks who sold them the policy essentially don't have the cash to back it up.

Warren: I think it's pretty clear that that's going to happen and it's a question of how much--it's a big data point coming for the markets. I think it has the markets a bit unsettled as well until we get past this unknown.

Dorsey: Exactly. So, we've got this settlement coming up on Friday. Then in a couple of weeks, we have a settlement for the credit default swaps for Washington Mutual.

Warren: That's right.

Dorsey: Again, so two key events for people to look for in terms of how does the market deal with events that no one expected in this highly unregulated and opaque market.

Warren: That's right. I would expect there to be a lot of contracts outstanding, because you have people actively betting against these companies and you also had a lot of companies that did business with these companies. They were trying to hedge away their exposure. So, the amount of contracts outstanding could be a non-small figure, it would be my guess.

Dorsey: Another test for the markets coming up. Thanks Matt.

Warren: Sure.

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

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