Monday, 13 October 2008 02:00

Interesting Lehman email

Here is a short email exchange on the recent Lehman auction and announced CDS settlement. It is timely considering my admonitions in the Asset Securitization Crisis series and the Great Global Macro Experiment (must read). The explanation was broken down with numbers for those who use the left side of their brains:

By the way, what is your thought on the Lehman CDS settlement situation? I smell something funny there.

The financial media has crowed in adulation that "only $6B was paid out on ~$400B of nominal derivatives". But wait a minute. Didn't the auction yield a $.91 to face value settlement? Doesn't that mean there will be, in aggregate, about $36B of write-downs? Yes, $6B may have changed hands, but that is on a reduced nominal value, which HAS to cost someone.

If so, where will those losses land, and when?

I don't know enough about this process to answer those questions. But it certainly has occurred to me that all the orderly derivatives settlement process gains is that massive losses will be bled out over a long period of time, rather than all derivatives imploding at once. So we get banks and other financials under-performing for more years, instead of all going to zero right now.

The reply:

The investors footed the bill for much of the reduced nominal value, and the creditors and clients of the bank. Some prime broker clients will get pennies back on the dollar for thier accounts and have been forced to side pocket those assets, thus freeze their own clients money (much of which will not be returned at all).

As for the CDS payout, they were referring to a netting process, where bank A sold protection for Lehman to bank C, but bought similar 80% protection from bank B. Netted out, only 20% of net exposure had to be paid, THEORETICALLY.

Here's the real world:
The problem with the netting argument is that everyone is assuming bank B has the 80% to cough up, which they don't because they bought 80% protection from insolvent monoline MBIA to hedge them against bank A, but insolvent mononline MBIA reinsured with insolvent monoline Ambac, who sold protection to banks A, B, C, and D at 120x leverage and can't pay all of them at once.

Hence, bank C is f1cked, because bank A is f2cked by bank B, who got f3cked by MBIA who is currently getting f4cked by Ambac who can't pay everybody (or maybe even anybody, now), hence can generally be considered to be f5cking everybody involved.

Even common sense tends to evade these smart people. This is what happens when you are allowed to write OTC insurance without reserves, an exchange and regulations!

I expect this whole house of cards to collapse any time now. The problem is the revolution will not be televised.

You see, I don't use swaps, the primary reason being that when my gains are the juiciest, the likelihood of getting paid are the slimmest. Banks are rallying hard, again. I am slowly deploying my ample store of dry powder... Again, price and value have diverged significantly. Before we go on, make sure you have read:

Now, keeping the email exchance above in mind, notice what this astute gentlemen had to say (I have not verified the dates, but they seem right):

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http://blownmortgage.com/2008/10/14/derivatives-the-great-unwind/

Distracted by worldwide stock market
crashes, attention shifted away from Lehman’s derivatives’ payouts
scheduled for October 21. Recovery value has been set at 8.625 cents
per $1.00, which means that sellers of credit protection must pay
91.375 cents to the buyers (according to Creditex, the company that holds auctions).

More than 350 banks and investors signed up to settle credit-default
swaps tied to Lehman. The list of participants in the auction includes
Newport Beach, California-based Pacific Investment Management Co.
PIMCO, manager of the world’s largest bond fund, Chicago-based hedge
fund manager Citadel Investment Group
LLC and AIG, the New York-based insurer taken over by the government,
according to the International Swaps and Derivatives Association in New
York.

According to JPMorgan, the largest foreign bank holders of Lehman’s
derivatives are Deutsche Bank, Barclays, Societe Generale, UBS, Credit
Suisse and Credit Agricole. Overall, as of June 30, 2008, the top ten
US banks in terms of derivatives exposure were: JPMorgan Chase, Bank of America,
Citibank, Wachovia, HSBC USA, Wells Fargo, Bank of New York, State
Street Bank, SunTrust Bank, and PNC Bank, according to the Comptroller
of the Currency Administrator of National Banks’ Quarterly Report on Bank Trading and Derivatives Activities for the second quarter of 2008....

... Washington Mutual could be another story. It’s Credit Event Auction
will settle, meaning prices will be determined, on October 23. Just
last week there were credit events at the largest three Iceland banks,
all of which have large quantities of derivatives outstanding. These
are all financial institutions; industrials haven’t started yet.

Last modified on Monday, 13 October 2008 02:00
More in this category: « About Lloyds... Shock & Awe: redux »

3 comments

  • Comment Link Ed Ryan Friday, 17 October 2008 01:31 posted by Ed Ryan

    Hank Paulson and his b**ch, Ben do not get it. It is not liqudity, it is a debt crisis. Gordon Brown gets it. Letting Lehman go is going to accelerate the process down. We have to wait untill October 21st to see where we are.

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  • Comment Link a b Wednesday, 15 October 2008 03:33 posted by a b

    Love Brad Sherman, thanks.

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  • Comment Link Phil V Tuesday, 14 October 2008 21:07 posted by Phil V

    Reggie, the arms adjusting in 2011 may have compelled the Fed to implement its policy of allowing banks to have 0% capital reserves in 2011...

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