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Wednesday, October 29, 2008


CDS funding disaster

recently, the cash settlement at auction of the lehman credit default swaps was received as a piece of good news in an otherwise horrible month. alea went so far as to call it a "non-event".

institutional risk analyst today questions the sanguine view -- and indeed puts unsettled CDS at the heart of the liquidity crisis that has necessitated huge dollar funding lines for europe -- moreover forecasting much worse to come.

The auction process begun by DTCC, by which holders of CDS on bankrupt Lehman Brothers settled in cash via the DTCC's facility, caused many tongues to wag as to the "net" amount providers of protection must pay to holders of CDS. Several members of the media called last week to ask if Don Donahue, CEO of DTCC, was speaking truth when he said that the net payments on Lehman contracts processed by the DTCC's warehouse were a mere $6 billion or so.

Of course Don Donahue is providing the straight skinny on the flow of transactions which have actually participated in the DTCC auction. But consider that other than holders of CDX and some holders of single name CDS not offended by the prospect of cash settlement, there remain a large number of total holders of CDS for Lehman who do not wish to take cash settlement and indeed are expecting to receive the underlying bonds.

Now the apparent non-event from the Lehman CDS auction is a source of media frustration. Wasn't there supposed to be a breakdown in the CDS markets, a dramatic failure event a la Lehman Brothers? But the merchants of doom should take heart.

The bad effect of the CDS market comes not merely from when there is market dysfunction and an individual counterparty fails. That happens often enough, but the prime broker-dealers clean up the mess quietly so as not to roil the markets. Remember, the dealer already owns the counterparty's collateral through the credit agreement, so there is no point forcing the issue with a messy and noisy bankruptcy. Right? This is why the media rarely hears of fails in CDS.

No, as with the repatriation of the Structured Investment Vehicles onto the balance sheets of C and other money center banks, the true significance of CDS comes when the markets function smoothly, as after a default event like Lehman. The trigger event putting a single name CDS contract in the money results in a liquidity-raising event for the seller of protection, who must fund the purchase of the debt at par less recovery value - whether or not the other party actually owns the debt!

This process of funding the CDS is reportedly a factor behind the high rates of dollar LIBOR in London and illustrates how cash settlement derivatives actually multiply risk without limit. Through the wonders of cash settlement, the derivative-happy squirrels at the Fed, BIS and ISDA created a liquidity-sucking monster in OTC derivatives that multiplies risk many times, for example, above the amount of underlying debt of Lehman Brothers. But remember two things: a) In some single-name CDS contracts, the buyer of protection must deliver to get paid; and b) in those contracts, where the buyer fails to deliver, the provider of protection can walk away.

We hear that there are more than a few EU banks which wrote CDS on Lehman over the past several years, CDS which were written at relatively tight spreads. These banks did not participate in the DTCC auction and instead have chosen to take delivery on the Lehman debt, forcing them to fund a nearly 100% payout on the collateral. A certain German Landesbank, for example, took delivery on $1 billion in Lehman bonds that are now worth $30 million, and had to fund same. Does this example perhaps suggest a reason why the bid side of dollar LIBOR in London has been so strong?

As one veteran CDS trader told The IRA on Friday, "It's not that people can't fund, it is that people have got to fund these CDS positions. These banks don't have access to sufficient liquidity internally to fund, so they hit the London markets... The Fed and the other central banks must start to deal with the huge overhang of currently hidden funding needs from the CDS and other derivatives." Another market observer suggests this is precisely why the Fed and other central banks have been furiously putting reciprocal currently swap lines in place.

... [T]he normal operation of the OTC derivatives markets is creating a cash position that must be funded in the real world and is thus distorting these benchmark cash markets such as LIBOR. This distortion is magnified by the dearth of liquidity due to the breakdown in the rules regarding valuation and price. So far, the Fed and other central banks have addressed the on-balance sheet liquidity needs of global banks. But as retail and corporate default rates rise, funding the trillions of dollars in notional off-balance sheet speculative positions in CDS, which become very real and require funding when a default occurs, could prolong the economic crisis and siphon resources away from the real economy.

i admit to having little knowledge of the nuance of the CDS market; someone better informed than i is going to have to validate/invalidate the thesis.

but if this is so (and if i am reading this correctly) -- that many banks which wrote and sold CDS on lehman are either contractually obligated or can elect to take delivery of the bonds which they insured before paying out -- and that, waiting for the CDS buyers to come up with the bonds, they have to arrange to finance the dollar payout -- it would explain the desperate need of dollars being reflected in interbank lending markets and further the arrangement of dollar swap lines between the fed and european central banks.

as above, the effect is similar to that when money center banks took their SIV structures onto their balance sheets, redeeming their asset-backed commercial paper investors at par with cash borrowed from the markets, leaving the banks with gaping holes on their financial statements.

moreover, as the IRA notes, there is some real possibility that the selling bank will not have to pay out on the CDS if the buyer cannot come up with the bonds. because outstanding contracts are several multiples of the available insured bonds, the banks, by electing to take delivery where they can, would effectively be betting that they will not have to pay in the end.

this would explain rather neatly why net exposure reported from the DTCC settlement auction was so small -- a point taken with relief at the time. it was because a lot of the contracts -- probably including those held in bank or insurer books that were not hedged -- did not come to the cash settlement auction and are holding out for delivery.

keep an ear to the ground on this one. if this is so, the implication for the spiralling corporate defaults and therefore CDS triggers we are sure to see in coming months and years will represent a tremendous threat to the real global economy.

UPDATE: one might further suspect that, in answer to the question posed by the new york times, this is where all of AIG's government loans are going.

UPDATE: more via yves smith.

UPDATE: yet more via jesse's cafe americain on the omissions of DTCC data as related to the synthetic CDO unwind.

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Another interesting nugget to ponder...

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