$400 Billion Lehman CDS Unwind?

I’ve heard concerns from various traders and hedge fund managers over the past few weeks that the Lehamn Brothers (LEH) derivatives unwind has been what’s roiling markets.

Early October, Citi (C) credit
analyst Michael Hampden-Turner estimated there is $400bn of Lehman credit
derivatives that will be settled on Friday

Hence, some recent fear can now be attributed in part to jumbo losses caused by Lehman’s derivative unwind . . . with JPMorgan (JPM) being the biggest potential collateral damage . JPM has the biggest derivative exposure on the Street (I have no opinion on how this impacts them or on their derivative exposure).

Here is the FT:

"At the moment, participants can’t just extinguish credit derivatives contracts with Lehman, they can only offset them. That, in turn, puts pressure on some participants to buy more credit insurance and the cost of such contracts is rising.

Moreover, many counterparties to Lehman who believe it owes them money have joined the ranks of unsecured creditors. This increases the number of claimants and reduces the money available to bondholders and other creditors.

The exact amount of any claim is determined by the difference between the value of the collateral and the cost of replacing the contract. The cost has risen in line with fears about the health of financial institutions and the creditworthiness of counterparties."

While Fannie and Freddie CDS settled at between 91.5 and 99.9 cents on
the dollar., expectations are for Lehman to settle at 10 cent on the dollar — causing a few $100 billion in losses. The unwind comes Friday.

More details after the jump . . .

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UPDATE: Octoer 9, 2008 11:08am

Wow, that was quick — the Dow flipped from plus 150 to minus 150 rather fast. . .

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Source:
Lehman exposes faults in credit default swaps
By Henny Sender in New York
FT, October 7 2008 03:00 | Last updated: October 7 2008 03:00
http://www.ft.com/cms/s/0/04733ac8-9408-11dd-b277-0000779fd18c.html

Banks prepare for CDS pay-outs:

Banks are hoarding cash in expectation of pay-outs on up to $400bn
of defaulted credit derivatives linked to Lehman Brothers and other
institutions, according to analysts and -dealers.

This added pressure on the frozen financial system comes as
authorities prepare to meet participants in the so-far unregulated
$54,000bn credit derivatives market to speed up plans for the creation
of a central clearing house.

The Federal Reserve will meet dealers, investors and exchange
executives in New York today. Although big dealers had committed to
setting up a central counterparty by the end of the year, urgency has
increased in light of the collapse of banks around the world and as
company bankruptcies loom.

"The New York Fed will hold a meeting [today] with a small number of
banks and buyside firms to discuss the progress being made toward the
creation of a central counterparty for credit default swaps," said a
Fed official, adding that this would "help reduce systemic risk
associated with counterparty credit exposure and improve how the
failure of a major participant would be addressed".

Reuters explains how the process will work:

Twenty-two dealers will participate in the auctions, which will
determine how much protection sellers will recover after paying out the
insurance. The timeline for the auctions follows, according to JPMorgan.

9:45 a.m.-10 a.m. Auction participants will submit bids and offers
for the debt backing the credit default swaps, which will be used to
determine the initial recovery rate of the swaps.

10:30 a.m. Auction administrators Creditex and Markit will publish
the initial recovery price and the open interest for the contracts will
be published. The open interest reflects the amount of bids and offers
that have been made, and will show if there are more buyers than
sellers, or vice versa.

12:45 p.m. -1 p.m. Participating dealers will submit limit orders
for the debt on behalf of themselves and their clients to fill the open
interest

2 p.m. The final price of the auction will be published.

Other Sources:
Banks prepare for CDS pay-outs
By Aline van Duyn in New York and Hal Weitzman in Chicago
FT, October 7 2008 03:00
http://www.ft.com/cms/s/5911e2d8-9407-11dd-b277-0000779fd18c.html

FACTBOX-Lehman CDS settlement auction timeline
Karen Brettell
Reuters   Oct 8, 2008 4:16pm EDT
http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSN0841811720081008

Credit market to price $500bn in bad deals
Aline van Duyn
FT, October 5 2008 18:55
http://www.ft.com/cms/s/0/339dd2c2-9304-11dd-98b5-0000779fd18c.html