Credit derivatives markets stumbled and staggered in a state of confusion on Monday as traders and analysts struggled to grasp the impact of the collapse of one of the major counterparties in the market.
Lehman Brothers was a party to hundreds of billions of dollars worth of bilateral over-the-counter derivatives contracts covering credit, interest rates, equities and commodities – all of which are now worth substantially less because the US investment bank no longer stands behind them.
Alongside the highly complex counterparty issues, Lehman is itself the biggest ever bankruptcy to hit debt markets. This will mean huge payouts on credit default swaps (CDS) bought to protect against losses on its debt, while also causing enormous losses for investors who hold nearly $150bn of its bonds.
Lehman bonds are trading at levels that imply losses on its debt of about $90bn, which assumes a standard recovery rate of 40 per cent. “Insurance companies, mutual funds and money market managers will bear many of these losses,” said Gregory Peters, managing director at Morgan Stanley.
In spite of a specially organised Sunday trading session in New York ahead of Lehman’s bankruptcy filing, the process for banks of working out their derivative counterparty exposures to the bankrupt dealer has only just begun.
In the credit derivatives market, which has been one of the fastest-growing financial sectors – hitting $62,000bn in notional outstanding volumes – short-term volatility and stuttering liquidity were immediately apparent. But the longer term effects on faith and activity in this still young market remain far from certain.
“The derivatives market is shellshocked,” said Brian Yelvington, analyst at CreditSights. “There are many aspects about unwinding trades with Lehman which people just don’t know yet how to resolve. The legal contracts which underpin the markets are not always watertight and this means unintended consequences cannot be ruled out.”
One thing was widely agreed upon however: that arguments about moves to improve the market infrastructure and especially to create a central clearing house have only been strengthened.
Eraj Shirvani, a senior Credit Suisse banker and recently elected chairman of the global derivatives industry trade body, insisted that trading had remained smooth given the circumstances of three huge credit events in little more than one week – Lehman’s failure adds to the state bail-out of Fannie Mae and Freddie Mac, the mortgage agencies.
“We could have come to work today and had no trading, no one accepting anyone else’s credit and the market going into total meltdown. The fact that prices are available and that index moves have been relatively limited shows that we have liquidity and that the market is actually operating smoothly,” he said.
However, analysts and traders in the market said that banks were mostly focused on calculating and then looking to offset their own exposures to Lehman first – and so liquidity had been fairly limited. Gavan Nolan, analyst at Markit Group, said the indices had seen their worst ever single-day correction.
The rules of the special Sunday session organised by the International Swaps and Derivatives Association meant that many trades put in place expired before Lehman filed for bankruptcy protection. However, parties to each trade can agree to revalidate those positions.
Volume on Sunday was relatively limited and so few think it will have lent more than a psychological crutch to banks. “That [the special session] was a matter of felling the tall trees as the traders say, trying to find the biggest exposures and netting those out,” says Michael Hampden-Turner, credit strategist at Citigroup. “But the trading period was far too short to get anything really significant done.”
Uncertainty about counterparty exposures that remain only boost the case for a central clearing house that would also be the central repository of counterparty risk in the minds of many.
Suki Mann, credit strategist at SG CIB in Europe, said: “I think this makes a central clearing house very likely now to help ensure transparency and funding in stressed periods. But the credit derivatives market has become too big an asset class now to disappear.”
Others were not so sanguine. “This is a big threat to the CDS markets as a whole, which is truly scary because that was the last liquid market,” said one hedge fund trader. “Here, we’re all wondering whether Lehman might have blown up the market.”
One thing is certain, it is likely to be even more difficult now for companies to tap the debt markets, particularly financial companies.
Mr Shirvani said that while a central clearing house and other infrastrastructure improvements that are in the pipeline would undoubtedly have helped, the market was capable of dealing with the Lehman failure.
“Compared with the many hedge fund failures seen in recent months, this counterparty failure is much more complicated, the numbers are a lot bigger and there are going to be more bumps in the road, but the process is robust, we have a very good contract and I think the closing out of contracts will happen in an orderly fashion,” he said.
