The Friday Swap Meet

Frightful Friday is here and much will be revealed, while some will not.

Early reports are not optimistic.

But first, the storyline so far. When Lehman went belly up, that triggered an event of default on its issued debt instruments. The holders of those instruments, though, bought what they considered to be insurance against such an event. And the so-called insurers who sold that insurance thought the premiums would be simple money for jam, since they never expected to really have to pay out.

Anyway, the holders of the instruments did not write off those Lehman debts when it rolled over because they had taken the precaution to insure any loss.

But not so fast, Pilgrim, because even if Lehman didn't pay, it doesn't necessarily follow, in this credit crunch, that the insurance would pay either. And today they learn if and how much the insurance will pay and what the size of their ultimate loss will be.

But that's not the whole story either because, you see, all this insurance swap business was done under the radar of regulation, and no one really knows the total amount of insurance risk that is riding on this event, nor who all the insureds and insurers are.

Estimates have been, as late as yesterday, that the insureds would lose about 87 cents on the dollars and the total pool was worth about %400 billion, which means the market would wipe out about, hmmm, $348 billion.

It looks more like the payout will only be about 9.75 cents on the dollar, in which case the market would lose value to the extent of $361 billion.

But that assumes the total outstanding pool is "only" $400 billion.

That's a lot of value that will simply go up in smoke. And so far, the smoke has kept hidden the identities of the losers (on both sides of the trade) and the total size of the pool at stake.

Thus the fright in the markets this Friday, so far.

Sources:

Day of reckoning
Lehman Swap Auction Initial Results Show Payout of 90.25 Cents
Early Results Published in Lehman Swaps Auction
Credit default swaps and those who issued them are to blame for crisis
The Next $350 Billion Hole
Lehman CDS: It Won't Be Over Today

FOLLOW-UP:

The auction house, as you might expect, said the action on the day went smoothly, and Guambat hopes his prognosis is accurate.

Similar auctions earlier this week to set the price of Fannie and Freddie debt were "messy," undermining confidence in the process, according to CreditSights, an independent fixed-income research firm.

However, the Lehman auction Friday went "smoothly" and "efficiently," according to Robert Pickel, chief executive of the ISDA, which represents major dealers in the CDS market.

Roughly $400 billion will be paid out on Lehman CDS, but, once all positive and negative positions are "netted" out, about 2% of that money will actually change hands, Pickel estimated. Payments are due on Oct. 21 to settle Lehman CDS in cash, he said.

Still, and again as you'd expect, not everyone was happy with the action, even though there was a bit of relief in the air to have the matter behind:

The final result in the settlement of the credit default swaps on Lehman Brothers was even lower than a disappointing early estimate, which leaves dealer banks facing higher than expected payouts on multi-billion dollar insurance contracts.

The recovery rate on the bankrupt firm's senior debt was fixed at 8.625 cents on the dollar, just below the 9.75 cents published in the first estimate Friday.

The low final rate qualifies this as one of the most expensive defaults ever in the credit derivatives market. The result nevertheless shouldn't come as a painful surprise for the sellers of protection on Lehman.

Since Lehman's Sept. 15 bankruptcy filing, there has been considerable anxiety that dealers who had underwritten some $400 billion of credit default swaps on the bank would be caught short in a massive payout.

But sharp market moves in the value of these insurance-like contracts would have obliged most sellers of these insurance-like contracts to post additional collateral to cover their potential losses. As a result, they should have sufficient funds set aside to handle their liabilities in this settlement.

What's more, the result is to the benefit of those banks that were buyers of the CDS.

"Keep in mind that the extra few billion to be paid will wind up in the hands of lucky buyers, making it a zero-sum game in reality," said Tony Crescenzi, strategist at Miller, Tabak & Co.

More at Bloomberg here.

And likely more details and fall-out will emerge as this plays out to end match.