The biggest payout in credit default protection history

Today the auction of bankrupt Lehman’s Credit Default Swaps finally arrived at a settlement price of 8.625 cents on the dollar for Lehman’s debt. This means the sellers of Lehman CDS, those who insured Lehman bondholders against the prospect of a Lehman default, now owe these bondholders 91.375 cents for every dollar of Lehman debt. Settlement will be on Oct. 21.

Now we know why banks have been hoarding capital, and reluctant to lend. They were building up capital in preparation for their expected payout on the Lehman CDS. Many of the larger banks were writers of Lehman CDS. We also have reason for the massive US stock market sellout. Many hedge funds and money market funds had to sell stockholdings in preparation for the payout. Many funds also were writers of Lehman CDS.

On Oct.21, we’ll see if all the CDS writers have enough capital to cover their obligations. If they don’t, Lehman bondholders will have to seek recourse on the guarantor of last resort for these financial market players, the US government.

Maybe the US government needs to start selling assets and hoarding capital.

Government should address the crisis at its roots, as Prof. Roubini suggests, or its obligations on the derivative effects and resultant defaults down the financial chain will never end.


Update: Oct. 21, the heightened concern seemed overblown. Reuters reports that no significant payouts from the settlement will be enough to cause another major upheaval: This is because large players in the market, such as dealers and some hedge funds, have both bought and sold protection, subsequently taking both gains and losses on Lehman's default that will offset each other.

For companies with net exposure to pay out protection, much of the pain of settling the swaps has also already been taken. "If you were the seller of protection, you had to pay collateral and that collateral was changed on a daily basis, based on where Lehman's bonds were trading,".

Definitely good news for the financial markets!