Sunday, October 12, 2008

Lehman's bond insurers to take a financial bath

NEW YORK — Sellers of insurance on bonds issued by bankrupt Lehman Brothers Holdings Inc. are now likely to face demands that they pay out more than 91 cents on the dollar to buyers of those insurance contracts, a payout that could total $270 billion or more.

That's the upshot of an unusual auction process Friday that established the price for defaulted Lehman debt, and in turn potential claims payouts on insurance protecting that debt, known as credit default swaps.

Certainly, some firms will take a hit because of the pricing. But it's too early to tell which companies will be on the hook or for how much, because there's no central exchange or system for reporting trades.

One of the largest writers of such insurance contracts is American International Group Inc., the giant insurer that teetered on the edge of bankruptcy before the federal government stepped in with a financial rescue.

In a best-case scenario, financial firms that sold CDS contracts would make their payouts in the coming weeks, have enough capital to cover all the positions, and take their losses and move on. In a worst-case scenario, sellers of the swaps would not have the cash to make the payments and would have to liquidate their assets to cover their positions.

"The next two weeks will be very telling," said Barry Silbert, chief executive of SecondMarket Inc., a marketplace for trading illiquid assets.

The auction set the value of $4.92 billion of debt issued by now-bankrupt Lehman at 8.625 cents on the dollar. Lehman bonds had been trading near that range in the past few weeks, meaning that Friday's auction price further reinforces current market values for the debt and, in turn, the credit default swaps.

"Since (the auction price) was not that far off from where bonds were trading, the hope is banks and funds with CDS exposure have prepared for the cash payout," Silbert said. "There is no longer much of a debate on what the claims are worth."

Auction may calm fears

Indeed, with the price set for the Lehman debt, uncertainty surrounding losses tied to those swaps should dim.

Credit default swaps have played a prominent role in the mushrooming credit crisis that in the past month led to Lehman's filing for bankruptcy protection, a government rescue plan for insurer AIG, and Merrill Lynch & Co.'s selling itself to Bank of America Corp.

The government bailout of AIG was necessitated in part because of the insurer's sales of CDS. Had AIG failed, it could have triggered billions of dollars in losses at many other banks and financial firms that bought swaps from AIG, sending them into failure as well.

The market for swaps, which is unregulated, is huge: estimated at as much as
$62 trillion. While little-known to many individual investors, swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt.

What is deemed the riskier, and probably larger portion of the swaps market, are swaps bought and sold as bets against bond defaults. The move is purely speculative.

Sellers of swaps have to make buyers whole on the price of the underlying debt if a company goes bankrupt or fails to repay the debt. In the case of Lehman, setting a price for the debt at 8.625 cents for every $1 now means any company that sold swaps tied to Lehman debt theoretically must pay out the remaining 91.375 cents for every $1 on the contracts.

Because credit default swaps are two-party contracts, there will be no net loss of wealth. For every company that takes a loss, there will be a corresponding gain elsewhere. The question remains which companies will be on the hook to make payments and take losses, and will they have the funds to cover such losses.

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