Lehman Failure May Spark Record Payout for Credit Swap Sellers

By Shannon D. Harrington

Source : http://www.bloomberg.com/apps/news?pid=20601087&sid=aX_FLjiKfbic&refer=home

Oct. 10 (Bloomberg) — The collapse of Lehman Brothers Holdings Inc. may force sellers of credit-default swaps including Pacific Investment Management Co. to make the biggest- ever payout in the $55 trillion market.

An auction to be held today will determine the size of the payments buyers of default protection can claim after New York- based Lehman filed for the largest bankruptcy with $618 billion in debt. Lehman’s $128 billion of bonds were trading yesterday at an average of 13 cents on the dollar, indicating credit swap sellers may have to pay 87 cents on the dollar.

“That’s a big hit,” said Byron Douglass, a strategist at Credit Derivatives Research LLC in Walnut Creek, California. He follows the market for collateralized debt obligations that sold protection on Lehman debt. The payment compares with a typical bond recovery of about 40 cents on the dollar and a payout closer to 60 cents, Douglass said.

More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman. No one knows exactly how much is at stake because there’s no central exchange or system for reporting trades. It’s that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market.

The list of participants includes Newport Beach, California-based Pimco, manager of the world’s largest bond fund, Chicago-based hedge fund manager Citadel Investment Group LLC, and American International Group Inc., the New York-based insurer taken over by the government, according to the International Swaps and Derivatives Association in New York.

Market Test

Hedge funds, insurance companies and banks typically buy and sell credit protection, which is used either to insure a bond against default or as a bet against the company’s ability to pay its debt.

The failures of Lehman, once the fourth-largest securities firm, and Seattle-based Washington Mutual Inc. as well as the government takeovers of Fannie Mae, Freddie Mac and Iceland’s biggest banks have provided the 10-year-old credit-default swaps market with its biggest test to date. The use of credit derivatives have grown more than 100-fold in the past seven years as investors began using the swaps to bet on companies’ creditworthiness.

Credit-default swaps are financial instruments that can be based on bonds and loans. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Record Highs

Five-year credit-default swaps on Lehman rose as high as 790 basis points before the firm filed for bankruptcy, according to Phoenix Partners Group., a New York-based inter-dealer broker. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Dealers earlier this week set values for bonds of Washington-based Fannie Mae and Freddie Mac of McLean, Virginia. Sellers who signed up for the auction will pay 8.5 cents on the dollar at most because the government is backing the debt of the two largest mortgage-finance companies.

The Pimco Total Return Fund had written protection on $105.4 million face amount of Lehman debt as of June 30, according to regulatory filings. Pimco spokesman Mark Porterfield didn’t immediately return a call seeking comment.

Primus

A unit of Primus Guaranty Ltd., a Bermuda-based company that has sold more than $24 billion in credit-default swaps, said last month it guaranteed $80 million of Lehman debt. The firm sold protection on $215 million of Fannie and Freddie debt and $16.1 million on WaMu. Yesterday, it said it also had made bets of $68.2 million on Kaupthing Bank hf, which the Icelandic government seized.

Primus said last week it had $820 million in cash and liquid investments to meet claims on the contracts.

CDOs that sold credit-default protection may lose money as defaults their ability to withstand losses, Douglass said. The CDOs pool the swaps and then sell off pieces with varying risk.

Standard & Poor’s has ratings on 1,889 CDOs that sold credit-default swap protection on Lehman, the New York-based rankings firm said last month. Pieces of 1,526 CDOs sold protection on Washington Mutual, S&P said. More than 1,200 made bets on both Fannie and Freddie.

To contact the reporter for this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net;

Last Updated: October 10, 2008 00:01 EDT

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