The Lehman auction

Wm

Fed Toxic Waste Removal Vehicles

It's Sunday and I've got a list (a mental one) of to dos in the house, but, the wife is away, so the mice have a few minutes…

First, let's resurface and underline that Lehman is bankrupt, which means it doesn't need nor will ever pay its debt obligations (update on October 15: derivative contracts receive special treatment under the Code and are free to terminate contracts and seize collateral to the extent they are owed money).

So, the Lehman bond auction was a minor first step in settling the final amount that Lehman swap sellers will have to pay October 21, to settle the Lehman insured debt, which hovers around $400 billion. Some are saying that quite a bit of this insurance payment is already hedged, so the pain or upheaval come payment day will be minor, in the order of 5% or $20 billion.

I can't agree with that statement, because the reality is that there are an estimated 10 times of Lehman swaps for every Lehman bond issued. In other words, the above Lehman sellers face a $4 trillion settlement on the 21st –some serious money, hedge or no hedge.

If you haven't dropped the ball yet, you'll understand that hedging has no bearing here, because somebody has to –finally– come  up with these $4 trillion –akin to LLoyd's men having to pay the insurance claims on a catastrophic storm event, as the last insurer in the chain. Let's pray that the sellers of last resort are a widely spread out group.

BTW, according to the auction, this payment settlement is steep: Sellers of credit-default protection on Lehman will have to pay holders
91.375 cents on the dollar, setting up the biggest-ever payout in the CDS
$55-trillion market.

And unfortunately, there's more bad news, Lehman itself was also a seller of CDS, whose obligations were left uncovered because it went bankrupt. In other words, there are a myriad of bond holders and swap buyers whose hedge has disappeared.

And the solvency question remains, who are they, and how many of these bonds are in trouble or at the verge of default?

So, this confirms the Paulson-Bernanke position and stresses the urgency to remove the trash. Banks will continue to hoard capital, until all toxic waste has been removed from the system. If, they themselves, can't even tell how bad their exposure is, how can it be expected from them to tell their counter-parties toxic exposure?

Continued here, here and here.