CDS settlement and Lehman - the eye of the storm

CDS settlements are pivotal if one strives to understand the current capital market crisis caused by a severe debt crisis. Yves Smith, creator of the most excellent blog "naked capitalism" sheds light on an interesting link between credit default swap settlements and interbank market rates like LIBOR by referencing a discussion in the current issue of the Institutional Risk Analytics. One of the few positive news in the last couple of weeks coming from Don Donahue, CEO of DTCC, is being challenged. To refresh memory, the DTCC claimed that the net payments on Lehman contracts were a mere $6 billion. This is only part of the truth according to the article since a large number of total holders of CDS for Lehman do not wish to take cash settlement and are expecting to receive the underlying bonds instead. The actual funding needs for CDS contracts linked to Lehman debt might therefore have been closer to the initially suggested $300 billion. This horrible number makes much more sense in light of the devastating effect in interbank lending markets after the surprised Lehman collapse. In the wake of the bankruptcy European Central Bank President Jean- Claude Trichet said U.S. lawmakers must pass a $700 billion rescue package for banks to shore up confidence in the global financial system. ``It has to go, for the sake of the U.S. and for the sake of global finance,'' Trichet said quoted by Bloomberg.

Here are the key passages:
This process of funding the CDS is reportedly a factor behind the high rates of dollar LIBOR in London and illustrates how cash settlement derivatives actually multiply risk without limit. Through the wonders of cash settlement, the derivative-happy squirrels at the Fed, BIS and ISDA created a liquidity-sucking monster in OTC derivatives that multiplies risk many times, for example, above the amount of underlying debt of Lehman Brothers.

We hear that there are more than a few EU banks which wrote CDS on Lehman over the past several years, CDS which were written at relatively tight spreads. These banks did not participate in the DTCC auction and instead have chosen to take delivery on the Lehman debt, forcing them to fund a nearly 100% payout on the collateral. A certain German Landesbank, for example, took delivery on $1 billion in Lehman bonds that are now worth $30 million, and had to fund same. Does this example perhaps suggest a reason why the bid side of dollar LIBOR in London has been so strong?

....the normal operation of the OTC derivatives markets is creating a cash position that must be funded in the real world and is thus distorting these benchmark cash markets such as LIBOR. This distortion is magnified by the dearth of liquidity due to the breakdown in the rules regarding valuation and price. So far, the Fed and other central banks have addressed the on-balance sheet liquidity needs of global banks. But as retail and corporate default rates rise, funding the trillions of dollars in notional off-balance sheet speculative positions in CDS, which become very real and require funding when a default occurs, could prolong the economic crisis and siphon resources away from the real economy.

On September 15 Lehman filed for bankruptcy. A look at the EURUSD exchange rate might help to understand. Decoupling has been put to rest once and for all.
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source: How Credit Default Swap Settlements Are Draining Liquidity From Interbank Market
Yves Smith, naked capitalism, Oct 29, 2008
http://www.nakedcapitalism.com/2008/10/how-credit-default-swap-settlements-are.html

source: In the Fog of Volatility, the Notional Becomes Payable, A Black Hole for Liquidity?
IRA, October 27, 2008
http://us1.institutionalriskanalytics.com/pub/IRAMain.asp