Reasons To be Cheerful # 002

One of the factors behind the recent financial market panics was ignorance on the part of an amazing proportion of market participants, and of those whose money was invested, as to the real amount of liabilities owed by financial firms (not just banks). "It is very hard to determine the location of the risk, partly because of the chain of interlinked securities, which does not allow the final resting place of the risk to be determined. But also, because of derivatives it is even harder: negative basis trades moved CDO risk and credit derivatives created additional long exposure to subprime mortgages." (Gary Gorton via Tyler Cowen)

The demise of Lehman Brothers was a shock not just for the obvious reason that an old, large and widely respected institution had succumbed but because of a fear that, with it gone, others would lose huge amounts on credit default swaps (CDS) with Lehman and a domino effect could engulf large swathes of the global financial services industry.

A figure of about $400 billion was widely mentioned as the amount of the possible fall-out. Via Felix Salmon, the good news (very) is that the total was only $6 billion.

Traders are accordingly much less nervous and governments are taking over banks that are not quite as "ropey" as once feared.

Rejoice !

Comments

[Longman Oz]

As I understand it, the figure of $400 billion was the gross amount of Lehman risk to be physically settled by way of credit default swaps. On Friday, an auction of Lehman's bonds valued the risk at 8-9 cents on the dollar, meaning that the required cash settlement on the CDS was around $360 billion (being the now worthless 91-92% of the nominal value of the physical settlement).

However, because the sellers of CDS are obliged to mark their position to market on a daily basis, the net amount of cash that needed to finally change hands on Friday had been whittled down to an impressively low 2%. This is more or less the $6 billion that you refer to (I have seen it said to be a bit higher elsewhere, but it is a hair-split of an argument for these purposes).

By the way, if you had bought $10 million worth of Lehman CDS as a pure play a year ago, you would now be pocketing a cool $9 million of profit! :-)

[Fergus O'Rourke]

It is Felix Salmon who contrasts the $400 billion and $6 billion figures. Any error of the kind suggested - and I rather doubt that there is one - is therefore his. It is not without significance, I suspect, that none of the many commenters to his article makes the same point. All that said, the episode demonstrates how most people do not know what they are talking about in this area !

[Longman Oz]

Och, I did not write that comment to agree or disagree with anyone in particular! Rather, I just wished to explain how the $400 billion and the $6 billion were not necessarily contradictory amounts, once properly defined.

In my haste earlier though, I did not add that a major way of marking a position to market is to be able to offset it with an opposite position. On a gross basis, this bulks up the size of the CDS exposure on the underlying name, but the NET cash flows, following a default, are ultimately a lot lower. Equally, when trades are ultimately netted out between institutions, they can also cancel each other out in much the same way.