Monday, October 13, 2008

10/21: The Bottom

Let's cut to the chase. On Oct 21, somebody A will have to pay somebody B $C in cash to settle CDS on Lehman. Estimates on C range from 100 billion to 600 billion (a recent DTCC press release claims that the total net payment on Lehamn CDS is only $6B but I'll write about how misleading that is later). Group A will almost certainly include AIG, the biggest net seller of CDS, and many hedge funds, who have been using CDS selling as their cheap (HA!) financing source for the past few years. Besides single-name CDS specifically on Lehman, other credit derivatives such as CMCDS, CDS options, or Nth to Defaults, CDX indices and bespoke CDOs with Lehman in it will also settle, partially or in full.

This will be arguably the biggest cash-exchange day in human history to date. I don't care how much tax-payer's money the government will use to bail them out, somebody will fail.

Group B includes two types. One has Lehman bonds. They will be made whole by the settlement although Lehman bonds changed hands at 8.625 cents on the dollar at today's auction. The other doesn't have Lehman bonds. They bought naked CDS on Lehman. They will have a HUGE windfall -- for every dollar notional, they'll get over 91 cents. If they could collect, that is.

Back to the more immediate concern. Who is A?

You could pore over the CreditFixings' auction info and guess. I think a lot of people did just that Friday. They pounced on MS, GS, CS, and DB, who happen to be the biggest Physical Settlement Sellers (meaning they sold CDS on Lehman). JPM shot up the whole day, which happens to be the biggest buyer.

But I don't know how productive this guessing game is. The dealers could be placing orders and requests for their hedge fund clients. Short of serious insider info, there's no way of knowing how much of those requests are for themselves vs clients. More importantly, physical settlement will almost certainly be just a small portion of the overall settlement size. Today's auction had $5.7B sell orders. Cash settlement will most likely be at least 10, maybe 100 times bigger than that. People learned the lesson from Delphi. Furthermore, it'd be very unusual for banks to have a huge net position on CDS, with the possible exception being their proprietary desks and funds. Again, most likely suspects are AIG and hedge funds.

Now you know what the government bailout of AIG is for, the initial $85B and then the additional $37.8B (suspiciously precise isn't it?). Don't be surprised if the number goes up again before 10/21. Will tax-payers get the money back after 10/21? Fat chance. Is the money really for saving AIG or making sure others who bought CDS on Lehman will get their windfall? Take your pick.

On to hedge funds. They knew how much they would need to pay since Lehman bankruptcy. Reportedly JPM, GS, and MS have issued massive margin calls to their hedge fund clients, which is consistent with their sell requests (except JPM who, being the clearing bank for Lehman, may have bought protection) at the ISDA auction and my suspicion that a big part of their requests are on behalf of their clients. Some hedge funds are forced to cash out. And since Thursday some apparently went shorting in desperation, trying to make a quick buck before the doomsday. The 900 point surge Friday 3PM in half an hour showed how nervous and desperate they are.

In the meantime, of course, hedge fund investors must be withdrawing as fast as they possibly could, adding to their misery. Bankruptcy law will be the golden profession for many years to come.

WaMu CDS settles on Nov 7. Its impact is expected to be much smaller, although nobody can be sure, as for all CDS. We may get some rough idea on its auction date, 10/23. If there're high-profile bankruptcies on 10/21 (banks, AIG), then market would be spooked and all eyes would turn to WaMu; otherwise it'd likely be a non-event in comparison.

If there were bankruptcies of anything other than hedge funds on 10/21 (or 11/7, though less likely), then we could be in a serious chain reaction. But governments all over the world would band together to stop it. Governments may be stupid and inept, but they're not suicidal. Fed window will stay open late on 10/21. For banks (or AIG) who cannot post enough collateral, Paulson will be ready to buy stocks in a heartbeat. If the initial $250B runs out that day, they can let foreign sovereign funds to buy perferred stocks. It's a wonderful world.

Moreover, I suspect the pending doomsday is a big reason why banks have shied away from lending to each other over the past few weeks. Nobody knows how much anybody else owes on that day. Coming 10/22, assuming no banks fail, it'd be a huge cloud gone. Back to business as usual, or as usual as it gets nowadays.

Hedge funds' fire-sale exit may be creating a very rare buying opportunity in many financial markets (stocks, bonds, commodities, maybe even dreaded CDOs and mortgages). Two days ago I wondered if the bottom is near. Now I'm convinced the bottom will be around 10/21, if not earlier. The way back up may be painfully fast or painfully slow. But the crisis is essentially over unless we let the chain reaction take place.

Then we'll only have to deal with the massive debt, recession, and inflation. Piece of cake.


display name said...

Very intersting post, I was wondering if you could expand on the DTCC assumptions and why they are misleading. Also I'm confused how the auction process for CDS occurs. What do the actial BID and ASK prices inputed by companies mean. Sorry I'm so naive, just an inexperienced but interested student.

Bo Peng said...

If you really want to understand the auction process, your best source is the ISDA Protocol. Maybe focus on the definitions first. Or check out the "Plain English" version (click on "2008 Lehman" on the left panel).

Bidders buy the CDS protection to be settled. She wants the recovery low so that she gets more payout, which is 1-recovery. So the bid/ask is the recovery of deliverable obligation (bond, usually senior unsecured -- maturity and coupon don't matter any more after Chapter 11).

It's a bit twisted. If you have sold a lot of cash-settled (naked) CDS, you might want to buy some physical settled protection in the auction and bid up the recovery. The price will be used for your cash settlement. Such parties would appear as net aggressive buyers. Is this why JPM was buying? We don't know, yet. My point is trying to read too much into the auction is pointless.

As to the analysis of DTCC press release, please read my following post.