Lehman’s CDS Risk

September 14, 2008

*See below for a list of Lehman counterparties in derivatives*

There’s right now fear of financial chaos on Monday, in case Lehman is forced into a liquidation. The problem is the size of the CDS market, and Lehman’s important role as a counterparty to a large number of deals. The CDS market is larger than the MBS, stock and treasury markets combined, and it’s unregulated. There’re often more contracts on credit insurance than there are bonds outstanding: in other words, leverage has found its way into this section of the financial markets too. Today the size of this market is 62 trillion dollar on notional amount, which means that it kept growing in size even while the stock market, commercial paper market, and the securitisation markets shrank during the last year.

Gra ph of CDS market’s size

My expectation is that Lehman’s end will happen with less trouble than some are fearing at the moment, since there has been ample time to make preparations for this widely publicized and discussed eventuality. The end of Bear Sterns was abrupt and relatively unexpected. There were rumours, but the collapse of the firm was too fast to allow a period of readjustment. In that sense, the Fed was right in bailing out Bear’s counterparties. The choice of less involvement is also the proper way of dealing with the particularities of the Lehman issue.

The size of Lehman’s CDS involvement is unknown, according to Wall Street Journal’s article. In a survey last year by Fitch Ratings, Lehman was listed among the 10 largest CDS counterparties by number of trades and the amount of debt to which the contracts were tied.

Update on CDS developments related to Lehman for September 15th is here.

Updated on September 15th, from JPMorgan, via Financial Times:

Lehman counterparty exposure

Lehman counterparty exposure

Counterparty exposure to Lehman of various major European firms. The top three are JP Morgan, UBS, and Societe Generale,  in that order. The exposure of  Deutsche Bank is in the order of 1 trillion dollars, although the actual losses on this notional amount is unclear.

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3 Responses to “Lehman’s CDS Risk”

  1. Re: the size of the CDS market.

    What is the reference of measurement? It appears to be notional value, which is meaningless in the CDS market as a measure of risk.

  2. moneymill said

    Not directly, but it is a measure of risk as it gives an idea about the amount of leverage involved in these transactions.

  3. BankREO said

    I would disagree Trainofthoughts, being that they are unregulated and do not require any reserves against them with them being into the Trillions of dollars I would say that carries a large amount of liability against all parties and counter-parties. And we need to keep in perspective that when a CDS goes default it goes from notional to nominal and at that point someone needs to actually pay out or?????? Thats a big question that almost makes the truth worse than the lie (almost).

    .02

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