Monday, March 16, 2009
Commonly-accepted wisdom is that the losses from credit default swaps against Lehman were really not that bad. The pundits say that the losses were grossly exaggerated, and that the low loss figures show that the CDS market still works, and does not pose that great a danger.
But Satyajit Das - a leading expert on credit default swaps - points out today that the CDS losses from the Lehman default are much higher than generally reported:
In other words, those saying that the CDS market is functioning well and that the CDS scare is overblown don't have all the facts.
In the case of Lehman Brothers, the net settlement figure of $6 billion that was quoted refers to the auction. Some banks and investors that had sold protection on Lehmans did not participate in the auction choosing to take delivery of defaulted Lehman debt resulting in losses of almost the entire face value.
CDS contracts can amplify losses in credit market. Lehman Brothers defaulted with around $600 billion in debt implying a maximum loss to creditors of that amount. In addition, according to market estimates, there were CDS contracts of around $400-500 billion where Lehmans was the reference entity.
Market estimates suggest that only around $150 billion of the CDS contracts were hedges. The remaining $250-350 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200-300 billion) are additional to the $600 billion. The CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by (up to) approximately 50%.