Banks Hoarding Cash to Pay Derivatives Liabilities

Tomorrow, the auction for Lehman’s credit default swaps will be held, and the final result will probably be that that holders of credit default swaps will have to pay around $360 billion dollars (see below). That’s for Lehman alone. Derivatives exposure due to other failed businesses is even higher.

This is why Wall Street firms and banks have been hoarding cash. As the Financial Times wrote on October 7th:

Banks are hoarding cash in expectation of pay-outs on up to $400bn (£230bn) of defaulted credit derivatives linked to Lehman Brothers and other institutions, according to analysts and -dealers.

***

Michael Hampden-Turner, a credit strategist at Citi, estimates that there could be $400bn of credit derivatives referenced to Lehman.

These contracts will be settled on Friday [October 10th], and with the recovery value on Lehman bonds currently estimated at about 10 cents on the dollar, the pay-out by banks and other sellers of credit protection on Lehman could reach a gross $360bn.

As Fox News puts it:

Massive positions are just starting to be unwound in the credit default swaps market as tens of billions of dollars worth of these contracts are now getting settled in the aftermath of several high-profile flops.

Banks are hoarding cash in expectation of expected payouts on anywhere from $200bn to $1 tn–no one knows the amount, adding to volatility–for defaulted credit derivatives linked to the collapse of Lehman Brothers, the government’s seizure of mortgage giants Fannie Mae and Freddie Mac, the government’s rescue of American International Group, and the failure of Washington Mutual.

And as leading economist Nouriel Roubini wrote today in an article entitled “What Is Really Bothering Markets: Lehman’s CDS Settlement on October 10 With A $360bn Expected Payout” (after quoting the above-described Financial Times articles):

  • Lehman was one of the top ten counterparties in the unregulated $62 trillion OTC credit default swap (CDS) market. As Lehman defaults, tens of billions worth of hedges become worthless and can only by renewed with a new counterparty at much higher premiums (i.e. CDS spreads). Moreover, Lehman bondholders will only receive about 10 cents on the dollar in exchange for defaulted Lehman bonds and protection buyers will have a claim on 90 cents on the dollar in the hope that protection sellers will be able to perform.
  • Systemic event: S&P acknowledges that Lehman’s default was key to AIG’s demise with spillover to Europe, as well as to money market funds breaking the buck with spillover to the commercial paper market. Hedge funds’s brokerage accounts have been frozen and they might also be exposed to derivatives trades.
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