The DTCC is a reliable source, and it says the Lehman CDS settlement flows on October 21 are going to be small:
In November 2006, The Depository Trust and Clearing Corporation (DTCC) established its automated Trade Information Warehouse as the electronic central registry for credit default swaps. Since that time, the vast majority of credit default swaps traded have been registered in the Warehouse…
The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range (in U.S. dollar equivalents).
This is massive-sigh-of-relief good news. The widely-cited $400 billion number was, as far as I could make out, pulled largely out of thin air, while this is concrete stuff. If net funds transfers are only about $6 billion, that’s not enough to bankrupt any systemically-important institution.
While I’m on the subject, I spoke to Creditex today about the way that the CDS auctions work. (I really should have done this before the Lehman CDS auction, but I was, um, distracted.)
In its simplified basics, it’s a two-part process: in the first part, a bunch of dealers are canvassed to give bid and offer prices on the cheapest-to-deliver bonds of the entity which has just gone bust. From those prices you get something called an "indicative inside market midpoint". That’s the level at which the CDS should, by rights, cash-settle.
But the problem is that there are also CDS which people want to physically settle. Some people need to deliver physical bonds — so they’re putting in bids, and need to buy them — and some people are going to be receiving physical bonds they don’t particularly want, and they’ll be putting in offers, wanting to sell them.
If the difference between the buy interest and the sell interest is zero, then the indicative inside market midpoint is the final price. Otherwise, there’s a second part to the auction, where the price is adjusted so that there’s equilibrium between buyers and sellers. That’s how the Lehman CDS cash-settlement price ended up falling from 9.75 cents on the dollar to 8.625 cents on the dollar: at 9.75 cents, there were more sellers of bonds than buyers.
Back in the bad old days of the Delphi CDS auction, single-name CDS had to be physically settled, which meant there was an enormous number of protection buyers all needing to come up with physical bonds. The result was a ridiculously high cash settlement price of 63.375 cents on the dollar — much more than any reasonable recovery value on the bonds.
Today, however, single-name CDS not only can be cash-settled, but usually are cash-settled. Which means that Delphi-like discrepancies are much less likely to occur.
What DTCC said yesterday is that even at 8.625 cents on the dollar, which means that sellers of protection have to cough up 91.375 cents for every dollar they insured, total payments aren’t going to go much over $6 billion. I can’t imagine why they would say that if it wasn’t true, so I believe them. Which means that one massive potential source of tail risk is not nearly as big as most people thought it was.