Lehman CDS: It Won’t Be Over Today

Vipal Monga today mentions something I was unaware of: the Lehman CDS auction today is not the end of the story when it comes to settling those trades. All it does is set the price: settlement doesn’t happen until October 21, the week after next. In other words, to the degree that there’s nervousness over counterparties being unable to meet their CDS obligations, it’s going to remain through not only this weekend but also the weekend afterwards.

In fact, the actual settlement price is one of the few things we already know, more or less: it’s going to come in somewhere between 10 cents and 20 cents on the dollar. The huge list of things we don’t know, by contrast, is going to remain unknown until after October 21. Michael Edwards has a good column up at Seeking Alpha today:

CDS pricing is even less transparent than it seems at first glance. Setting aside the counterparty risk, the liquidity risk, and the litigation risk (due to absurdly complex CDS contracts), the cash settlement procedure can and does set prices on swaps that are wildly different from their ostensible value as "get out of default free" cards to be paired with some specific physical bond.

The classic trouble with derivatives – as generation after generation of investors has learned the hard way – is that their price has the intended mathematical relationship to the underlying security, right up until it doesn’t. The one circumstance in which the value of a credit default swap is certain not to match the risk it is supposed to counterbalance is when there is really a default.

I think it might not be a coincidence that the enormous fortunes which have been made in the CDS market so far, such as that of John Paulson, who bought protection on mortgage-backed securities, were largely made trading CDS (buying low and selling high) rather than holding them through default and settlement. Buying CDS is a good way of betting that spreads are going to widen. Holding CDS in the wake of a credit event, by contrast, is much more of a crapshoot.

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