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Lehman Swaps Auction: What It Means

Sellers of insurance on bonds issued by bankrupt Lehman Brothers Holdings Inc. are now likely to face demands that they pay out more than 91 cents on the dollar to buyers of those insurance contracts.

That's the upshot of an unusual auction process Friday that established the price for defaulted Lehman debt, and in turn potential claims payouts on insurance protecting that debt, known as credit default swaps.

Certainly, some firms will take a hit because of the pricing, potentially amounting to billions of dollars in combined losses. In the Lehman auction, participants included most major financial firms from around the world. But it's too early to tell which companies will be on the hook or for how much.

"Where this is helpful is this is the first real-world situation where we see how market participants handle settling CDS," said Barry Silbert, chief executive of SecondMarket Inc., a marketplace for trading illiquid assets.

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In a best-case scenario, Silbert said, financial firms who sold CDS contracts would make their payouts in the coming weeks, have enough capital to cover all the positions, and take their losses and move on. In a worst-case scenario, sellers of the swaps would not have the cash to make the payments and would have to liquidate their assets to cover their positions.

"The next two weeks will be very telling," Silbert added.

The auction set the price on $4.92 billion of debt issued by now bankrupt Lehman at 8.625 cents on the dollar. Lehman bonds had been trading near that range in the past few weeks, meaning Friday's auction price further reinforces current market values for the debt and in turn the credit default swaps.

"Since (the auction price) was not that far off from where bonds were trading, the hope is banks and funds with CDS exposure have prepared for the cash payout," Silbert said. "There is no longer much of a debate on what the claims are worth."

Indeed, with the price set for the Lehman debt, uncertainty surrounding losses tied to those swaps should dim, providing banks more comfort with a portion of theirs and others' balance sheets.

Credit default swaps have played a prominent role in the mushrooming credit crisis that in the past month led to Lehman filing for bankruptcy protection, a government rescue plan for insurer American International Group Inc. and Merrill Lynch & Co. selling itself to Bank of America Corp.

The government bailout of AIG was necessitated in part because of the insurer's sales of CDS. Had AIG failed, it could have triggered billions of dollars in losses at many other banks and financial firms who bought swaps from AIG , sending them into failure as well.

The market for swaps, which is unregulated, is huge: estimated at as much as $62 trillion. While little-known to many individual investors, they are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt.

What is deemed the riskier, and likely larger portion of the swaps market, are swaps bought and sold as bets against bond defaults — a buyer doesn't necessarily have to own a bond to buy the CDS that insures it. In such cases, investors use swaps to essentially place bets on a company's performance, similar to shorting a stock — the move is purely speculative, as the investors are betting only on whether a bond or security will be paid off or fail.

(Tim Backshall, Credit Derivatives Research, talks about the Lehman implications in the video).

Sellers of swaps have to make buyers whole on the price of the underlying debt if a company goes bankrupt or fails to repay the debt. In the case of Lehman , setting a price for the debt at 8.625 cents for every $1 now means any company that sold swaps tied to Lehman debt theoretically must pay out the remaining 91.375 cents for every $1 on the contracts.

Because credit default swaps are two-party contracts, there will be no net loss of wealth. For every company that takes a loss, there will be a corresponding gain elsewhere. The question remains which companies will be on the hook to make payments and take losses, and will they have the funds to cover such losses.

Amid the ever increasing blame CDS markets have taken for spurring the credit crisis, the Federal Reserve Bank of New York on Friday hosted a second meeting with market participants to try and accelerate the process of creating a centralized clearinghouse for trading swaps.

Earlier this week, CME Group Inc., an exchange operator, announced plans to launch an electronic trading platform with Citadel Investment Group LLC for the trade of credit default swaps.

Over the past month, state and federal regulators have increasingly called for oversight of the swaps market. Securities and Exchange Commission Chairman Christopher Cox urged Congress last month to begin regulating the market for CDS contracts.

Cox's testimony calling for the regulation of the swaps market came a day after state regulators in New York said they will begin in January to oversee the portion of the market in which the buyer of a CDS actually owns the bond or debt, considering them akin to a traditional insurance policy like one taken out on a home.

The New York state policy would force financial firms to register with the state, face more oversight and hold adequate reserves to ensure they can cover any payouts.