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Dealers scramble for collateral as Lehman CDS unwinds begin

Volumes traded in the credit default swaps market were enormous and ranges were huge during a remarkable week in which Lehman Brothers filed for Chapter 11 bankruptcy, Merrill Lynch sought and found a buyer in Bank of America, the US government bailed out AIG with a $85bn loan, and the two sole remaining broker dealers, Morgan Stanley and Goldman Sachs were left vulnerable and potentially looking for merger partners.

Not only were dealers plugging the holes uncovered by the bankruptcy of Lehman they were deleveraging en masse while others put on huge speculative positions. “The amount of money and risk changing hands....well, I don’t like to think how much it is,” said a dealer in London at the end of Thursday.

Volatility was unprecedented. The iTraxx financial subordinated index, for example, traded between 290bp on the upside and 245bp on the downside before closing at 270bp in a single session on Thursday. “We’re seeing a ton of trading. There are a lot of offsets, unwinds and assignments,” said one credit trader in New York on Monday.

Most shops reported febrile trading of synthetic credit instruments; but it was not the sort normally seen. Everyone was attempting to assess exposure to Lehman and take evasive action as much as possible through novation and unwinds. The main Europe Index closed around 133bp/135bp after opening at 142bp and hitting a high for the week of 149bp. The Crossover closed at around 620bp.

In New York, the CDX Investment Grade Index was around 177bp at the close, after hitting a high of 220bp.

The US credit derivatives market was working at white hot pressure throughout the week New York as Wall Street reeled from the collapse of Lehman Brothers.

The International Swaps and Derivatives Association said on Monday that an auction to determine a cash settlement for trades involving Lehman as a counterparty will be held shortly.

Although the Federal Reserve deemed Lehman small enough to fail, it was “one of the biggest counterparties on the Street” said a dealer in New York, and the CDS market has never seen a failure of this kind. “You can go up and down Wall Street and no-one can claim with any confidence they know what their risk position is,” said a dealer.

The operational obstacles could absorb the market for weeks, and the use of collateral the process is likely to involve could be so massive that a lot of the remaining counterparties will have nothing left over for new trades. Only the capital rich, financial powerhouses like Bank of America, Deutsche Bank and JP Morgan may remain to dominate a much slimmer CDS market. Dealers admitted that when CDS desks weren’t offsetting positions with Lehman they were cutting other positions across the board as well. “The deleveraging we’ve seen for months has been put into a very high gear by Lehman,” said one.

But the panic trade extended beyond Lehman of course. Financial institutions across the US, the UK and much of Europe were well bid. Only German and Italian banks remained relatively stable, said a dealer in London.

Lloyds TSB, the new owner of HBOS, was dealing at 200bp at the close in London yesterday, while HBOS was at 320bp. HBOS had been as wide as 500bp. In theory, the two should converge, but, almost inevitably, there is confusion about whether there will be a succession event or not.

Barclays is around 215bp while Deutsche is 155bp. In these febrile and emotional conditions, irrationalities and inconsistencies occur. Royal Bank of Scotland has been bid out to 220bp/240bp, while its new unit, ABN Amro, is still “relatively tight”, in the words of one dealer, at 160bp/180bp.

The Icelandic banks are back in the red zone. Landisbanki has sold off by more than 400bp in the last week to 900bp, while Kaupthing and Glitnir are dealing in upfront territory.

Non-banks that depend on wholesale funding also staggered. General Electric Capital Corp — rated triple A — began trading at over 500bp in CDS land due to doubts about its ability to raise debt in the capital markets. Spreads have ballooned and the market is closed until further notice anyway. Without cheap funding, its business model is imperilled.

International Lease Finance Corporation (IFLC), the aircraft leasing company, narrowed a touch from the highs of 840bp as it seems very likely it will be sold by parent AIG. The latter has been loaned $85bn by the US government and needs to raise capital fast. The ILFC may fetch as much as $8bn. “It’s hard to cut through the fact and fiction and frayed nerves to get a clear picture of what is going on. Fiction is as strong as reality these days,” observed a Wall Streeter as the market began to close on a sunny September day in New York.


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