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By Aline van Duyn and Michael Mackenzie in New York
Published: September 14 2008 20:26 | Last updated: September 15 2008 00:56
Wall Street dealers held an unprecedented emergency trading session on Sunday afternoon in a frantic effort to prepare for the possible bankruptcy of Lehman Brothers and limit the knock-on losses of its collapse on other financial institutions.
After meetings with New York's Federal Reserve ended in the early hours of Sunday, the Fed later called dealers at lunchtime and urged them to hold the special session. The plan was to allow dealers to take on new positions offsetting the risks from derivatives trades they have with Lehman, in order to reduce the rush to unwind billions of dollars of contracts on Monday should the investment bank file for bankruptcy.
However, according to several people involved, there was only limited trading, in part reflecting the difficulty of getting traders into Manhattan with less than an hour's notice on a
Sunday afternoon. "It was a bust," said one executive.
Lehman is one of a handful of large counterparties in the $62,000bn credit derivatives market, a market which has boomed in the last decade. The default of such a counterparty could lead to a spiral of losses - one of the reasons the Fed stepped in to help Bear Stearns in March.
The special afternoon trading session was first scheduled to last for two hours and then extended to four hours so that banks could hedge in case Lehman filed for bankruptcy later in the day.
The trades covered credit derivatives, as well as other parts of the over-the-counter derivatives market, worth nearly $600,000bn at the end of 2007. The contracts expire at midnight if Lehman does not file for bankruptcy.
The International Swaps and Derivatives Association said the trading was for "risk reduction" and involved credit, equity, interest rate, foreign exchange and commodity derivatives.
"We have been preparing for the default of a major counterparty all weekend," said a senior credit derivatives executive. "It would be unprecedented, to say the least."
The credit derivatives market, as with other over-the-counter derivatives such as swaps, is traded privately between banks and investors. Without an exchange or clearing house backing the market, the risks are taken on by the biggest dealers.
Even though banks may be able to hedge their exposure to Lehman, other participants in the derivatives markets such as hedge funds or insurance companies may be left holding credit default swaps (CDS) with Lehman as a counterparty which are supposed to give protection against other companies defaulting.
If Lehman defaults, it would trigger defaults on CDS which others have offered on the banks' creditworthiness. However, it would also erode the value of the insurance contracts Lehman has written, even if there has been no actual default on the underlying credit.
The potential sharp fall in the value of these credit instruments could feed through to lower prices and illiquidity across the credit markets, which remain very dysfunctional over a year after the US mortgage crisis first hit sentiment.
The crisis around Lehman comes as the credit derivatives market scrambles to handle the unwinding of up to $500bn of contracts linked to Fannie Mae and Freddie Mac, triggered by the US government's seizure of the mortgage groups.
Regulators have long feared that credit derivatives could be a source of systemic risks, and efforts have accelerated in recent months to reduce them. The market has grown extremely quickly, but its settlement systems and risk controls have fallen behind.
The steps taken to prepare for a possible default of Lehman came as it looked unlikely that the investment bank will succeed in finding a buyer.
Yet even a rescue of Lehman could create waves. In the Bear Stearns bail-out, holders of debt did not suffer losses; the pain of its downfall was felt mainly by equity investors. But Lehman debt-holders may not get off scot-free, especially if the US government sticks to its intent not to use taxpayers' money to help Lehman.
"The legal structure of any [deal] would also be a significant factor for fixed income investors," said Brian Zinser, strategist at Merrill Lynch.
Credit ratings agencies have warned that Lehman faces a downgrade should it fail to find a buyer. A large downgrade would imperil the investment bank's existing relationships with other banks in the derivatives market, damage Lehman's ability to borrow from the market and require the posting of more collateral for existing trades with counterparties.
Last week, a gauge of financial counterparty risk closed at its highest level since mid-March.
Copyright The Financial Times Limited 2008
Published: September 14 2008 20:26 | Last updated: September 15 2008 00:56
Wall Street dealers held an unprecedented emergency trading session on Sunday afternoon in a frantic effort to prepare for the possible bankruptcy of Lehman Brothers and limit the knock-on losses of its collapse on other financial institutions.
After meetings with New York's Federal Reserve ended in the early hours of Sunday, the Fed later called dealers at lunchtime and urged them to hold the special session. The plan was to allow dealers to take on new positions offsetting the risks from derivatives trades they have with Lehman, in order to reduce the rush to unwind billions of dollars of contracts on Monday should the investment bank file for bankruptcy.
However, according to several people involved, there was only limited trading, in part reflecting the difficulty of getting traders into Manhattan with less than an hour's notice on a
Sunday afternoon. "It was a bust," said one executive.
Lehman is one of a handful of large counterparties in the $62,000bn credit derivatives market, a market which has boomed in the last decade. The default of such a counterparty could lead to a spiral of losses - one of the reasons the Fed stepped in to help Bear Stearns in March.
The special afternoon trading session was first scheduled to last for two hours and then extended to four hours so that banks could hedge in case Lehman filed for bankruptcy later in the day.
The trades covered credit derivatives, as well as other parts of the over-the-counter derivatives market, worth nearly $600,000bn at the end of 2007. The contracts expire at midnight if Lehman does not file for bankruptcy.
The International Swaps and Derivatives Association said the trading was for "risk reduction" and involved credit, equity, interest rate, foreign exchange and commodity derivatives.
"We have been preparing for the default of a major counterparty all weekend," said a senior credit derivatives executive. "It would be unprecedented, to say the least."
The credit derivatives market, as with other over-the-counter derivatives such as swaps, is traded privately between banks and investors. Without an exchange or clearing house backing the market, the risks are taken on by the biggest dealers.
Even though banks may be able to hedge their exposure to Lehman, other participants in the derivatives markets such as hedge funds or insurance companies may be left holding credit default swaps (CDS) with Lehman as a counterparty which are supposed to give protection against other companies defaulting.
If Lehman defaults, it would trigger defaults on CDS which others have offered on the banks' creditworthiness. However, it would also erode the value of the insurance contracts Lehman has written, even if there has been no actual default on the underlying credit.
The potential sharp fall in the value of these credit instruments could feed through to lower prices and illiquidity across the credit markets, which remain very dysfunctional over a year after the US mortgage crisis first hit sentiment.
The crisis around Lehman comes as the credit derivatives market scrambles to handle the unwinding of up to $500bn of contracts linked to Fannie Mae and Freddie Mac, triggered by the US government's seizure of the mortgage groups.
Regulators have long feared that credit derivatives could be a source of systemic risks, and efforts have accelerated in recent months to reduce them. The market has grown extremely quickly, but its settlement systems and risk controls have fallen behind.
The steps taken to prepare for a possible default of Lehman came as it looked unlikely that the investment bank will succeed in finding a buyer.
Yet even a rescue of Lehman could create waves. In the Bear Stearns bail-out, holders of debt did not suffer losses; the pain of its downfall was felt mainly by equity investors. But Lehman debt-holders may not get off scot-free, especially if the US government sticks to its intent not to use taxpayers' money to help Lehman.
"The legal structure of any [deal] would also be a significant factor for fixed income investors," said Brian Zinser, strategist at Merrill Lynch.
Credit ratings agencies have warned that Lehman faces a downgrade should it fail to find a buyer. A large downgrade would imperil the investment bank's existing relationships with other banks in the derivatives market, damage Lehman's ability to borrow from the market and require the posting of more collateral for existing trades with counterparties.
Last week, a gauge of financial counterparty risk closed at its highest level since mid-March.
Copyright The Financial Times Limited 2008
