• C++ Programming for Financial Engineering
    Highly recommended by thousands of MFE students. Covers essential C++ topics with applications to financial engineering. Learn more Join!
    Python for Finance with Intro to Data Science
    Gain practical understanding of Python to read, understand, and write professional Python code for your first day on the job. Learn more Join!
    An Intuition-Based Options Primer for FE
    Ideal for entry level positions interviews and graduate studies, specializing in options trading arbitrage and options valuation models. Learn more Join!

Dealers hold emergency trading session

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
 
If you're the seller of protection, and you smell blood, you'd be shorting the stock and looking to aquire the bonds to fine tune your hedge, would you not? Or scrambling to close out your trade. Or both.
 
Holding reports? No, it's about to happen now.

Does anyone care to guess how many more dominoes are going to fall in this case?

Sheesh, and here I am trying to find a job in financials.

Oh joy. Talk about bad timing.
 
bad timing? ahahah....

I went through an I.T. degree being told that people would line up to give me a job... and then the dot com crash happened. I spent a few years working and travelling, came back and started my masters of financial math, due to graduate this november, and the biggest financial collapse in 80 years happens...

Maybe I should study weapons manufacture next... I'm sure we'd see world peace in no time ;)
 
I'm going to go out on a limb here and say that at the end of this, there will still be a BofA, a JPMorgan, a Goldman Sachs, a Morgan Stanley, a Credit Suisse, a BNP Paribas, a Nomura, an HSBC and a Barclays. That's as bold as I'm going to be on the big banks/securities firms.

The only thing surprising element of the Merrill Lynch / Lehman Brothers story is how long they managed to keep above water. I thought they'd dip under long ago!
 

Indeed. How gauche to think that a southern bank would wind up owning Merrill!

***

I think I had the mechanics of the CDS obligations a bit backwards. In a default, it's the seller who pays face, it's the buyer that has to deliver bonds, correct?

***

Fear not, gents. Capital markets don't die. The only morph. And even that's superficial.
 

Sanket Patel

i do stuff
I think I had the mechanics of the CDS obligations a bit backwards. In a default, it's the seller who pays face, it's the buyer that has to deliver bonds, correct?

That is correct. The swap buyer - the party seeking to insure - in the event of a default, receives the notional amount and delivers the defaulted securities.


b2bjanfeb.jpg
 

Sanket Patel

i do stuff
Gotta wonder about how all those protection sellers, and all those speculative protection buyers, are doing.

The speculative buyers are probably loving the current conditions. Hopefully the sellers had the common sense to hedge.

But then this bring up the issue of the enforcement of position limits...
 
Indeed. How gauche to think that a southern bank would wind up owning Merrill!

***

I think I had the mechanics of the CDS obligations a bit backwards. In a default, it's the seller who pays face, it's the buyer that has to deliver bonds, correct?

***

Fear not, gents. Capital markets don't die. The only morph. And even that's superficial.

Gauche indeed. I'm sorry, but it just feels WRONG to have a southern bank on Wall Street.

How so many people erred so grossly is beyond me...I thought all of these bulge bracket firms hired only the best and the brightest. How did nobody see this coming aside from a few Goldman traders?
 
The speculative buyers are probably loving the current conditions. Hopefully the sellers had the common sense to hedge.

But then this bring up the issue of the enforcement of position limits...

The buyers have to deliver bonds, though, and if they're speculative, they probably don't own them...could be a problem.

Many hedge funds are in a precarious place, I think.

One blogger writes:
"This is a big threat to the CDS markets as a whole, which is truly scary because that was the last liquid market. Here, we're all wondering whether Lehman might have blown up the market", said one hedge fund trader"

Not sure how reliable his sources are, but it certainly makes perfect sense. Moneymill
 

doug reich

Some guy
The buyers have to deliver bonds, though, and if they're speculative, they probably don't own them...could be a problem.

I know they come to some workout value when there are more contracts than notional covered. From wikipedia (Credit default swap - Wikipedia, the free encyclopedia)

In addition, growing concern over the sheer volume of CDS contracts potentially requiring physical settlement after credit events for names actively traded in the single-name and index-trade market where the notional value of CDS contracts dramatically exceeds the notional value of deliverable bonds has led to the increasing application of cash settlement auction protocols coordinated by ISDA. Successful auction protocols have been applied following credit events in respect of Collins & Aikman, Delphi Corporation, Delta Air Lines and Northwest Airlines, Calpine Corporation, Dana Corporation, Dura Operating Corporation and Quebecor. ISDA is also using a protocol for the settlement of contracts on Fannie Mae and Freddie Mac debt, after these entitities were placed in conservatorship.[4]
 
"How so many people erred so grossly is beyond me...I thought all of these bulge bracket firms hired only the best and the brightest. How did nobody see this coming aside from a few Goldman traders?"

The firms did hire the "best and the brightest" and the "best" did the math.... If by taking on risk and leveraging 30:1, the Desk makes $100 million and $40 Million returns to the desk for bonuses, the "best" buy the big house, the fast boat, the exotic vacation, and their children go to the best schools.... If they loose big, they "best" get fired, and hopefully re-hired at somewhere else where they can play with other peoples money once again!! What's not to understand? The "best" can do the math, and the math says "roll the die"!!

The problem for entry and middle level staff is that even if you see the train coming, your management will not let you pull the trigger and get off the gravy train as you can be too early to the exit and mess up next years numbers.
 
Look, I'm not going to lie to you--I want to go into finance to play the big game, to win big, and win for the sake of winning in and of itself, because once that happens, all of those goodies come with it. But what kind of winning is it when THIS is the result? You call those Lehman "best and brightest" the best and brightest?

Doesn't look like it to me today.
 

Sanket Patel

i do stuff
While I agree with what you are saying, it is easy for us to point out the seemingly nonsensical acts of these firms. But in the face of greed and fear, even the most rational man/woman may throw caution out the window.

Besides, throughout the course of history, greed and fear have been the catalysts behind virtually every major 'event in one way or another. I'm not trying to defend these firms, just merely trying to look at it from the other side.
 
Top