Lehman Brothers Holdings Inc. (LEH)

Anxiety levels in the global financial markets were ratcheted up yesterday after credit derivatives linked to the failed US investment bank Lehman Brothers, with a face value estimated at $200bn (£118bn) to $440bn, began to be unwound.

Many banks are involved in the credit derivatives market and are exposed to the Lehman default. They include RBS and Barclays which could be forced to make further writedowns if they fail to recover all of their money.

Financial firms sold credit default swaps (CDSs) - a form of insurance against a company defaulting on its debt - to investors in Lehman's bonds and those betting on the bank's creditworthiness. These companies will now be forced to pay out 91.4 cents in the dollar. The figure is more than market expectations for losses on underlying Lehman bonds.

Banks around the world are hoarding cash partly in preparation for the settlement of these credit derivatives linked to a wave of major corporate defaults and lower than expected recovery levels. There have been seven major defaults in the past month, including those by US mortgage giants Fannie Mae, Freddie Mac and banking group Washington Mutual. Most recently a rash of Icelandic banking failures have added to the sense of foreboding.

"There are going to be others," said one credit analyst. "This is just the start."

Sandy Chen, an analyst at Panmure Gordon, said a "rough guess" suggested the Icelandic banks alone could trigger gross credit default swap payouts estimated at $200bn, though net payouts would be much lower. Credit derivative prices show investors believe many large companies are close to collapse. The annual cost of insuring £10m of Morgan Stanley's debt against default is now trading at £2.5m, implying a very high risk the bank could fail.

In the almost unregulated credit derivatives market, no one knows the scale of Lehman CDSs that have been bought and sold - estimates range from $250bn to $440bn. Market experts expect many of these positions to be offset as many investors are thought to have hedged some or all of their risk on Lehman credit derivatives. Michael Hampden-Turner, a credit analyst at Citigroup, said he expected the net payout on Lehman CDSs to be closer to $10bn. However, he noted that the lower than expected recovery rate on credit derivatives was likely to further fuel market concerns about the impact of future defaults.

Other analysts have pointed to concern that the recent run of large-scale defaults may leave many hedge funds with payout demands they cannot meet. This in turn may force writedowns for those failing to receive the payouts, many of them major banks.

Chen described the prospect of mass payment failures as "key drivers of the current apocalypse". He singled out Barclays and Royal Bank of Scotland as being most exposed among the UK banks to the credit derivatives market. Both have bought and sold, in roughly equal measure, £2.4 trillion of such contracts.

Chen believes Barclays and RBS are highly likely to be prominent among those required to pay out on Lehman CDSs. Meanwhile, counterparties failing to meet their payout obligations to the two banks could lead to big writedowns.

"Against this, tangible shareholders' equity bases of £20bn to £30bn seem like cloth tents in a hurricane," Chen said.

http://www.guardian.co.uk/business/2008/oct/11/...bankofscotlandgroup