Lehman Credit Fixings and what it tells us

Credit fixings for Lehman brother are out.

http://www.creditfixings.com/information/affiliations/fixings/auctions/current/lehbro-res.shtml

The final price was 8.625. For non financial folks out there, that means that a CDS protecting $10mm of debt is worth $9.1325mm. The recovery on the Lehman bonds was way under what I expected it to be. In fact, before the auction, the defaulted bonds were trading at 13c to the dollar., indicating that the CDS is worth $8.7 mm.

What does this mean?

This means that whoever has sold protection now has to cough up extra cash in order to settle their obligations. It means that the funding markets will continue to be stressed, and it means that the markets won't recover anytime soon.

Just want to point your attention to the website - in fact, if one looks closely at the auction, you see that the first market midpoint was $9.75. Look closely at Goldman or ML's prices. ML had a 8-10 market, Goldman said 8.875/10.875. For Physical Settlement requests, you can see that GS offered a staggering $1.5bn in bonds to sell @ 9.75. Two things: 1) They thought that the $9.75 price was too high and were trying to drive it down, or 2) they really had $1.5bn in bonds to sell. Anyway, in anycase, everyone seems to think that $9.75 is too high, and the net open interest was a $5bn selling interest after the first round.

What can economics, the study of incentives, tell you about this round of bidding? Looking at the net open interest to sell, one can speculate that the dealers were net BUYERS of Leh protection. (if they were intending to drive the price down - CDS is worth more to them if the recovery is as low as possible), or that the dealers, having bought WAY too many Leh bonds, were trying to offload them in the market at $9.75.

Anyway, what is interesting next are the limit orders. ML posted a buy order at $10.25 for $670mm, which was partially filled. Barclays bought $775mm at $9.75. GS bought $825mm bonds at $9.75 and above. Citi got $500mm @ 9.125. GS got another $270mm at 8.75-9.75. and JPM got $830mm at $8.625 and above.

Anyone who thinks about this auction should see what was coming. Having dealers who had a net interest in BUYING, they indicated to sell a ton at the first phase of the auction in order to drive the price down before getting their orders filled at a much lower price. i.e. Dealers were all net buyers of protection, they needed to deliver cheap bonds, and how they did this was to indicate an interest to sell FIRST, before buying the bonds at a cheap price.

Here's a breakdown

ML - Indic $141mm to sell @ $9.75. Bought: $670mm @ $10.25 WTB $250mm @$8.5
GS - Indic $1.47bn to sell @ $9.75. Bought: $825mm @ @9.75, $270mm @ 8.625-9.75
JPM - Indic $612 to buy @ $9.75. Bought: $830 above $8.625.
Barc - Indic $130 to buy @ 9.75, Bought $775mm @ $9.75

etc etc

What does this show?

1) GS is smart. They indicated a HUGE SELLING INTEREST, before turning around and buying most of their requirements above the indicative price $9.75.
2) JPM is honest, they wanted to buy at the start, and they bought in the end.
3) ML bought way too high. ML tried to be a GS, indicated huge selling interest (okay just $141mm), and bought their bulk of their orders at $10.25
4) Barc is honest as well.

What does this tell us? A lot of the CDS sellers, got SCREWED. Since this is a one sided market, and dealers were incentivized to push down the price since they were NET protection buyers, folks like AIG/PIMCO who sold massive amounts of protection now either have to cough up a huge amount of cash to settle their CDS obligations, or buy defaulted bonds in order to settle physically. Guess from who? That's right, the dealers.

I have to applaud the market, collectively, they played this poker game to a wonderful ending, and a lot of guys who don't want to do the analysis will accept the results and cough up the money.

Then again, that's why I want to be a trader:).