Monday, 15 September 2008

Fasten your seatbelts

This is going to be more painful than we all thought: Lehman Brothers (LEH) has gone bust.

For the best, detailed coverage, read the website.

For a high level summary, get your news from the BBC News website.

This is the biggest bankruptcy in history.

  • On Monday last week, you could have bought protection for Lehman Brothers at about 350bps. Sadly, I did not: I am not Nostradamus.
  • On Tuesday it was about 500bps. I am not Nostradamus but I can smell blood.
    Rab said, "yes, I do".
  • On Friday it was about 900bps but nobody was really selling. The game was up.
  • On Monday, LEH files for bankruptcy protection, a credit event, letters are being exchanged and the CDS contract is triggered. In a few days, the post-default recovery value will be established by a panel of ISDA members. Bond holders will deliver the bonds, physically, to the protection sellers, and these will pay up the nominal value of the bonds. If you bought the bonds at discount to face value, the capital gain could well be over 10% of the nominal for subordinated debt.
  • The seller of protection swallows the defaulted bonds in their balance sheet and becomes a creditor to LEH.
  • As we say in Catalan, "bon vent i barca nova!" or "See youse later!"

And the question is: who is next? UBS, Deutsche Bank, Morgan Stanley, Barclays?

If your fund manager has not bought CDS protection by now, it's probably too late. Corporate bond funds overweight financial bonds are going to suffer capital losses in investment grade bonds. The credit rating agencies have proven to be incompetent and unfit for purpose. The EU will get their way and will ensure CRAs are properly regulated, like it should have always been.

This is not going to be a quick adjustment, a blip, as the usual cheerleaders of excess are claiming:
Our view: On balance, we believe that the worst is now over for bank
debt as an asset class, but this does not means that some individual
organisations may not come a cropper. Indeed, respected
US economist
Kenneth Rogoff has stated that there is a high
probability of a "high profile casualty" amongst the US banks.

We just had two casualties in one weekend, all powerful Lehman Brothers (apparently the best algorithm trading and risk systems) and all-mighty Merrill Lynch (apparently biggest equity capabilities), and AIG seems to be next. For retail investors in open-ended vehicles, the pain of mark-to-market values of debt holdings will last for a while. If your fund is overweight financial equities, I am really sorry for your loss.

I believe we are going to see a reshaping of financial institutions that was unthinkable two years ago. Many of us, not least the FSA (as published in their Financial Risk Outlook 2007), were expecting a repricing of risk, and an increase in risk premia. We adjusted positions accordingly a long time ago. But this is just something else. Highly geared banks dependent on wholesale funding will see their value destroyed. Not even senior debt holders are safe. The CDS market is going to be tested in a way nobody predicted. Good luck to all those participants who bought protection without holding reference assets. The scramble for post-default bonds will push their value above recovery price. The promise of "best endevours" of cash settlement are worth as much as LEH shares. It is going to be a once in a lifetime event.

If you are lucky enough to have serious money (+£100k) invested in cash deposits and savings accounts, I would urge caution. Check out your financial regulator website and find out how much your national deposit protection insurance actually covers. In the UK for example, only the first £35,000 of savings held in a bank account are guaranteed. If you have much more than that with one bank, you should spread the risk by opening savings accounts with other institutions.

No comments: