Lehman Default Swaps May Recover 9.75 pct Area

NEW YORK, Oct 10 (Reuters) - Banks, hedge funds and other sellers of protection on Lehman Brothers LEH.N (LEHMQ.PK: Quote, Profile, Research, Stock Buzz) are facing losses in the area of 90.25 percent of the insurance they sold, based on the initial results of an auction on Friday to determine the value of the credit default swaps.

There are also substantially more sellers than buyers of the debt in the auction, indicating that the final price of the swaps may be even lower than the initial recovery levels of 9.75 percent, according to results published by auction administrators Creditex and Markit.

"At 9.75 market midpoint and a large open interest, we could see a further drop in the final settlement price," said Tim Backshall, chief strategist at Credit Derivatives Research in Walnut Creek, California.

"On the bright side, we believe that the open interest is actually below our expectations and could prove that the systemic contagion worries are smaller than many suggested," he added.

The auction to settle Lehman's credit default swaps is one of the largest settlements of contracts in the $55 trillion market, with around $400 billion in contract volumes estimated on Lehman's debt.

I’m a staunch critic of the EMH, and that I’ve said that the market for this paper is broken as well.

I think the idea of the “hold to maturity value” is yet more economist BS posing as hard science when in fact it is just gibberish decorated with mathematics. A large part of the reason why we’re in this mess is that a whole bunch of over-educated, but not terribly real-world people, used a whole lot of advanced mathematics to create instruments whereby they thought (due to monte carlo simulations) they could dispose of risk.

What is pretty quickly apparent when one reads papers on quantitative finance is that they completely disregard the fact that financial market events do not follow a Gaussian distribution. What is pretty apparent to anyone with experience in markets is that the EMH is a complete crock at the irrational margins. So you get what we have here: an event in the tails well out past two sigmas, simply overwhelming all the expected gains of the +/1 1 sigma world in which they’d like to think we live.

The market for compromised debt is clearly broken. I have no doubt that the market is under-pricing the asset(s) in question. I also have no doubt that Bernanke is going to over-pay for these assets, because, as he testified in front of Congress, paying “too little” for the assets won’t “sufficiently re-capitalize” the banks in question.

This idea of trying to re-cap a bank by buying their crap paper is just silly. Either the bank gets screwed and the taxpayers win big, or the taxpayers get screwed and the bank wins big in the valuation debate. The Treasury proposed a reverse auction process, which is also silly, because if there’s one thing that the California power crisis showed us, it is that reverse auctions can be easily gamed.

I want to remove all valuation debate completely. If the banks need capital, then we should provide it on the same sort of terms that Buffett provided capital to Goldman: get senior prefereds, paying a punitive rate (per Bagehot’s dictum for lenders of last resort: “Lend freely, at high rates”), and make it a fixed rate, not a spread above a benchmark, since the benchmarks aren’t working either. Just get the broken market(s) out of the way and be done with it.

Oh, and I’d tell all the people whinging about “this is socialism” to calm themselves and think long-term, because the longer this goes on, the more seats the DNC takes in Congress and if they get the presidency with a 60-seat majority in the Senate, Katie bar the door: we’re going to see a LOT more socialism than just infusions of capital into banks.

I agree with some of what you are saying, but disagree with parts of it.

The instruments DO have a “hold to maturity value.” That is a fact. These instruments will generate some, now unknown, future cash flow. I acknowledge that it is extremely difficult to accurately estimate the future cash flows, in part because of factors dependent on future events, like the level of house prices, default rates, recoveries, etc.

I respect those who advocate the government taking direct equity positions in the banks as being a more effective way to recapitalize the banks.

In my opinion, however, the precedent of government taking ownership interests in the major banks, especially with Democrats in power, and the opportunities for intruding political and social policies into the workings of the banks (which is how we got into this mess) is worse than the alternative of the government buying mortgage-backed securities on the market and later reselling them or holding the assets to maturity.

I agree completely that the instruments have a “HTM value” — but WHAT is it? Aye, there’s the rub.

You might have one idea, I might have another, and both of us will likely be wrong, and the banks have yet another - because some of these instruments are going to see higher rates of mortgage defaults than there has been to date. Some of them might even out (eg, the ones for early vintgage) and level off — ie, the defaults won’t get much worse than they are now.

That all takes quite a bit of work to determine - and we simply don’t have the luxury of time just now.

The problem is, with these assets, the value is very much tied to the economy and how tapped out the mortgage borrowers become as a result of the declining economy.

I agree that there’s room for all manner of mischief in taking an ownership stake in banks - but remember — the current administration has the power to set the terms of the preferred stock if we get the deal done now. Most common stock has voting rights, most preferred don’t, and senior preferred stock is issued with its own one-off terms.

The banks and Treasury could hammer out a deal right now, before the change of administrations, to try to short-circuit some of the foolishness that the Democrats might try to impose on the banks via holding preferred stock. The key is to get going on these deals ASAP to get the terms set the way we want them.

There isn’t a single EMH — there’s strong, semi-strong and weak EMH.

All crap. A tremendous amount of math used to justify a ideological hand-wave by people who like to examine market entrails, but who don’t actually trade in the market.

Here’s all anyone needs to know about market behavior:

Let’s put the extreme bear and extreme bull case off into their own bucket.

The middling part of the market behavior might resemble something like EMH - if we assume that all markets are open. But, as we now know, markets are increasingly opaque, not increasingly open. Witness all the dark pools and non-retail exchanges being set up all over the world. Heck, just look at ICE for commodities.

Now, let’s talk about the bull/bear extremes. Let’s use “strong EMH” to start with.

EMH would have us believe that the market reflects ALL known information (public and private) on both the upside and downside.

This is a complete crock, because as anyone who has been in markets knows that at market extremes, price begets price. Why do markets go down harder when they go down hard? Because a downdraft uncovers stops that were already put in place, the downward price movement causes more selling to happen, which in turn can cause more stops to be uncovered. What information caused that extra selling to happen? Nothing. Purely the price movement. And if the price whipped down and then whipped back up — so sad, too bad, you got whipped out of your stop.

If we are to believe EMH in the long term (let’s put aside purely technical trading), then Warren Buffett would be no better off than I am.

Semi-strong and weak EMH are just hand-waves over the original hand-waves, attempts to cut some slack to a theory which simply doesn’t hold any predictive power. Let’s agree on the facts: there are some people who, through risk management, skill (and yes, luck), are able to create returns well in excess of market averages over the long term with enough regularity to matter. If EMH were true, there would be nowhere near as many people who are able to do this.

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