Analysts: Lehman Failure May Hurt Credit Markets

BANGALORE (Reuters) – Analysts on Monday said the failure of Lehman Brothers Holdings Inc (LEH.N) will cause a major reduction in credit market liquidity and raise concerns over substantial counterparty risk exposure that Lehman had, while forcing other brokers to mark down the value of their assets.

“We expect the financial markets to be under unprecedented strain over the next several days as players respond to outsized industry deleveraging,” Oppenheimer & Co’s Meredith Whitney said.

The immediate impact of Lehman liquidation will be a dramatic credit spread widening and ultimately negative valuation marks for the remaining players, Whitney wrote in a note issued late Sunday.

In a separate research note, veteran banking analyst Richard Bove on Monday said he expects the credit default swap (CDS) market to be in turmoil.

Credit default swaps are used to hedge against the risk of a borrower defaulting on their debt, or to speculate on a company’s credit quality.

“The biggest issue today will be following the money trail. Who has the most indirect lending to Lehman? Who has the greatest counterparty risk?,” Ladenburg Thalmann & Co’s Bove added.

Panmure Gordon & Co’s Sandy Chen echoed Bove’s sentiment.

Chen said the market’s focus will now shift from estimates of write-downs, capital needs and merger and acquisition scenarios, to concerns about counterparty exposures and default risks.

Analysts say that there exists substantial counterparty risk to derivatives transactions with Lehman, and that these contracts are private with no firm having yet disclosed their exposure to any single counterparty.


Panmure’s Chen expects counterparty default charges to “sweep” through the global financial sector over the next few weeks.

“Unfortunately given their nature… we will only find out after those defaults have occurred,” Chen said.

As of May 31, Lehman had $729 billion of notional derivatives contracts and had estimated the fair value of these derivatives contracts at $16.6 billion, Chen said.

Lehman had also disclosed $25.6 billion in assessed fair value of over-the-counter interest rate, currency and CDS exposures, he wrote in a note to clients.

The real stress will come from CDS markets, Chen added.

Given that the CDS market as a whole had notional contracts roughly four times greater than the underlying debts issued, it is not far-fetched to estimate that there are at least $350 billion in CDS written on Lehman debts, Chen said.

“With estimates that Lehman debt will trade at 60 cents on the dollar; this would mean that $140 billion in CDS payouts could be trying to settle over the next days and weeks,” Chen said.

“This, we expect, will trigger further counterparty defaults,” he added.

Analyst David Trone at Fox-Pitt Kelton estimated that 2 percent of each firm’s derivatives receivable has Lehman as counterparty.

“Thus, we derive exposure-to-equity of approximately 5.4 percent for Goldman Sachs Group Inc (GS.N) and Morgan Stanley (MS.N). Universal banks JPMorgan Chase & Co (JPM.N) and Citigroup Inc (C.N) have exposures of about 2 percent,” Trone wrote in a note to clients.

“In reality, some institution(s) may have significantly outsized exposure to Lehman,” Trone added.

Lehman on Monday filed for bankruptcy protection, after trying to finance too many risky assets with too little capital, making it the largest and highest-profile casualty of the global credit crisis.

The Chapter 11 filing did not include its broker-dealer operations and other units, such as asset management firm Neuberger Berman. Those businesses will continue to operate, although Lehman is expected to liquidate them.

“Upon cyclical normalization, we believe surviving competitors will benefit from the demise of both Lehman and Bear Stearns, whose revenue will be reaped by other market participants,” Trone said.

Goldman Sachs stands to be the biggest beneficiary, with an estimated cross-cycle revenue lift of 5.5 percent, while Morgan Stanley should see a benefit of about 4 percent, Trone said.

Universal banks should see boosts of about 1 percent, while middle-market or boutique firms should see lifts of between 3 percent to 4 percent, he added.


Analysts expect the collapse of Lehman, once the fourth-largest investment bank in the United States, to have wide-reaching implications, with holders of Lehman securities and its creditors and lenders likely to suffer losses.

Longer term, the liquidation of Lehman’s $600 billion balance sheet and still large residential-and commercial mortgage-backed securities positions will pressure the credit markets and further delay the recovery of credit market liquidity, Sanford C. Bernstein’s Brad Hintz said.

Lehman’s failure is expected to impact European banks as well.

Analysts at Cazenove expect U.K. banks, particularly Barclays Plc (BARC), Royal Bank of Scotland Group (RBS.L) and HBOS Plc (HBOS.L), to take additional valuation write-downs, but did not specify the size of the writedowns expected.

Cazenove analysts also said there “…remain questions over at least two other major US financial institutions,” but did not name the two.

Lehman is one of the biggest investment banks to collapse since 1990, when Drexel Burnham Lambert filed for bankruptcy protection amid a collapse in the junk bond market.

By Tenzin Pema
(Editing by Jarshad Kakkrakandy)