The world's major couterparties on the $US455 trillion derivatives market go into technical default and no one is sure what is going to happen.

The world's major couterparties on the $US455 trillion derivatives market go into technical default and no one is sure what is going to happen.Lehman Bros yesterday formally petitioned the State Bankruptcy Court of the Southern District Court of New York for Chapter 11 protection. Lehman would also have filed what are called "first day motions", which allow the bank to pay salaries and wages, while it continues to market its non-toxic, broker-dealer operations and work out what on earth to do with its highly toxic $US53 billion residential and commercial mortgage portfolio.
But, as scary and Spartan as it might sound, failure is as essential to the workings of an effective marketplace as is success. Which means only that, given this shattered, battle-weary investment bank is unable to find itself a new owner or think its own way through the current calamitous circumstances, then one of the legendary brands of Wall Street should be left to fail. In a weekend of unprecedented drama, the Fed seems to have been forced to play Solomon and choose between Merrill Lynch and Lehman. Both were facing mortal threat. But it seems only one could survive intact. So, the Fed seems to have shifted Bank of America's sights away from the arguably unsalvageable Lehman and onto the bigger and more systemically important Merrill Lynch. It was the right choice. Mind you, there are some more tough ones ahead for the Fed, not least of them being how to respond to the request from US insurer AIG for $US40 billion in emergency assistance.
AIG is reported to have but days to survive. The rating agencies, bless them, have threatened to downgrade AIG's credit if it cannot raise $US40 billion by Monday. The company has been in unsuccessful negotiations with KKR, TPG and J.C. Flowers. But the price, so far, has not been right. But as the risks mount, so will the pressure to surrender. The predators are playing it very tough indeed in their quest for bargains. In the 13 months since the sub-prime crisis froze US credit markets, three of the world's top five independent investment banks have essentially failed, while the US Government has assumed control of mortgage twins Fanny Mae and Freddie Mac.
Of Wall Street's big five independents, only two are now left standing, Goldman Sachs and Morgan Stanley. Both must be wondering whether it is the model that is broken here. Now, if you had said 18 months ago that three US investment banks would fail or be forced into shot-gun marriages to avoid failure, people would have looked at you like you had two heads. Particularly if those people worked in the investment banking sector. But nothing in that sector is certain any more. Of the two remaining independents, Goldman Sachs remains steadfastly aloof from sub-prime's deathly creep because it closed out all its paper positions ahead of the credit crunch. At least that's what it believes. Morgan Stanley, on the other hand, is still a player in the potential lethal shadow markets, but seems currently to sailing in comparatively clear air. And then there is Lehman Bros. It will now likely be dismembered by the Wall Street wolves. The prices will be low and the cost to the banking system and Lehman shareholders quite frightening. According to the senior work-out specialist with one of Australia's so far insulated Four Pillars, the global banking system has now "drifted into unchartered waters". "What we know, well, what we believe we know at least, is that is that Lehman is in the top 10 players in the global credit default swap market. "What we don't know is how many trades that equates to. And that means we do not really have any way of anticipating the short-term impact on that market as it opens in Europe overnight and the US this morning.
"But you can expect massive two-way pricings as counterparties move to close-out trades currently being held with Lehmans. What will flow from that, well, who knows. But certainly you can expect another round of big losses to be brought to book in the next batch of quarterlys in the States." The problem in making predictions here is that a counterparty the size of Lehmans has never failed before. It is that simple. The hope, expressed with typical confidence on Sunday by none other than Alan Greenspan, is that there will be an orderly liquidation and wind-down of Lehman with the usual suspects, the US hedge funds and private equity buyout merchants, picking the eyes out of what still has value. That makes some sense given that the one thing everyone agrees on is that, whatever Lehman was worth on Friday, it is worth a lot less now. But there isn't much else to make a bet on here.
There remain two distinctly divergent schools of thought on the ramifications of the collapse of an organisation as pivotal to the synthetic securities markets as Lehman is. The likes of Warren Buffett would have it that the defaults triggered by Lehman's implosion would resound fearfully through the multi-trillion-dollar derivatives market, generating a global, capital-burning bushfire in global markets.
Then there are those who believe the systemic risk in the $US455 trillion derivatives market has been overcooked. But even those who maintain a less cataclysmic view than Omaha's Oracle accept that a major default event like the collapse of the 158 year old Lehman will result in massive value burn. And there will be hot-spots in unexpected places -- like, for example, a sad selection of deluded Australian councils and public works authorities that disgracefully figured derivatives were a good place to put public monies. The fact that banks around the globe spent the weekend re-assessing their position says everything about the latent potential for systemic unravelling. As does the Fed's decision to busy itself over the weekend with, among it other tasks, the creation of a $US100 billion liquidity dyke to secure against the risk of the sort of counter-party default tsunami Buffett has so often warned of. Up to 10 senior US banks are reported to have pledged to support the emergency fund. What every bank in the world will be doing right now is assessing where Lehman stood as counter-party. The trades you then will be most concerned to identify will be those where they have acquired protection and Lehman is the protection seller.
Where that has happened, there will be tremendous concern because that protection simply no longer exists. "Fear is ruling the market," another senior banker said yesterday. "Nobody knows what is going to happen and nobody is trusting anyone." And what, you might sensibly ask, does all this mean for Australian's banking system? If you believe the markets, it means a fair bit, given $4.6 billion was lopped from the market value of the Big Four in the wake of uncertainty's dramatic return.
But if you believe the banks themselves, it doesn't mean a whole lot, at least not yet. The consensus is that our pillars have, at very worst, non-material exposures to Lehman here or in the US and that their exposures to counterparty risk are similarly immaterial. The bigger issue for our banks, given their umbilical dependence on global capital markets to fund their lending, is how the weekend's ordeal at Lehman, Merrily Lynch and AIG play out in global credit markets over the medium term.