Friday, October 10, 2008

The reason for the distrust: Lehman assets facing write-downs of 91.25 percent

I just wrote a post about distrust in the market. My argument is that rational human interpretation is driving current economic behaviors. Specifically, until it is again rational to trust, the crisis will continue. Why is distrust 'rational'? One reason is data like this:

Banks, hedge funds and other sellers of protection on Lehman Brothers are facing losses in the area of 91.25 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.

The net open interest to sell the debt is $4.92 billion, they said. The auction to settle Lehman's credit default swaps will be one of the largest settlements of contracts in the $55 trillion market, with around $400 billion in contract volumes estimated on Lehman's debt.

Lehman's bankruptcy filing last month sent its bond values plunging as the majority of the investment banking assets that had supported the debt were purchased by Barclays Bank, leaving debt holders at the abandoned holding company with little to reclaim.

Lehman's bonds were trading in the 11 cent on the dollar area on Friday, compared to around 12-to-13 cents on Thursday, according to MarketAxess.

The depth of the bad assets that have been artificially inflated the past few years is staggering. It would be downright stupid -- sorry for the language, but it's true -- for an economic actor, any economic actor, to trust the financial system until substantive re-regulations occur. This is why pumping more and more money into the system, or cutting interest rates, will not alone fix things. This is not a problem of supply: it is a problem of sociological relations gone bad.

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