Lehman Debt Protection Cost Set at Auction

Updated from 9:43 a.m. EDT

Issuers of unregulated derivatives promising a payout in the event of a Lehman Brothers default will pay more than 91 cents on the dollar to settle credit default swaps related to the bankrupt company.

An auction Friday arranged by the International Swaps and Derivatives Association determined the final settlement price on Lehman debt was 8.625 cents on the dollar, meaning that sellers of credit default swaps will have to pony up 91.375 cents on the dollar to those who bought the protection.

Cash settlement of the CDS are to be made on Oct. 21, according to the ISDA. On a conference call, ISDA CEO Robert Pickel said the auction went "smoothly and efficiently." He downplayed concerns about CDS sellers having to come up with the money to settle the trades.

"Because of mark-to-market, preparations and adjustments had been made," Pickel said. "The sellers had already marked them down and provided collateral for their positions."

The next auction is on Oct. 23 for Washington Mutual, which was seized by federal regulators last month and sold to JPMorgan Chase ( JPM).

Lehman is the biggest corporate bankruptcy in U.S. history and with $400 billion of credit default swaps protection.

Because ISDA has run only nine such auctions since 2005 -- it is running five this month alone, including Lehman and WaMu -- and because the CDS market is an unregulated set of agreements between buyers and sellers, how the auction unfolds was of keen interest to observers. Stocks fell after the initial auction results were announced, but some traders said the Lehman auction, if successful, may help reestablish trust to the market.

The list of participants reads like a who's who of finance including investment bank, foreign and domestic banks, hedge funds and mutual funds. Struggling names like AIG ( AIG), Royal Bank of Scotland ( RBS) and Wachovia ( WB), as well as JPMorgan, Goldman Sachs ( GS)and Morgan Stanley ( MS).

CDS are bought as protection for the underlying bonds. Previously, the owner of the CDS had to physically present the corresponding bond to be paid and the seller, or insurer, was responsible for trying to collect as much as possible from the company that defaulted. But with the explosion of the CDS market, there may be more CDS sold than bonds. Protocol set up by the ISDA allows for a cash settlement without delivering bonds.

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