EUROPE - European pensions funds may already be paying as much as 20bps more to replace the swaps they held before the Lehman Brothers collapse was announced this week, as bid/offer spreads have widened as much as 10 basis points among contract suppliers, on top of the rising inflation curve.

Every pension fund holding inflation swaps - as part of their liability-driven investment strategy -  where Lehman as a counterparty are now attempting to work out this week what their exact exposure might be in relation to the collateral funds set aside and how much it may now cost to put their swaps back in place.

But evidence presented by UK consultancy Redington Partners suggest pension funds across Europe will have been hit by the collapse of the firm and could be paying as much as 5-10bp higher simply to buy a fresh swap because traders are adding additional costs to cover the prospect of not winning the business from other clients.

More specifically, every investor holding swaps contracts with Lehman or as a counterparty is now talking to 4-5 banks who might provide a new swap replacement quote but traders are effectively adding an extra fee on every quoted deal, to cover the cost of the replacement contracts they may not win but have to do substantial amounts of work on anyway.

At the same time, RPI swap curves have risen by around 10 basis points since Monday when the news first broke - the UK RPI curve has risen by 11bp - simply because of demand for new contracts from all asset managers, banks and pension funds.

While UK pension funds had not done substantial swaps work with Lehman prior to its collapse, the Netherlands market had strong interest in their structured notes, according to 
Dawid Konotey-Ahulu, partner at Redington.

"Lehman Brothers were counterparty to everyone, not just the pension funds. When you look at the UK, there has not been a major play on the curve.  The number will be many times higher in the euro swaps market. In the Netherlands, Lehman was a big player in the structured note market. Every swap has to be replaced," said Konotey-Ahulu.

"Part of the reason the dealing costs have gone up is the trader is talking to four banks, so the business could go to other firms. The spread have widened out to compensate where they may need it," he added.

One of the reasons for this rise in costs is there is still no automated system for OTCs, in part because every one is different, and there is no comprehensive database, so firms are having to produce each quote from "huge PDF documents" according to Rob Gardner, also a co-founder and partner at Redington.

To make matter worse,  every pension fund itself will now need to go through every document signed when the swap was created to find out what collateral was supposed to be placed against the contract and how frequently it was paid, to find out what value of the earlier contract had actually delivered, according to Konotey-Ahulu.

As well as perhaps needing to change the delivery of collateral from weekly or monthly to daily from now on, they will also need to work out what the actual collateral was behind the swap and whether it holds sufficient value against the hedging contract.

"You have to work out how much collateral you posted. The posting of collateral was put in place to protect against the event where the counterparty ceases to exist," said Konotey-Ahulu.

"Eligible collateral could be cash (ie no haircut), government bonds - US, UK, France and Germany - right down to corporate bonds rated AA/AA-. Some [pension funds] might have daily basis collateral, others weekly. Going forward, everyone might find it is more sensible to have daily collateral.

"For most people, cash and play on government bonds is the collateral. But some people had been loosening the terms of that collateral,  using corporate bonds, and some of this was in financials.

"So you have to pull out all of your documents to find out what terms you have got on the collateral. The position with one company could be very different to another because of the negotiations made at the time," he continued.

Any pension fund questioning whether they should refrain from setting up new swap contracts could find the RPI swap curve has risen in value again if they delay, suggested Konotey-Ahulu, so delaying may eventually cost more than the current replacement rate.

"It is a difficult call on whether pension funds might be better to wait. The danger and tension is we are in very constrained unprecedented times and it may well be the wait is a very long one. It could be that in the meantime that 40-year inflation rises from to 4.1%, 4.3%, 4.5%. The supply of non-government inflation is severely constrained. No-one is supplying, no-one wrapping," he added.

If you have any comments you would like to add to this or any other story, contact Julie Henderson on + 44 (0)20 7261 4602 or email julie.henderson@ipe.com

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