It took more than 150 years to build the Lehman Brothers franchise from its humble beginnings as an Alabama general store1 and only a few weeks for the firm to collapse.
On September 15, 2008, the Lehman group parent holding company, Lehman Brothers Holdings Inc. (“LBHI”), filed for bankruptcy protection,2 setting into motion the largest corporate failure in US history.3 As recently as May 31, 2008, the firm had reported itself solvent, with consolidated assets of $639 billion against liabilities of $613 billion.4 Even as late as the day before filing, the Lehman estate’s unaudited balance sheets for LBHI and its affiliates indicated that the entire firm had $626 billion of assets against just $560 billion of liabilities, with LBHI itself holding $209 billion of assets and only $189 billion of liabilities.5 Nevertheless, LBHI and its affiliates6 seem to have had little choice but to file for Chapter 11 protection.
Lehman faced a severe liquidity crisis, which regulators and market participants had increasingly feared would befall the firm after the near failure of The Bear Stearns Companies, Inc. (“Bear Stearns”) in March 2008, which itself suffered from a run before being acquired by JPMorgan.7 Lehman’s court-appointed bankruptcy examiner (the “Examiner”) explained the rationale behind this fear, noting that “[f]inancial institutions such as Lehman ha[d] a relatively greater risk of failure due to a lack of liquidity, as compared to a risk of failure due to the value of their liabilities exceeding the fair value of their assets.”8 Lehman management, however, downplayed the firm’s liquidity risk and “told the rating agencies that it was focused on building its ‘liquidity fortress.’”9
In the end, the fortress was breached. Describing the firm’s final days, Lehman’s CFO reported that “cash and collateral were being tied up by [its] clearing banks ... [and] cash had drained very quickly over the last three days of the previous week.”10 The market believed that the current value of the firm’s liabilities exceeded the value of its assets or soon would. While former Lehman CEO Richard Fuld has argued that fears over Lehman’s solvency were unwarranted,11 the Examiner uncovered evidence to suggest otherwise, concluding that at least some of Lehman’s assets might have been unreasonably valued, without regard to fire sale considerations.12
Lehman made significant missteps in the years leading up to its bankruptcy, although the firm was not alone in embracing high leverage and risky strategies. “Excessive leverage was a pervasive problem” among financial institutions, according to former Federal Deposit Insurance Corporation (“FDIC”) Chairman Sheila Bair.13 Indeed, in concluding that “[i]n the years leading up to the crisis, too many financial institutions ... borrowed to the hilt,” the Financial Crisis Inquiry Commission (“FCIC”) emphasized that “as of 2007, the five major investment banks were operating with extraordinarily thin capital,” leading to leverage ratios as high as 40:1.14
Chief among Lehman’s missteps was an overly aggressive growth strategy that, beginning in 2006, led it to commit an increasing amount of capital to commercial real estate, leveraged loans, and illiquid private equity investments.15 This plan proved exceedingly risky given the firm’s high leverage and small equity cushion.16 When the market for certain assets targeted for increased investment began to show signs of weakness in 2007, Lehman management decided to “double-down” so as to take advantage of “substantial opportunities.”17 The Examiner found that even as its competitors were shedding risk, Lehman saw an “opportunity to pick up ground and improve its competitive position.”18 Seizing this opportunity proved costly, nearly doubling the reported value of Lehman’s commercial real estate assets from $28.9 billion at the end of 2006 to $55.2 billion at the end of 2007.19 Not only did the firm’s commercial real estate portfolio account for a large portion of the company’s reported losses,20 but it also fueled concerns among possible suitors over future write-downs.
Lehman explored a number of options to secure at least a partial survival of the firm. By the summer of 2008, management began contemplating a spin-off of the firm’s problematic commercial real estate exposure into an entity labeled SpinCo, relieving Lehman’s balance sheet of worrisome assets and reducing the need for continued markdowns.21 Lehman would need to ensure that SpinCo was a viable standalone entity and infuse it with equity equivalent to at least 20 to 25 percent of the value of the transferred assets.22 By September 2008, Lehman hoped to obtain this equity by selling 51 percent of its investment management division for $2.5 billion, issuing $3 billion of equity directly and raising over $2 billion from a third-party investor.23 Lehman was ultimately unable to carry out this plan quickly enough to avoid bankruptcy. Even absent time constraints, Treasury Secretary Henry Paulson, JPMorgan CEO Jamie Dimon, and Berkshire Hathaway CEO Warren Buffett, among others, were highly skeptical of the spin-off.24 In its final months, Lehman also borrowed from the Fed in order to access needed liquidity. The firm had as much as $18 billion outstanding under the Fed’s single-tranche open market operations in June 2008, as well as a $45 billion loan from the Primary Dealer Credit Facility near the time of its bankruptcy.25
Lehman also explored the possibility of entering into a strategic partnership or, as its situation grew more dire, selling itself to a competitor. Lehman contacted, among others, (1) Warren Buffett, who demanded better terms than Lehman was willing to offer in March 2008 and dismissed Lehman’s SpinCo proposal around September 2008;26 (2) Korea Development Bank, which had expressed interest in a $6 billion investment in “Clean Lehman” (i.e., Lehman without SpinCo) as late as August 31, 2008, but failed to reach an agreement with Lehman owing to significant valuation differences and rapidly deteriorating market conditions;27 and (3) MetLife, which passed on an investment on August 20, 2008, because it already had substantial commercial real estate exposure.28
Lehman’s most promising potential buyers were Bank of America Corporation (“Bank of America”) and Barclays PLC (“Barclays”). Lehman held two rounds of discussions with Bank of America, first proposing a merger between the two firms’ investment banks that would have given control over the combined entity to Lehman.29 Then, in early September 2008, fearing “that Lehman could become a serious problem,” Secretary Paulson began pressuring Bank of America to buy Lehman.30 Bank of America ultimately refused, as CEO Ken Lewis believed that the deal would yield little strategic benefit. Bank of America’s due diligence team concluded that Lehman’s commercial real estate positions were overvalued. It “had uncovered approximately $65–67 billion worth of Lehman assets that ... it did not want at any price,” and was unwilling to pursue a deal without government assistance, which was not forthcoming.31
Barclays expressed greater interest and, indeed, ultimately purchased Lehman’s US and Canadian investment banking and capital markets businesses in bankruptcy.32 Barclays was unable to consummate a deal prior to the bankruptcy filing because its UK regulator, the Financial Services Authority (“FSA”), refused to waive the requirement that a guaranty by Barclays of Lehman’s obligations prior to the closing of the transaction (as demanded by the Federal Reserve Bank of New York, “FRBNY”) garner the prior approval of Barclays shareholders.33 Had the requirement been waived, Barclays would have purchased Lehman’s operating subsidiaries for approximately $3 billion and would have guaranteed Lehman’s debt.34 Notably, however, Barclays would not have assumed any of the commercial real estate assets that Lehman planned to transfer to SpinCo.35 Thus, even had the envisioned transaction been consummated, the remaining Lehman entities would have retained the highly problematic commercial real estate exposure, although they might have succeeded in avoiding a bankruptcy filing. The Fed had great difficulty determining whether or not Lehman was solvent over “Lehman weekend,” due to these commercial real estate assets that Lehman valued at $50 billion but a valuation that others disputed.36 Reportedly, certain staff members at the FRBNY had determined that Lehman was solvent, while other senior government officials had reached the opposite conclusion. The fact that these assets could not be valued, contributed to the Fed’s unwillingness to lend to Lehman.37
As a result LBHI was left with no choice but to file for bankruptcy. Because LBHI was so critical to Lehman’s operations and functioned as “the central banker for the Lehman entities,”38 its filing caused key subsidiaries to seek similar protection. Although apparently solvent, such subsidiaries lacked the liquidity to function without LBHI’s support. On the same day as LBHI filed under Chapter 11, its European broker-dealer subsidiary, Lehman Brothers International (Europe) (“LBIE”), was placed into administration.39 While LBIE’s balance sheet then implied that it had nearly $17 billion in equity ($49.5 billion in net assets against only $32.6 billion in net liabilities), it was forced to seek administrative protection because “LBHI managed substantially all of the material cash resources of the Lehman Group centrally,” and “LBIE was informed by LBHI that it would no longer be in a position to make payments to or for LBIE.”40 Four days later, LBHI’s US broker-dealer, Lehman Brothers Inc. (“LBI”), was placed into liquidation proceedings under the Securities Investor Protection Act of 1970 (“SIPA”).41 Despite reporting more than $3 billion in excess capital at the end of August 2008 and generally being in compliance with regulatory requirements, LBI was forced to wind down because “it was a foregone conclusion that [it could] not survive as an independent entity.”42 By the beginning of October, fifteen LBHI subsidiaries filed for Chapter 11 in the United States, and in the end, more than twenty would do so.43
Lehman’s Chapter 11 filings provoked heated dispute,44 particularly over the contentious issue of whether and to what degree LBHI’s affiliated US debtors would be “substantively consolidated” with LBHI. An equitable remedy that recognizes debtors as one combined entity, “substantive consolidation” “pools all assets and liabilities of ... subsidiaries into their parent and treats all claims against the subsidiaries as transferred to the parent.”45 The remedy also “eliminates the intercorporate liabilities of the consolidated entities,”46 an important aspect of the Lehman case due to the vast array of intercompany and guarantee claims filed.47 The estate’s initial plan in April 201048 rejected substantive consolidation and instead “recognize[d] the corporate integrity of each Debtor,”49 splitting creditors into two opposed groups, those that favored substantive consolidation (the Ad Hoc Group) and those that opposed it (the Non-Consolidation Group), each of which produced its own favored counterplan.50 After protracted wrangling by the parties over successive plans,51 a so-called Modified Third Amended Plan52 was finally confirmed on December 6, 2011, following a creditor vote53 and became effective on March 6, 2012, enabling Lehman to emerge from bankruptcy.54 Distributions commenced on April 17, 2012, with a disbursement of approximately $22.5 billion to creditors.55
The Modified Third Amended Plan supports the core conclusion of this book: direct exposure to Lehman entities filing for bankruptcy in the United States did not destabilize significant Lehman counterparties, either in the immediate aftermath of the Lehman shock or subsequently. The estimated magnitude of unsecured third-party exposure to LBHI and its US debtor affiliates was between about $150 billion and $250 billion.56 To be sure, such figures are large. Nevertheless, in light of the fact that such exposures were distributed across a large number of individuals and institutions—only a small fraction of which were of systemic importance—such sums would likely have been manageable in the aftermath of the LBHI filing, even assuming that these parties were to recover nothing of their exposures.
Moreover some creditors believed that they would recover—and in fact did recover—a considerable portion of certain claims well before a plan was even proposed. By September 2009, claims against Lehman Brothers Special Financing Inc. (“LBSF”), guaranteed by LBHI, were trading at roughly forty cents on the dollar, a price around which Morgan Stanley sold a $1.3 billion claim that month.57 Further, even if unlikely to receive forty cents on the dollar, most other creditors still had good reason to expect nonzero recoveries, given that the estate had substantial assets. The extent of these assets is underscored by the Initial Plan, which indicated that as of the end of 2009, on an undiscounted basis, LBHI and its US affiliates would yield approximately $66 billion to creditors after an orderly liquidation.58 With the estate then projecting about $370 billion in allowable claims,59 such a liquidation would have yielded an average recovery of nearly 18 percent. As of March 2014, allowed claims were reduced to $303.6 billion60 and Lehman’s unsecured creditors had received a total of $86.0 billion, representing a realized recovery of more than 28 percent.61 As of September 2015, distributions totaled $144 billion, amounting to a 35 percent recovery for unsecured general creditors. 62 Given the expectation of substantial recoveries, which were borne out in fact, the exposure of counterparties is further diminished in importance. These findings tend to undermine the “too interconnected to fail” hypothesis.63
Other researchers have been unable to find a significant correlation between Lehman’s bankruptcy and the failure of other interconnected financial institutions, rejecting the idea that Lehman’s downfall led to a cascade of bankruptcies through asset interconnections.64 Some scholars have argued that connectedness did play an important role during Lehman’s bankruptcy.65 However, the importance of Lehman’s connectedness was limited to the internal connectedness among Lehman entities (i.e., Lehman subsidiaries were connected to each other). While the connectedness of Lehman entities potentially played an important role in Lehman’s demise, this is entirely separate from the issue of Lehman’s connectedness to other firms, which is really the connectedness that would matter for systemic risk.
Another way to examine the impact of the Lehman failure is to look at how particular kinds of counterparties, clients or investors, as opposed to creditors as a whole, were affected by the Lehman collapse. This section examines the impact of the Lehman bankruptcy on (1) third parties directly exposed to LBHI and its US affiliates, (2) derivatives counterparties, (3) prime brokerage clients, (4) structured securities investors, and (5) money market funds. The conclusion of each of these separate examinations is that the Lehman failure, while costly, did not prove catastrophic to any of these parties as a result of “asset connectedness.”
The Lehman bankruptcy implicated a vast number of affiliated and third-party creditors with a dizzying array of connections to the failed firm. The Modified Third Amended Plan dictates how Lehman’s assets are to be distributed and thus provides a reasonable baseline for expected losses. Table 4.1 illustrates the Modified Third Amended Plan’s projected recoveries and losses for key creditor groups, totaling $135 billion, a modest number especially considering that it was not concentrated in any systemic firm.
Projected recoveries of key creditors under modified third amended plan (USD in billions)
Note: See Disclosure Statement for Third Amended Plan, supra note 190, Exhibit 4. In this table and the text and tables that follow, all claims and recovery data for the Modi- fied Third Amended Plan are based on information from the disclosure statement for the Third Amended Plan.
The projections in the table are, however, of limited value, as potential recoveries may diverge due to the uncertainty of the realizable values of Lehman’s assets.66 To say claims proved to be modest is less important than gauging how great such claims were estimated to be at the time of the Lehman bankruptcy. This subsection therefore focuses on the magnitude and nature of third-party exposures to LBHI and its Chapter 11 affiliates and, to some degree, the recoveries that third parties expected or had reason to expect from the estate, concluding that the potential exposure of $150–250 billion was not destabilizing and that creditors could have reasonably expected to recover on a nonnegligible portion of their claims.
The claims data from the Initial and Modified Third Amended Plans provide a clear picture of the magnitude and sources of potential third-party exposure to Lehman. As table 4.2 indicates, $1.162 trillion in claims were initially filed against LBHI and its affiliated US debtors,67 but, for several reasons, this number is at least around four times higher than the most relevant real exposure figure.
Claims filed against LBHI and affiliated Chapter 11 debtors (USD in billions)
Note: Numbers may not add up due to rounding or, in the case of the Third Amended Plan, the exclusion of (a negligible amount of) priority and secured claims. See Alvarez & Marsal, Lehman Brothers Holdings Inc.: The State of the Estate 23 (Sep. 22, 2010) (for the first three columns); Disclosure Statement for Third Amended Plan, supra note 190, Annex A-2, A-3 (for the final two columns).
a. Claims data have been made available only for the Third Amended Plan, but the Modified Third Amended Plan is presumably based on the same claims data as the Third Amended Plan. Thus, in the claims context, all references in this report to the Modified Third Amended Plan are based on information from the disclosure statement for the Third Amended Plan.
First, only about 50 percent of the initially filed claims—around $570 billion—were actually brought by actual third parties as opposed to Lehman affiliates.68 The claims of Lehman entities in Chapter 11 against other Lehman entities (the bulk of which were also in Chapter 11)69 have no direct impact on the overall recovery of third parties and are thus of limited value in assessing the fallout from LBHI’s filing. However, claims of Lehman entities not involved in the Chapter 11 proceedings, such as those filed by foreign affiliates, are relevant.
Second, third-party claims tend to overstate exposures. Many third-party claims were filed twice—once as a primary claim against an LBHI affiliate and once as a so-called third-party guarantee claim against LBHI pursuant to its guarantee. Underscoring the extent of such double filing, approximately $144 billion in primary third-party claims were initially filed against an LBHI affiliate,70 and $255 billion in third-party guarantee claims were filed against LBHI.71 Regardless of the propriety of permitting third-party guarantee claims—an issue that was at the core of the substantive consolidation debate—it is clear that when the same underlying obligation supports multiple claims, total claims overstate total underlying obligations.
Third, invalidly filed claims further contribute to the general overstatement of third-party exposure. In the First Amended Plan filed in January 2011 (“the First Amended Plan”)72, the estate reduced the $775 billion in total then-filed claims to a $367 billion “estimate of claim amounts” on grounds that many filed claims were inappropriate because they were duplicative, overstated, or unrelated to any liability of a Lehman debtor in Chapter 11.73 Obviously some creditors filed inflated claims to maximize their recovery even though they knew such claims exceeded their actual losses.
Focusing solely on the subset of third-party claims deemed valid by the estate,74 only $242 billion in unsecured third-party exposure remains.75 Moreover, as third-party guarantee claims constitute $95 billion of this amount76 and as most of these claims were also filed as primary claims, the amount of unique third-party claims—and thus the true level of third-party exposure is closer to $150 billion. This relatively low amount of third-party exposure may be attributed to Lehman’s capital structure, especially its use of secured financing arrangements. As of August 31, 2008, Lehman had approximately $157 billion of repo obligations and $35 billion of securities lending obligations, which together eclipsed the firm’s approximately $136 billion of long-term unsecured debt and $4 billion of commercial paper.77 Creditors in these transactions had collateral and were thus not significantly exposed to Lehman’s failure. Had Lehman financed a greater share of its borrowings with unsecured debt, third-party claims would have been larger. Thus Lehman’s capital structure arguably mitigated systemic risk. That said, the probability of failure in the first place might have been lower had Lehman been less reliant on short-term secured financing and instead relied more on long-term unsecured funding.
Long-term, unsecured financing, principally in bonds, is nevertheless the largest source of third-party creditor exposure. The Modified Third Amended Plan estimates that approximately $84 billion in claims were validly filed on account of senior unsecured debt securities issued by LBHI.78 Not only is this exposure small relative to the firm’s repo exposure, but it was also likely spread across a wide variety of parties at the time of LBHI’s filing. Standard & Poor’s estimates that, as of the filing date, “a broad range of institutions, not just large capital markets players, ... [held] ... this paper.”79
Relative to bonds, exposure to loans and other debt not classified as securities (accounting for about $20 billion of initially filed claims80) appears to have been more concentrated before the filing, with a large amount of such debt seeming to have originated from loans made by major Japanese banks.81 Japanese banks and insurers announced a combined $2.4 billion in potential losses from their holdings during the week following LBHI’s filing.82 The Bank of Japan, however, did not view this sum as sufficiently large to threaten the stability of the Japanese financial system.83
Aside from senior unsecured debt securities, OTC derivatives accounted for the largest source of third-party exposure. In fact derivatives claims were filed in greater amounts than unsecured debt claims, although they have also been reduced to a much greater degree. According to the Initial Plan, about $150 billion in derivatives claims were filed, half as primary claims against an LBHI affiliate and half as guarantee claims against LBHI.84 Apart from the fact that these claims are duplicative, both the Initial Plan and, to a greater degree, the Amended Plans indicate that the filings significantly overstate exposure, because many might have been exaggerated or invalid. The estate significantly reduced estimated primary and guarantee derivatives claims, cutting the former to $30 billion in the Modified Third Amended Plan.85 More on the significance of derivatives claims below.
Another important class of claims involves instruments with embedded derivatives, including structured securities issued in connection with Lehman’s European Medium Term Note (“EMTN”) Program.86 According to the estate’s estimates, about $30 billion of these securities were issued by Lehman Brothers Treasury Co. N.V. (“LBT”), a Dutch affiliate, and about $5.5 billion were issued directly by LBHI.87 A large number of third parties filed claims relating to these products in Lehman’s US proceedings, either because the instruments were issued by LBHI directly or because they were guaranteed by LBHI.88 Such claims suggest a substantial level of exposure, but the instruments did not in fact pose systemic risk because of their broad retail investor base and small denominations.
Two other types of third-party claims bear mention, although the estate greatly reduced the estimated amounts of both. First, more than $73 billion in claims were filed in connection with Lehman’s obligations either to repurchase residential mortgage loans or to indemnify loan purchasers against losses arising from breaches of loan purchase and sale agreements.89 The estate asserted, however, that these repurchase and indemnity claims were significantly duplicative, overstated, and unsubstantiated.90 The Modified Third Amended Plan accordingly estimates that exposure from these claims amounted to only about $10.4 billion.91 Second, approximately $22 billion in claims were filed against LBHI and its affiliated Chapter 11 debtors in connection with prime brokerage agreements, typically involving LBI or LBIE.92 The Modified Third Amended Plan does not deem any of these claims to be valid.93 Unlike mortgage-related claims, however, the estate’s main contention is not that parties do not stand to suffer the alleged losses but rather that their claims are not actionable against LBHI and its affiliated Chapter 11 debtors, because these entities were not part of the agreements at issue.94
In sum, third-party exposure to LBHI and its US debtor affiliates could not and did not have a systemically significant destabilizing effect. This conclusion does not depend on estimates of the value of the Lehman estate. Even if parties had reason to assume that the estate entirely lacked assets to provide for recoveries, asset connectedness would still not have been a significant problem in the immediate aftermath of LBHI’s filing.
Another way to assess the exposure of creditors is based on the expectation of creditor recoveries as reflected in the Lehman bond prices. Figure 4.1 illustrates that even at their lowest point, prices of LBHI bonds and, by extension, LBHI senior unsecured claims were always well above zero in the aftermath of LBHI’s filing.
Parties holding claims guaranteed by LBHI had even more reason for optimism. In the months leading up to the September 2009 claims deadline, expected recoveries on LBSF claims backed by LBHI guarantees rose from approximately twenty cents to forty cents, as market participants believed that they would be able to seek recovery from both entities.95 The effect of this early optimism was particularly significant, because sellers of LBSF claims during this period were primarily large broker-dealers, while buyers were hedge funds specializing in distressed debt.96 The buoyant market thus allowed for systemically risky institutions (large broker dealers) to off-load Lehman exposure at meaningful recovery levels and—with transfers of Lehman claims totaling approximately $4.4 billion in 2009, $28.7 billion in 2010, and $32.4 billion in 201197—in substantial amounts. Liquidation would generate about $59 billion and an orderly liquidation would produce about $76 billion in distributable value.98
At the time of LBHI’s filing, Lehman’s derivatives contracts fueled significant concerns that positions to which Lehman was a counterparty or on credit default swaps (“CDS”) for which Lehman was a reference entity—ones that would pay off if Lehman failed—could lead to substantial losses by major financial institutions.99 First, because Lehman had a large exchange-traded derivatives portfolio—futures and options—its failure could have conceivably imperiled the clearinghouses and clearing firms with which it dealt. Second, because Lehman was a reference entity on a large number of CDS contracts, its default could have triggered a massive payout, potentially bankrupting the sellers of Lehman CDSs. Third, because Lehman was party to a large number of OTC derivatives, its failure to honor its contracts could have left counterparties as unsecured creditors and thereby caused already weak financial institutions to take crippling write-downs. This section demonstrates that none of these issues materialized to the extent that had been feared, if at all.
Exchange-Traded Derivatives Portfolio Lehman’s exchange-traded derivatives portfolio was far smaller than its OTC holdings but was far from insignificant: as a clearing member of each of the four Chicago Mercantile Exchange (“CME”) designated contract markets, LBI accounted for over 4 percent of the aggregate margin requirements of all CME clearing members and maintained roughly $2 billion in collateral and clearing deposits connected to proprietary positions that it held on behalf of itself and other LBHI affiliates.100
The firm’s exchange positions, transferred within three days of LBHI’s filing, not only were resolved much more quickly than its OTC derivative holdings but also imposed no losses on counterparties. Owing to the size of Lehman’s exchange positions, which the CME feared would be difficult for the market to digest in an open market sale,101 the CME selected six firms from which to solicit bids on LBI’s proprietary positions and delivered information to these institutions about LBI’s positions on September 14, 2008.102 Based on this private auction process—the first ever such forced transfer of a clearing member’s positions103—all of LBI’s proprietary derivatives were transferred as of the end of business on September 17. Barclays assumed LBI’s energy derivatives portfolio;104 Goldman Sachs assumed its equity derivatives portfolio;105 and DRW Trading assumed its foreign exchange, interest rate, and agricultural derivatives portfolios.106 These institutions did not take on this risk gratis, and indeed the Examiner found that LBI could have a colorable claim against these firms and the CME for losses owing to the “steep discount” at which the positions were purchased.107 Nevertheless, the possible existence of such a claim does not affect the finding that Lehman’s exchange-traded portfolio did not impose losses on the firm’s exchange counterparties or the CME and thus did not result in a connectedness problem. This was a testimony to how the counterparties and CME managed risk by requiring adequate collateral in the form of margin.
CDS Portfolios Referenced to Lehman The fear surrounding CDSs referencing Lehman was that other parties—with no connection to Lehman whatsoever—would not be able to make good on their obligations. This fear arose because Lehman was a popular reference entity on CDSs, and the aggregate CDS payout on its default was expected to be quite large given the low anticipated recovery on its debt payouts were based on the value of the CDS minus the value of Lehman bonds.108 Typifying the extent to which CDS notional value in many instances surpassed the notional value of the underlying debt, as much as $400 billion in CDS contracts109 had been written on only about $72 billion of deliverable Lehman bonds.110 The payout on the CDS contracts was determined through a bond auction and the auction settled at $0.08625 (implying a payout of $0.91375).111 With as much as $400 billion in outstanding CDS notional value, the Lehman CDS settlement auction could have therefore produced an aggregate payout—and thus, direct losses for CDS sellers—of over $360 billion, by far the most in the history of the CDS market.112
The fallout from such a payout would have been considerable and, indeed, far more significant than the losses suffered by creditors to LBHI and its affiliated debtors. As discussed above, third-party creditor exposure to LBHI and its affiliated debtors was on the order of only $150 billion to $250 billion, spread across a variety of parties. By contrast, it was thought that the $360 billion in CDS losses would be borne by a concentrated group of systemically important financial institutions (“SIFIs”) assumed to be net sellers of Lehman CDS. Thus, as the Lehman CDS auction approached, these large institutions suffered double-digit percentage declines in their stock prices. On October 9, 2008, the shares of Morgan Stanley, Barclays, Goldman Sachs, and JPMorgan dropped 44, 18, 16, and 12 percent, respectively.113
Although the auction was ominously expected to be a “day of reckoning,”114 the reckoning proved to be quite small, notwithstanding the lower than expected auction settlement price. For the $72 billion of Lehman CDS registered in the Depository Trust & Clearing Corporation (“DTCC”) warehouse, a total of only about $5.2 billion was actually required to be paid after the Lehman auction.115 There is no evidence that the settlement of CDSs not registered through the DTCC proved any more problematic.116 The low percentage of funds transferred relative to outstanding CDS notional value in Lehman proved to be the rule, not the exception, for other institutions. For example, the Bank of France estimates that the percentage of net funds exchanged relative to total CDS notional value was only 3.4 percent following the Washington Mutual failure and 6.5 percent following the collapse of the major Icelandic banks Landsbanki, Glitnir, and Kaupthing.117 In the case of payments on CDS contracts related to Greece, $2.89 billion in net funds were exchanged.118 With $80.1 billion of total CDS value notional outstanding,119 this amounted to a payout of 3.61 percent.
The generally low ratio of required payments to outstanding notional value can be attributed to the prevalence of offsetting positions,120 which caused the net exposure for institutions on outstanding CDS holdings—and OTC derivatives more generally—to be far lower than notional CDS exposure. Further, while by June 2008 the OTC market had reached a peak of nearly $684 trillion in notional amount of derivatives outstanding,121 parties would not have suffered anything close to $684 trillion in losses if all contracts were breached, quite apart from netting. The notional of a derivatives contract is merely the face amount of the contract, a sum that provides the basis for the calculation of each party’s payments to the other. A more appropriate measure of exposure is the fair market value of a contract, which represents the worth of a derivative at midmarket and is far smaller than aggregate notional. For example, the Bank for International Settlements (“BIS”) estimates that in December 2007, at the dawn of the credit crisis, the “gross market value”122 of all outstanding OTC derivatives was $15.8 trillion.123 However, gross market value is an overestimate of risk in the derivatives market, as it does not incorporate the risk-reducing effects of netting. BIS also estimates “gross credit exposure,” which does incorporate netting effects. The gross credit exposure of the global OTC derivatives market was around $3.3 trillion in December 2007.124 Even this figure may overstate the risks from derivatives, as it does not incorporate the risk-reducing effects of collateral. The International Swaps and Derivatives Association has estimated that, after adjusting for collateral, gross credit exposure of the global OTC derivatives market was $1.1 trillion in December 2007.125
The prevalence of such offsetting positions explains why the net payment demanded after the Lehman auction was relatively small and, ultimately, why the auction did not have destabilizing effects. Also contributing to the auction’s muted impact, albeit to a lesser extent, was its price efficiency. In general, implied recoveries from auction settlement prices tend to track market expectations as expressed by bond prices preceding the auction.126 To be sure, the link between the settlement price and pre-auction bond prices was smaller for Lehman than it has been for other defaulting entities, because, as noted above, the Lehman auction settled several cents below pre-auction expectations.127 Nevertheless, relative to the fall in bond prices that had already occurred before and after LBHI’s filing, the further decline induced by the auction was small.
As illustrated by figure 4.2, almost the entire decline in Lehman bond prices occurred before the October 10 auction. Between early September and October 9, bond prices declined from around $1.00 to about $0.13. Against this approximately $0.87 fall, the $0.04 to $0.05 decline following the auction appears de minimis. This fact is relevant because CDS prices reflect recoveries implied by reference bonds, and CDS sellers are generally required to post collateral if their positions decline in value. Accordingly, with the bulk of the bond price decline having occurred before October 10, most of the losses that parties suffered from Lehman CDSs were likely already taken into account and collateralized prior to the auction.128 In other words, the “reckoning”—which did not prove to be large in any case—had for the most part already happened.
Lehman OTC Derivative Portfolio Lehman’s own positions in CDSs and other OTC derivatives might have been the most significant cause of concern among market participants and regulators.129 Indeed, given the size of Lehman’s derivatives business, many feared that LBHI’s filing would produce an “immediate tsunami.”130 As of August 31, 2008, the derivatives assets and liabilities of LBHI-controlled entities were valued at $46.3 billion and $24.2 billion, respectively.131 Based on BIS estimates, this combined gross market value of approximately $70.5 billion (assets plus liabilities) likely accounted for about 0.3 percent of the gross market value of all outstanding derivatives.132 Lehman was estimated to have a portfolio of between $3.65 trillion and $5 trillion in total notional value of CDSs alone,133 accounting for as much as 8 percent of the overall notional CDS market.134 Moreover, across products, Lehman had a derivatives portfolio at the time of its bankruptcy filing consisting of over one million trades,135 or perhaps around 2 percent of all outstanding OTC positions.136
Simply stated, the market feared that if Lehman were to fail, its OTC derivatives counterparties could themselves be vulnerable to failure, as they would not be able to fully recover or recover at all on Lehman contracts for which they were owed money (i.e., “in-the-money” contracts).137 This fear proved to be vastly overstated. As noted above, misplaced emphasis on notional value rather than actual market value tended to exaggerate the true risks of these derivatives, and netting further reduced the market’s exposure. Moreover the safe harbors for derivatives under Title 11 of the United States Code (the “Bankruptcy Code”)138 served to mitigate the fallout from a default. Specifically, derivatives counterparties to a bankrupt institution can seize collateral posted prior to the default (which would normally violate the automatic stay),139, including collateral posted on the eve of the institution’s bankruptcy filing (which would normally violate preference rules).140 These special rules—criticized by some—place derivatives counterparties on firmer ground than many other creditors, both before and during bankruptcy.141
Nonetheless, the high concentration of the OTC derivatives market raised fears that the default of a major counterparty could prove catastrophic. Before the crisis a small number of institutions accounted for the vast majority of dealer holdings and activity, and this concentration has only intensified since. The Office of the Comptroller of the Currency (“OCC”), for example, reports that in the first quarter of 2012, just five holding companies accounted for almost 96 percent of the OTC derivatives notional value of the top twenty-five holding companies in the United States.142 Notwithstanding this heavy concentration, the concern that the collapse of Lehman would bring down the entire financial system was nevertheless exaggerated. The risk of Lehman’s collapse was significantly mitigated by (1) the positive positioning of Lehman’s derivatives portfolio, with assets exceeding liabilities—Lehman was in the money (their counterparties owed them money)— and (2) the frequency with which Lehman’s derivatives contracts were collateralized, could be netted, and were centrally cleared (interest rate contracts). Central clearing mutualized the losses on Lehman contracts to all members of the clearinghouse, rather than imposing it just on Lehman counterparties. The value of central clearing in risk reduction played a significant role in the requirements for central clearing imposed by the Dodd–Frank Act. By contrast, AIG had a negatively positioned and noncentrally cleared portfolio of CDS, thereby potentially exposing counterparties to greater losses. The remainder of this subsection discusses the Lehman and AIG OTC derivatives portfolios in turn.
Lehman: “Big Bank” Derivatives Claims and Recoveries On Sunday, September 14, 2008, major market participants moved to net down their Lehman exposure through a special trading session.143 This effort proved largely ineffective, as some entities could not fully determine the extent of their Lehman exposure and others sought to resolve only contracts for which Lehman owed them money.144 Nevertheless, despite the failure of this session, Lehman’s collapse did not produce a cascade of losses. As burdensome as the effects of Lehman’s default might have been on certain derivatives counterparties, they fell well short of the market’s worst fears and resulted in no counterparty insolvencies of systemically important institutions.
A starting point for considering the losses on OTC derivatives is the $75 billion in third-party OTC derivatives claims filed against the Lehman estate,145 with a group of about thirty major financial institutions that the Lehman estate labels “Big Banks”146 accounting for approximately 50 percent.147 Practically all of these claims were governed by standard form agreements designed by the International Swaps and Derivatives Association (“ISDA”),148 in particular, the 1992 and 2002 ISDA Master Agreements. These agreements each classify bankruptcy as an event of default,149 upon the occurrence of which the nondefaulting party has the right to terminate all transactions under the agreement.150 Accordingly, the vast majority of Lehman trades had been terminated by January 2009,151 with the gross derivatives assets and liabilities of LBHI-controlled entities falling to about $26 billion by June 2009.152
Counterparties who terminated their derivatives contracts or otherwise had grounds for a derivatives claim against the estate were required to file a special Derivative Questionnaire by October 22, 2009.153 The questionnaire instructed claimants to provide a valuation statement for any collateral,154 specify any unpaid amounts,155 and, most significant, supply their derivatives valuation methodology and supporting quotations.156 To the extent that a nondefaulting party is owed more than the defaulting party has posted in collateral, it becomes an unsecured creditor to the estate. Under this framework, the Master Agreements enable a nondefaulting party to assert a claim for an amount that, if fully recovered, would place it in the same position absent the default.
The Master Agreements permit parties a choice between three different valuation methodologies,157 each of which shares two important features. First, the valuation methods premise claims primarily on replacement costs—that is, the value that the nondefaulting party would need to pay or receive to enter into an economically equivalent position, in effect to be made whole. Notably, this amount is likely to depart from fair market value, as parties generally must pay an amount above fair market value when they buy (paying the offer price to dealers) and receive an amount below fair market value when they sell (receiving the bid price from dealers). In markets where the bid-offer spread is high, as is typical following a major counterparty default, there can therefore be a considerable difference between what a nondefaulting party would have to pay or receive to reestablish a position and what the market value of the position is worth. Thus, it is not surprising that the Lehman estate has cited “abnormally wide bid-offer spreads and extreme liquidity adjustments resulting from irregular market conditions” as core challenges in the claims and recovery process.158 Second, calculating replacement costs under each of the methodologies is as much an art as a science. To assert a claim based on replacement costs, the nondefaulting party need not actually enter into a replacement position. Indeed, in the Lehman case, few contracts seem to have been substituted in a manner replicating the exact terms of the trades,159 and it is unclear to what extent their economic substance was actually replaced. As a result replacement costs need not—and in the Lehman case, likely did not—track actual costs.160
The inexact nature of the derivatives claims and valuation process fueled considerable contention between Lehman and the Big Banks. Believing that the Big Banks exaggerated the extent of the damage suffered, the Lehman estate reduced estimated allowable Big Bank derivatives claims by over $11.7 billion in the Third Amended Plan, to $10.3 billion from claims of $22 billion. In May 2011 the Lehman estate proposed a settlement framework to thirteen of the largest Big Banks “with the intent of creating a standardized, uniform and transparent methodology to fix unresolved Derivative Claims ... of the Big Bank Counterparties.”161 This framework called for derivatives contracts facing Lehman to be valued at mid-market (the midpoint between the bid and offer) as of a specific valuation date (between September 15 and September 19, 2008), plus an “additional charge” based on product-specific grids adjusted for the maturity and risk of the contracts.162 However, if the Big Banks can prove that they actually entered into economically identical and commercially reasonable replacement trades on the date of LBHI’s filing, they could substitute the value of these trades for the settlement framework’s methodology.163
The Lehman estate has contended that derivatives claims against it have been exaggerated. However, even at the outside figure of $75 billion, such claims are far smaller than had originally been feared for three reasons. At the end of Q3 2008, five dealer banks—JPMorgan, Bank of America, Citi, Wachovia, and HSBC—represented more than 95 percent of bank-held derivatives in the United States.164 At the end of Q4 2008 JPMorgan had $184.7 billion in capital,165 Bank of America had $171.7 billion in capital,166 Citi had $156.4 billion in capital,167 and HSBC had $35.1 billion in capital.168 Excluding Wachovia, which was placed into receivership in September 2008, these four banks had total capital of roughly $550 billion, or seven times the $75 billion figure.
As it entered bankruptcy, Lehman was owed more by its derivatives counterparties than vice versa, namely Lehman’s derivatives portfolio was overall “in the money.” As of August 31, 2008, the firm’s stated derivatives assets exceeded its liabilities by $22.2 billion.169 Moreover, consistent with its pre-bankruptcy status, the Lehman’s derivatives book has been a positive source of cash during bankruptcy. Although the estate has encountered difficulty monetizing certain transactions,170 it had already collected $15 billion in cash through July 2013.171 By April 2014, Lehman had roughly $1 billion in derivatives assets remaining.172 In short, Lehman made money from its derivatives trades. The losses borne by any derivatives counterparty from Lehman’s default were in effect reduced by the extent of the party’s derivatives liabilities. If Lehman’s derivatives liabilities had exceeded its assets such that Lehman on net owed its counterparties money, one might expect derivatives claims to have been considerably larger.
Despite the fact that Lehman’s overall position was in the money, some counterparties did have an in-the-money portfolio against Lehman. Even so, most large financial institutions would not have incurred sizable losses from Lehman derivatives exposure, because their exposure to Lehman was collateralized by collateral provided by Lehman. The vast majority of these parties had entered into Credit Support Annexes (“CSAs”) with Lehman, requiring the out-of-the-money party to post collateral based on mark-to-market liability.173 Indeed, among Lehman’s top twenty-five counterparties by number of derivatives transactions, all but one were subject to a CSA.174 Although these agreements may not have insulated parties from “gap risk”—that is, the risk that mark-to-market value dramatically changes between collateral postings—the evidence suggests that they greatly mitigated the effects of a default. For example, JPMorgan, one of Lehman’s largest derivatives counterparties,175 has sought a comparatively small amount of damages for derivatives exposure, mainly because the bank applied nearly $1.6 billion in cash collateral posted by LBHI against the roughly $2.2 billion owed to its main derivatives affiliate.176 To be sure, JPMorgan’s experience may not be representative, as the bank also served as Lehman’s principal clearing agent.
Most significant, JPMorgan provided Lehman with tri-party repo clearing services, functioning as an intermediary between Lehman and the institutions supplying the repo funding that it used to finance its daily operations.177 In this role JPMorgan held collateral that Lehman posted to obtain repo financing and provided Lehman with intraday cash advances to be repaid with funds that Lehman received from tri-party investors.178 Lehman thus might have faced greater pressures to submit collateral to JPMorgan than to other derivatives counterparties. These pressures might have been particularly strong in Lehman’s final weeks as JPMorgan obtained added protection by executing amended clearing, security, and guaranty agreements with Lehman in both August and, more controversially, September 2008.179
It is important to emphasize that JPMorgan and other large Lehman counterparties had put in place protections well before the filing. The prevalence of such protections, in the form of CSAs, suggests that even if Lehman’s portfolio had not been as strongly in the money as it ultimately proved to be, the fallout from its failure would still have been manageable for its counterparties. In other words, large derivatives counterparties did not escape calamity from Lehman’s collapse merely because Lehman fortuitously held a net in-the-money derivatives portfolio. They escaped because of standard collateral arrangements, which, by 2007, covered 59 percent of all derivatives transactions and an even higher percentage of such transactions among large, systemically important firms.180
Clearinghouses also benefited large counterparties. The exact percentage of Lehman’s OTC derivatives subject to clearing is difficult to determine, yet it appears that a large portion of its interest rate derivatives (while almost none of its credit derivatives) were cleared.181 Across products that were cleared, “[t]he comprehensive responses by [central counterparty clearinghouses] enabled the vast majority of Lehman Brothers’ proprietary and client positions to be settled as expected, with no substantial losses to central counterparties or the members of the clearinghouse.”182 For example, LCH.Clearnet managed the default of Lehman’s interest rate swap portfolio (consisting of 66,000 trades and $9 trillion in notional value) within three weeks and without loss to other market participants.183 According to the Bank of England, LCH.Clearnet “illustrate[d] the ability of a clearinghouse to protect market participants from bilateral counterparty risk, even in the event of default of a major participant.”184
In addition to directly protecting counterparties from Lehman’s default and thus mitigating any potential connectedness problems, clearinghouses might have helped mitigate contagion problems by reducing systemic risk. Some scholars have observed that the opacity of the OTC markets might lead to excessive, inefficient risk-sharing that can be remedied by increasing the transparency of OTC clearinghouses in a manner that reduces the probability of default.185 Others have found that when default seems likely, “[clearinghouses] ... lower the systemic risk associated with runs by derivatives counterparties,” since “[their] contractual obligations to [their] clearing participants prevent [these participants] from novating or terminating positions”186 and since the guarantees that they provide reduce the incentives for counterparties to run.187 Runs are potentially destructive not only because they might hasten a large dealer’s demise but also because, before and after a default, they might foment general market instability. Thus, even if OTC derivatives did not lead to Lehman’s failure and caused only limited connectedness problems in the wake of the failure, more pervasive central clearing might have still been beneficial to market participants. Of course, the requirements of Dodd–Frank for more widespread central clearing will further reduce the potential for destabilizing connectedness from OTC derivatives.
The estate’s framework has been relatively successful. Through settlements with 8 of the 13 Big Banks, net of collateral, it reduced approximately $19.2 billion in derivatives claims (about 44 percent of those at issue) to about $12.4 billion.188 Extrapolating this set of resolutions to the entire pool of Big Bank derivatives claims, the approximately $44 billion in derivatives claims would be reduced to $28 billion. As half of these claims were guarantee claims, this would imply underlying derivatives exposure of only $14 billion in contrast to the $22 billion that the Big Banks initially asserted. Even were the Big Banks to have a full $22 billion in collective derivatives exposure, their losses would be manageable. Had the Big Banks written their entire exposure down to zero in 2008, they would have recorded at most $22 billion in losses, quite small compared to the $1.8 trillion of total losses incurred by financial institutions during the credit crisis189 and, more significantly, compared to the amount of capital that they held on their balance sheets. At the end of 2008, the five institutions with the largest OTC derivatives portfolios in the United States190 held over $530 billion in tier I capital.191 Even the smallest institution among this group held nearly $50 billion in tier I capital,192 and no bank individually has sought anything close to such a figure for derivatives claims against Lehman.193
This limited exposure was no accident, as risk management practices reduced exposure to an acceptable percentage of capital by limiting uncollateralized exposure and using clearinghouses to mitigate bilateral risk. In short, there was no significant connectedness problem flowing from the very substantial OTC derivatives portfolio of Lehman.
Comparison to AIG It is often asserted that AIG was rescued by the government due to the interconnection of its derivatives positions with other important financial institutions. As such, a comparison of the Lehman and AIG situations is instructive.
While it is clear that derivatives were at the heart of AIG’s failure, there is no substantial evidence that its failure would have put its counterparties at risk of insolvency. Unlike Lehman, AIG’s derivatives portfolio was overall “out of the money,” but direct losses from in-the-money CDS positions held by counterparties were small relative to their capital. AIG also suffered losses from its securities lending practice, which might have endangered the solvency of its insurance subsidiaries. However, prior studies have shown that if AIG had defaulted and failed to pay its securities lending counterparties, then the losses to AIG’s securities lending counterparties would not have endangered their solvency.194 As former Treasury Secretary Timothy Geithner stated, “the risk to the system from AIG’s collapse is not particularly reflected in the direct effects on its major counterparties, the banks that bought protection from AIG.”195 Rather, as with Lehman, the real threat of an AIG failure would be the potential spread of contagion through short-term funding markets and through the fire-sale spillovers to the collateral held by AIG’s counterparties,196 particularly when such collapse came so closely on the heels of the Lehman bankruptcy. McDonald and Paulson show that “even for the six banks that were individually owed more than $500 million, in no case did the shortfall exceed 10 percent of their equity capital.” 197 However, as these counterparties began to sell assets to stabilize their debt-to-equity ratios, the risk of fire-sale spillovers can also emerge, a matter of contagion and not connectedness. 198
In sharp contrast to Lehman, the government offered considerable support to AIG, ultimately as much as $182 billion.199 The support started the day after LBHI’s filing, on September 16, when the Federal Reserve Board of Governors exercised its emergency powers under §13(3)200 of the Federal Reserve Act201 to authorize the FRBNY to establish a secured credit facility of up to $85 billion in return for a 79.9 percent preferred stock stake in AIG.202 Further, about a month later, on October 8, 2008, the Board of Governors used its emergency §13(3) powers to supply AIG with up to an additional $37.8 billion of liquidity secured by investment-grade fixed-income securities.203 This was followed on November 10 by the Treasury’s purchase of $40 billion of AIG preferred shares under the Troubled Assets Relief Program (“TARP”) as well as the establishment under §13(3) of two additional Fed lending facilities totaling up to $52.5 billion for two portfolios of mortgage-related securities.204
Although some believe that AIG’s derivatives portfolio might have been a significant factor in the government’s decision to bail out the ailing firm, it remains unlikely that a default on AIG’s positions would have directly caused destabilizing losses or capital shortfalls for its counterparties. That the failure of one of the derivatives markets’ riskiest participants—which “had made the gross error of taking only one side of CDS transactions”205—would not have imperiled the solvency of other major financial institutions underscores the thesis that derivatives connectedness was not central to the 2008 crisis.
Table 4.3 summarizes AIG’s CDS portfolio. Having used AIG’s sterling credit rating to sell credit protection on ostensibly low-risk exposure,206 AIG Financial Products (“AIGFP”) had amassed a $527 billion notional value CDS portfolio insuring “super-senior” risk—a layer of credit risk even senior to AAA207—consisting of credit derivatives on corporate loans ($230 billion), prime residential mortgages ($149 billion), multi-sector CDOs ($78 billion), and corporate debt and collateralized loan obligations (“CLOs”) ($70 billion).208 AIGFP also sold CDS on less senior tranches, but as table 4.3 illustrates, this portfolio was relatively inconsequential.209
AIG’s CDS portfolio (USD billions)
Note: See Am. Int’l Grp., 2008 Annual Report (Form 10-K) 130–31 (2008) [hereinafter AIG 2008 Annual Report].
Table 4.3 further reveals that AIG’s CDS losses stemmed almost entirely from its CDS on multi-sector collateralized debt obligations (CDOs)—namely CDOs backed by a combination of other CDOs, commercial mortgage-backed securities, and prime, Alt-A, and subprime residential mortgage-backed securities.210 While the CDS on these CDOs accounted for only about 15 percent of AIG’s super-senior portfolio by notional, they contributed to more than 93 percent of the firm’s super-senior losses from 2007 to 2008, as $61.4 billion of these CDS were exposed to US subprime mortgages.211
Counterparty losses on AIG’s CDSs on multi-sector CDOs were, however, manageable. First, much of this exposure was collateralized. AIG’s multi-sector CDS portfolio accounted for about 96 percent of the $13.8 billion in collateral that the firm had posted as of June 2008,212 and as table 4.4 illustrates below, at least $5 billion more collateral had been posted by the time of the government bailout. After AIG’s long-term debt was downgraded by each of the three rating agencies on the date of LBHI’s filing, AIG did not have enough liquidity to meet further collateral demands, absent Fed support. Indeed, the downgrades, coupled with subsequent market movements, caused AIG’s collateral posting obligations to soar to more than $32 billion over the following fifteen days,213 compared to only about $9 billion of cash entering the week.214
Maximum losses on multi-sector CDS relative to equity (USD billions)
Note: See COP AIG Report, supra note 356, at 76; FCIC Report, supra note 151, at 376-77. For shareholders’ equity information, see Crédit Agricole, Financial Review at 30 June 2008, Sept. 11, 2008, http://www.credit-agricole.com/en/Investor-and-shareholder/Financial- reporting/Credit-Agricole-S.A.-financial-results; Deutsche Bank, Interim Report as of June 30, 2008, https://www.db.com/ir/en/download/Interim_Report_2Q2008.pdf; Goldman Sachs, Goldman Sachs Reports Second Quarter Earnings per Common Share of $4.58, June 17, 2008, http://www.goldmansachs.com/media-relations/press-releases/ archived/2008/pdfs/2008-q2-earnings.pdf; Merrill Lynch, Merrill Lynch Reports Second Quarter 2008 Net Loss from Continuing Operations of $4.6 Billion, July 17, 2008, http:// phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MTY1MzB8Q2hpbGRJRD0t MXxUeXBlPTM=&t=1; Société Générale, Second Quarter 2008 Press Release, Aug. 5, 2008; UBS, Second Quarter 2008, Aug. 12, 2008, https://www.ubs.com/global/en/about_ubs/ investor_relations/quarterly_reporting/archive/2008.html?template=layer&selected=1 39333&template=layer&selected=139333.
AIG’s potential inability to meet collateral demands would have caused it to go bankrupt (since it could not, due to state regulation, liquidate its solvent insurance companies to cover its losses) and was the proximate cause of its bailout, suggesting that counterparties might have been so significantly undercollateralized as to threaten their solvency had AIG actually defaulted. Yet losses from any collateral shortfalls would have been mitigated by counterparties’ own hedging activities. For example, Goldman Sachs, AIG’s second largest counterparty, attests that it was not exposed to AIG’s credit risk, since it bought CDS on AIG in an amount that covered what it perceived to be its uncollateralized exposure on the CDS that it had purchased from AIG.215 Moreover losses from multi-sector exposure would have been manageable, since the notional value of the portfolio was relatively small and risk was spread across a number of firms. Table 4.4 underscores this point. The table, which is based on exposure to the $62.1 billion in multi-sector CDSs that AIG fully honored in its Maiden Lane III transaction, suggests that in the extremely unlikely event that counterparties suffered losses equal to the notional value of their CDSs less any collateral posted prior to the government bailout, no firm would have faced losses of more than one-fifth of its equity, around the 25 percent single-counterparty credit limits established by Section 165(e) of Dodd–Frank.216 Further the firms would still have likely remained above capital adequacy thresholds after bearing these maximum possible losses. In fact, based on its reported 14.2 percent total capital ratio at the end of the second quarter of 2008,217 even Goldman Sachs—whose exposure-to-equity ratio is among the highest of the firms listed in table 4.4—would have exceeded the 8 percent Basel II total capital minimum if it had absorbed the maximum possible loss.218
Some were concerned with another part of AIG’s swap portfolio that was devoted to regulatory capital relief. AIG’s combined $379 billion notional value of CDS on corporate loans and prime residential mortgages had been sold to provide such relief primarily to European banks subject to Basel I.219 Under Basel I, counterparties could use CDSs written on their borrowers to reduce the amount of capital required against loans from as much as 8 percent (if the underlying loans had a 100 percent risk weighting) to a level of 1.6 percent.220 But this regulatory capital portfolio was not a source of write-downs or liquidity strains for AIG, as it consistently had a fair value of around zero,221 meaning that unlike its other CDSs, AIG could terminate (and indeed, has since terminated) these positions at essentially no cost.
But what about the counterparties who would lose the benefit of these “Basel-friendly” swaps?222 Regulators were concerned that there was no longer a market for these derivatives to which counterparties could turn, that they could not be replaced and counterparties would then not be adequately capitalized.223 The FRBNY estimated that counterparties subject to regulatory capital requirements would have to raise approximately $18 billion in equity upon an AIG’s default.224 In the prevailing market climate of late 2008, raising such an amount of capital would have proved challenging.225
However, as indicated by table 4.5, no individual firm would have lost more than $3.5 billion in capital relief from AIG’s default. Given the size of the banks listed, this suggests that most would have remained above required capital adequacy levels. It is impossible, however, to state with certainty how European bank regulators would have reacted to a decline in capital ratios. As the Congressional Oversight Panel concluded, some countries might have granted forbearance, while others might have taken a tougher approach, perhaps even seizing the noncompliant banks.226 The most likely outcome is that these banks would have stayed afloat.
Regulatory capital relief recipients (USD billions)
Note: See, for example, COP AIG Report, supra note 356, at 92.
a. Based on the Congressional Oversight Panel’s estimate of $16 billion in total capital relief.
This section considers an important group of financial institutions that were directly affected by the insolvency of LBIE, which was placed into administration in the United Kingdom on September 15, 2008.227 In the aftermath of the Lehman failure, certain hedge funds that had used Lehman’s prime brokerage unit (part of LBIE), for a variety of bank services, lost access to their assets since LBIE was in bankruptcy.
Serving as prime broker to about 900 hedge funds and asset managers,228 LBIE held between $40 billion and $65 billion in client assets, an estimated $22 billion of which had been rehypothecated, loaned by Lehman to various borrowers. Through rehypothecation, Lehman was able to use hedge fund assets as security for its own funding purposes.229 Hedge funds that granted Lehman the right to hypothecate were able to reduce their financing costs by as much as 2.5 percent.230
These rehypothecation agreements were governed by UK law, which differed in several important respects from US law. First, UK law enables prime brokers to rehypothecate an unlimited amount of client assets, in contrast to the United States, which limits rehypothecation to 140 percent of funds owed to a customer. The UK framework offered customers little in the way of protection for their rehypothecated assets.231 Not only did the United Kingdom lack a broker-dealer protection regime akin to the Securities Investor Protection Corporation in the United States,232 but once assets were rehypothecated, the customer lost title to them.233 Thus Lehman’s rehypothecated prime brokerage assets became part of the LBIE estate and were unavailable for return to customers.234 Hedge funds that had allowed rehypothecation faced the prospect of becoming unsecured creditors to LBIE and ultimately never seeing their money again.235 Regardless of whether they stood to recover any of their assets over the long term, the inability to recover funds in the short term undoubtedly caused problems for a limited number of firms. Notably, MKM Longboat Capital Advisors closed its $1.5 billion fund partly because of frozen assets,236 and the chief operating officer of Olivant Ltd. committed suicide, apparently because the fund had accumulated a $1.4 billion equity stake in UBS that it placed with LBIE and was believed to be unlikely to recover.237
The freezing of LBIE’s prime brokerage assets did not, however, produce widespread consequences, in part because of the small size of Lehman’s prime brokerage operation. Before the collapse of Bear Stearns, the prime brokerage industry had long been dominated by just three firms, with Goldman Sachs, Morgan Stanley, and Bear Stearns accounting for roughly two-thirds of the market.238 Lehman had never been a large player in the industry. Moreover, in the wake of Bear Stearns’s demise, funds had increasingly used multiple prime brokers to mitigate counterparty risk.239 In fact, despite the traditionally concentrated structure of the prime brokerage business, as far back as 2006, about 75 percent of hedge funds with at least $1 billion in assets under management relied on the services of more than one prime broker.240
The fact that not all of LBIE’s prime brokerage assets were, or should have been, commingled with other funds, or rehypothecated, further mitigated the impact of LBIE’s insolvency. When it entered administration, LBIE held $2.16 billion in segregated accounts and was believed to have segregated several billions more.241 In December 2009, a UK High Court judge held that clients whose assets should have been segregated but were instead commingled would not receive the same protections as those entities whose money had actually been segregated.242 In August 2010, an appeals court reversed the decision and ruled that clients whose money should have been segregated would be treated as if their funds had been.243 Although the total size of the claims that may be affected by this ruling is unclear, some hedge funds will now obtain higher payouts to the detriment of the pool of general unsecured creditors. Moreover, according to LBIE’s administrator, the decision is likely to slow the return of money to clients.244 However, as of March 2014, the administrators of LBIE expect to have a surplus of £5 billion after repaying unsecured creditors.245
The prime brokerage connectedness therefore did adversely affect a few hedge funds, but there is no evidence that they raised any significant systemic risk concerns.
Lehman guaranteed and issued tens of billions of dollars in face value of structured securities backed by a variety of different assets.246 Most of the securities were sold through other financial institutions. These securities attracted the interest of retail investors, who viewed the instruments as low-risk investments offering the possibility of high returns.247 Lehman, on its part, increasingly relied on structured securities as a means of obtaining relatively cheap funding in a market that was growing wary of its credit risk.248 From 2007 to 2008 alone, Lehman issued approximately $19.2 billion of structured securities,249 and in total, parties would file about $78 billion in guarantee claims against LBHI on account of such “program securities.”250
Losses related to these securities have not been and will not be systemically destabilizing. First, although some of Lehman’s structured securities were issued to institutions,251 they tended to be issued mainly to retail investors, whose losses pose little systemic risk.252 Second, unlike many other Lehman creditors, structured security investors could pursue remedies against the financial institutions that sold them the structured products on behalf of Lehman, and have successfully pursued such settlements.253 In April 2010, Citigroup, for example, paid approximately $110 million to repurchase Lehman-issued products at fifty-five cents on the dollar from more than 2,700 Spanish investors, and the bank has recently made an analogous offer to Hungarian investors. Similarly Credit Suisse spent over $85 million to buy back Lehman-issued products from Swiss nationals. There is no evidence that the settlements could have been or were problematic for these firms.
Although structured securities come in a variety of forms and tie returns to a variety of different assets, most amount to a hybrid of a vanilla credit instrument—in effect, an unsecured loan—and a derivative. One such variant, principal protected notes, provides investors with exposure to a particular asset (e.g., a stock index) while promising to return their full principal upon maturity.254 Investors are thereby able to obtain the chance of enhanced returns with no apparent downside to their principal—a seemingly “no-lose” prospect that explains their appeal. The downside comes from the possible failure of the guarantor to honor the guarantee. Even if the guarantor does honor the guarantee, investors tend to pay far more for the instruments than they are worth. For instance, one study examining a representative Lehman principal protected note found that it was worth only about $89 per $100 invested when it was issued in August 2008.255
The investors who purchased such products not only paid more than they were worth but also exposed themselves to the issuer’s credit risk, the possibility that the issuer-guarantor would not make good on the principal. As Lehman’s structured products were primarily by European affiliates,256 the ultimate recovery on these products depends partly on the resolution of Lehman proceedings outside the United States. However, because these instruments were also subject to a blanket LBHI guarantee,257 about $78 billion in total third-party guarantee claims were filed against LBHI on account of “program securities.”258 These claims were reduced in the bankruptcy proceeding by $31.5 billion in valid claims due to LBHI-guaranteed securities and by $5.5 billion due to LBHI’s own issuance.259
Another type of structured security issued by Lehman were “minibonds,” and losses on these securities were also manageable. Ironically, these structured products received the most attention in the aftermath of Lehman’s collapse, despite the fact that they were not actually issued by Lehman. Minibonds were credit-linked structured notes sold to Asian retail investors subject to certain LBHI guarantees. “Minibonds” were essentially basket credit derivatives that paid a coupon unless a reference entity defaulted, in which case the investor’s principal would be reduced and they would continue to earn coupons on undefaulted entities.260 They attracted the interest of about 43,000 retail investors in Hong Kong and about 10,000 in Singapore, who together invested approximately $2 billion in the products on account of their enhanced fixed coupons.261 While they aroused considerable concern in the wake of LBHI’s filing,262 like other structured products, the minibonds have not posed any systemic risk due to their small and diffuse retail investor base. Minibond investors ultimately recovered between 85 and 96.5 percent.263
As will be discussed at greater length in part III, the US money market industry was afflicted by contagion in the aftermath of Lehman’s collapse. Asset connectedness, however, was a much less significant problem. While many funds held Lehman debt, only one fund was ultimately forced to “break the buck” on account of its Lehman exposure.
Money market funds, which managed $3.8 trillion in assets in the United States by the end of 2008,264 were a key part of Lehman’s funding model, as they financed Lehman’s long-term assets through short-term tri-party repos.265 Money market funds also invested in unsecured short-term commercial paper issued by Lehman.266 This paper was supposed to carry negligible credit risk but became increasingly risky. In the years leading up to Lehman’s collapse, certain money market funds began to take more risk as they sought higher yields in a quest for more investors, the so-called chase for yield. 267
On September 16, 2008, one day after the announcement of the LBHI bankruptcy, the Reserve Fund’s Primary Fund “broke the buck.” The RPF was a prime money market fund, that is, a fund that holds “a variety of taxable short-term obligations issued by corporations and banks, as well as repurchase agreements and asset-backed commercial paper.”268 The RPF was the flagship prime fund of the fastest growing fund family over the preceding several years and had invested $785 million in unsecured Lehman commercial paper, accounting for about 1.25 percent of its assets.269 While the RPF did not immediately write down the value of its Lehman investment and continued to report a $1.00 net asset value (“NAV”) on September 15, 2008, the fund faced redemption requests totaling almost $25 billion.270 Unlike other funds that had invested in Lehman paper, the RPF could not rely on credit support from a deep-pocketed parent to maintain the fund’s NAV.271 On September 16, the market value of the RPF’s assets had fallen below $0.995, legally requiring the fund to “break the buck” and float its NAV. Upon breaking the buck, the RPF also exercised its legal authority to suspend investor redemptions for up to seven days.272 In order to extend its suspension of investor redemptions beyond seven days, the RPF was required to file an application with the SEC. The RPF promptly did so, and the SEC granted the application shortly thereafter.273
During that same week, and prior to the RPF’s breaking the buck, a run had begun by institutional investors on prime money market funds in general, including on funds with no significant asset exposure to Lehman. Following the Lehman shock, contagion effects were evident not only among prime money market funds but also in the ABCP market, interbank lending markets (including the market for unsecured LIBOR borrowing and secured repurchase agreement financing), and other areas of the nondepository banking system. However, this severe money market fund run was not a by-product of asset connectedness, for other funds did not incur catastrophic losses on account of their exposure to Lehman but still suffered large withdrawals. Moreover even the RPF’s losses from Lehman exposure were quite small, as the fund held only $785 million of Lehman debt. Indeed, even if the RPF had not been able to recover anything for this debt, investors would have received about a 98.75 percent recovery, according to the fund’s subsequent projections.274 In any event, the RPF was able to sell its Lehman holdings for over twenty-one cents on the dollar,275 providing investors with a recovery of over 99 percent.276 That investors ultimately lost less than 1 percent from the RPF’s collapse underscores the insignificance of asset connectedness to the money market run.
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Whether assessed from the perspective of direct third-party exposures, derivatives counterparties, prime brokerage clients, structured securities investors, or the money market fund industry, the above review demonstrates that asset connectedness was not central to either the Lehman collapse or to that of AIG, and there is no evidence of any other significant asset connectedness problem during the 2008 crisis. Furthermore, those studies that do claim to show high interconnectedness often provide evidence of the relative levels of interconnectedness among financial institutions, without demonstrating that absolute levels are a problem. 277 There is evidence that some types of direct interconnectedness among banks – such as interbank counterparty exposures – has decreased since the crisis; however, other types of direct interconnectedness have increased (for example, clearinghouse exposures).278
This is consistent with the findings of the empirical literature. The relatively small shock of subprime losses could be absorbed by the system, and network externalities due to asset connectedness “did not pose a serious threat to the financial system.”279 While sufficiently large enough shocks at implausibly high levels could theoretically lead to systemic collapse,280 such was not the case in 2008.