naked capitalism

One of the reasons that Bear Stearns unraveled so quickly was that hedge fund customers and trading counterparties started reducing their exposures out of fear that their funds would become subject to a bankruptcy proceeding, leaving them unable to trade them. Worse, as some hedge funds are learning, customer agreements permitted Lehman (as most other prime brokerage agreements do) to use prime brokerage collateral as assets for their own repos, which has the effect of co-mingling them and thus making them subject to creditor claims.

Bear admittedly unravelled quickly, before the Fed’s new facilities came into effect. But even with the new programs in place, Lehman was deteriorating for months. It is thus surprising to read that some major firms got caught.

The Bloomberg story does a nice job of discussing the mechanics:

Lehman Brothers Holdings Inc. will take “considerable time” before returning assets stranded by the world’s largest bankruptcy to hundreds of hedge fund clients, according to PricewaterhouseCoopers….

GLG Partners Inc., which oversees $24 billion, CQS U.K. LLP and Bay Harbour Management LC are among the hedge funds that used Lehman as a prime broker for borrowing stock and clearing trades. Funds with assets at Lehman probably will have to write them down when they report net asset values, according to Laven Partners LLP, a London-based hedge fund consultant.

“If your hedge fund assets have been included with Lehman’s, you’re in the back of a queue that’s quite long,” said Laven Partners founder Jerome Lussan. “What’s the market value of, say, $100 million that’s owed to you by Lehman? I’d say it’s not that great, and it’s going to have to be written down.”

Bay Harbour said in a Sept. 19 court filing that money it deposited with the New York-based bank “appears to have been siphoned from London to the U.S. as part of an $8 billion asset transfer and then “trapped” by the midnight bankruptcy filing. This happened “despite repeated assurances of the integrity of the cash,” according to Bay Harbour’s objection.

Lehman was entitled to use prime-brokerage clients’ securities as collateral for money it borrowed through so-called repurchase agreements, PwC said. Securities used for these purposes were mingled with Lehman’s, PwC said.

“The assets, once `used,’ were no longer held for the client on a segregated basis, and as a result the client may cease to have any proprietary interest in them,” PwC said in the statement.

Using securities pledged as collateral, a practice known as rehypothecation, is common, said Richard Frase, an attorney at Dechert LLP who represents hedge funds in London.

“Most investors aren’t used to waking up and not knowing where their assets are,” Frase said. “There are several basic questions: are the assets there or not, what value do you place on them and what do you say to investors.”

Determining which assets are Lehman’s and which are clients’ is “exceptionally complex,” Steven Pearson, a partner at PwC, said in an Internet presentation last week…..

GLG, founded as a unit of Lehman 13 years ago, filed a suit in New York last week to protect assets that “may have been misappropriated” in Lehman’s sale of its U.S. investment bank to Barclays Plc.

GLG said it “holds significant claims” against Lehman, according to an objection filed Sept. 18 in U.S. bankruptcy court. GLG said last week it had some “residual” trades with Lehman that didn’t clear before it filed for bankruptcy…

Because many hedge funds pulled accounts before Lehman’s collapse, their losses may be limited. Gottex Fund Management Holdings Ltd., a Swiss-based manager with about $16 billion invested in hedge funds, is among those who last week said the exposure to trapped assets at Lehman was “minimal.”