Lehman Bankruptcy Looms; Emergency Lehman Swaps Session Today (Slightly Revised and Updated)

Reader Steve A , Scott and Saboor also pointed to the Bloomberg story reporting that the International Swaps Dealers Association had announced an emergency Sunday session to net Lehman-related position in anticipation of a possible bankruptcy filing,

From Bloomberg:

Wall Street prepared for a potential Lehman Brothers Holdings Inc. bankruptcy after Barclays Plc said it pulled out of talks to buy the firm and the government indicated it wouldn’t provide funds in a resolution.

Banks and brokers today held a session for netting derivatives transactions with Lehman, or canceling trades that offset each other, in case the New York-based firm files for bankruptcy before midnight New York time.

“The purpose of this session is to reduce risk associated with a potential Lehman Brothers Inc. bankruptcy filing,” the International Swaps and Derivatives Association said in a statement today. The ISDA includes 218 banks, brokerages, insurance companies and other financial institutions from the U.S. and abroad….

“ISDA confirms a netting trading session will take place between 2 p.m. and 4 p.m. New York time for over-the-counter derivatives,” the ISDA said. “Trades are contingent on a bankruptcy filing at or before 11:59 p.m. New York time, Sunday, Sept. 14, 2008. If there is no filing, the trades cease to exist.”

Update: Reader Dwight pointed to this comment from Alea:

In the U.S., as in most countries with well-developed securities markets, derivative securities enjoy special protections under insolvency resolution laws. Most creditors are “stayed” from enforcing their rights while a firm is in bankruptcy. However, many derivatives contracts are exempt from these stays. Furthermore, derivatives enjoy netting and close-out, or termination, privileges which are not always available to most other creditors. The primary argument used to motivate passage of legislation granting these extraordinary protections is that derivatives markets are a major source of systemic risk in financial markets and that netting and close-out reduce this risk. To date, these assertions have not been subjected to rigorous economic scrutiny. This paper critically reexamines this hypothesis. These relationships are more complex than often perceived. We conclude that it is not clear whether netting, collateral, and/or close-out lead to reduced systemic risk, once the impact of these protections on the size and structure of the derivatives market has been taken into account.

Update 4:00 PM: The Wall Street Journal weights in:

As word that a Barclays deal was off filtered across Wall Street, credit derivative traders scrambled to unwind their outstanding contracts with Lehman and shift their positions to other banks. CDS traders at many Wall Street firms were told to come to work immediately.

With many trading desks open, investors rushed to buy credit default swaps tied to other brokerages and corporations, sending the cost of protection on investment banks such as Goldman Sachs and others sharply higher. One senior trader said
Bank of America is offering to face Lehman’s counterparties in CDS trades, as long as the swaps don’t reference Lehman’s own debt…

A disorderly unwind of Lehman’s derivatives trades is only one worry. Another worry is that if Lehman collapses, its distressed assets — such as commercial real estate — could suddenly hit Wall Street for sale, forcing prices even lower and potentially forcing other dealers to mark down once again the value of their own holdings.

The headline and intro sentence were modified with the second update.

Update 4:50 PM: Cash Mundy in an earlier comment highlighted Nouriel Roubini’s reading on the consequences of a Lehman unwinding:

It is now clear that we are again — as we were in mid- March at the time of the Bear Stearns collapse — an epsilon away from a generalized run on most of the shadow banking system, especially the other major independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley, Goldman Sachs). If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup). Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer.

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  1. bg

    yves called it first:

    Treasury would let Lehman fail.

    As Einstein said: You cannot simultaneous prepare for a Lehman bankruptcy and avoid a Lehman bankruptcy.

  2. Anonymous

    Netting is all well and good — it will help cut nominal-value exposures down to actual equity-value exposure. But … the equity-value exposure could still be a problem.

    For instance, the now-abandoned proposal to have 10 parties put up $3 billion each to fund a “bad bank.” This would only have made sense if they had $3 billion or more of exposure to Lehman. Maybe some did and some didn’t.

    Thus, the WSJ quote posted by Cash Mundy in another thread: “With many trading desks open, investors rushed to buy credit default swaps tied to other brokerages and corporations, sending the cost of protection on investment banks such as Goldman Sachs and others sharply higher …”

    It’s not the magnitude of the exposure; it’s the CONTAGION. Otherwise stated, could a monarch butterfly’s wing flapping in Mexico bring down AIG tomorrow? Stay tuned for … “As the FIRE Sector Burns.”

  3. Randy

    Good news confirmed:

    Reuters website now says:

    Breaking News
    Bank of America no longer in bidding for Lehman Brothers: report 3:48pm EDT

  4. Steve

    In today’s special trading session, CDX IG leapt to 180/190.

    I suspect the Fed may be prepared to take on what’s left of Leh’s derivative book after today’s netting, just as the Fed took on Franklin’s FX book way back in the last century. I’m assume the Fed will assess the residual exposure when trading closes today (now extended to 6:00PM). If it’s small, the courts can bang on it, otherwise the helicopter will fly.

  5. ScottH

    re: BAC and MER merger talks

    so … in addition to WaMu, what do they do about AIG? If LEH goes BK, AIG is bound to have some marking down to do on their $0.4 trillion derivatives book. If they don’t do the markdown (in light of Paulson’s suggestion of a near-term lax regulatory stance) the investment community surely will.

    There are so many balls in the air, it’s hard to see how they can all remain elevated.

  6. a

    JPM buys WaMu.

    China buys AIG. AIG began in China, so it completes the circle and makes sense in a mystical sort of way.

  7. Anonymous

    This is such crap to play games with regulation. Congress has dropped the ball yet again as lobby groups create loopholes for accountability. If the music stops with your pension funds, then, maybe you will call a local representative and ask why you got stuck holding the bag!

  8. Anonymous

    Einstein also said that you can’t solve a Lehman derivative problem by using a Lehman derivative solution.

  9. Anonymous

    Re: Isn’t anybody going to save poor little WaMu? (chuckle)

    That is why they re merging, to help out the little guy

  10. Anonymous

    You can prepare for a bkptcy – and avoid a bkptcy – remember the Bear? Sometimes it’s just a threatening posture to assume.

    But anyone buying Lb was probably wary of their inherent inability to manage risk…or the desks shall we say…they were all talk no action – bring back Madelyn (former head of risk – demoted for being too diligent)(not in so many words).

  11. Anonymous

    If I were Paulson, and had everybody in the same room:

    Announce that the government is doing a $30 billion guarantee for Lehman like it did for Bear Stearns. In return, every company in the room agrees to a one-year industry-wide moratorium on bonuses and dividends, no exceptions.

    Bankers “voluntarily” inflicting pain on themselves provides political cover for one last federal bailout, and there’s also cover for the weaker players to cut costs without stigma and without fear of their talent being poached.

    Why would the stronger players agree to it? Because their stock prices might actually go up sharply. It could be the mother of short-squeeze rallies, the long awaited market bottom, and unlike July this one might actually stick because there’s no quick expiry after a few weeks.

    Bring Barney Frank into the room at a critical juncture to play the role of unhinged “bad cop”, and announce that the Administration is working closely with him to explore some new interesting legislation…. ba da boom!

  12. doc holiday

    Gross needs another bailout; guess Fannie wasnt enough?

    Re: Pimco’s Bill Gross said on Sunday that a Lehman Brother’s (LEH.N: Quote, Profile, Research, Stock Buzz) bankruptcy risks an “immediate tsunami” because of the unwinding of derivative and credit swap-related positions worldwide.

    Talks to sell Lehman faltered Sunday, triggering concerns that the investment bank may be heading into bankruptcy by the end of the day and prompting banks to call an emergency trading session to unwind positions with the firm.

    “It appears that Lehman will file for bankruptcy and the risk of an immediate tsunami is related to the unwind of derivative and swap-related positions worldwide in the dealer, hedge fund, and buyside universe,” Gross, the chief investment officer of Pacific Investment Management Co (Pimco), told Reuters. Pimco oversees more than $812 billion in assets.

  13. dd

    NYT reports:
    “A consortium of banks will provide a financial backstop to help provide an orderly winding down of the 158-year-old investment bank. And the Federal Reserve has agreed to accept lower-quality assets in return for loans from the government.
    But Lehman’s filing is unlikely to resemble those of other companies that seek bankruptcy protection. Because of the harsher treatment that federal bankruptcy law applies to financial-services firm, Lehman cannot hope to reorganize and survive as a going concern. It will instead liquidate its holdings.
    It was not clear whether the government would appoint a trustee to supervise Lehman’s liquidation, or how big the financial backstop would be.”
    “Moreover, changes to the bankruptcy code mean that counterparties to Lehman’s credit-default swaps can seize their collateral at any time, posing an enormous potential risk to the entire financial markets. Investment banks, hedge funds and other financial players labored throughout Sunday to offset their exposure to Lehman, moving their contracts to other firms.”

    JMHO but derivatives have reduced shareholders from “owners” to mere claimants against a precarious revenue stream and undermined the notion of bondholder “priority.”
    Long term investors are the losers as derivatives hollow out future value and coupled with leveraging the impact is exponential.

  14. private

    jmh, says “JMHO but derivatives have … undermined the notion of bondholder “priority.”
    Long term investors are the losers as derivatives hollow out future value and coupled with leveraging the impact is exponential.”

    Bondholders can protect themselves with covenants restricting debtor activities. The thing is in the past several years bondholders have been willing to accept bonds with weak covenants issued by debtors with crappy balance sheets. Now they will pay the piper. There is no free song.

  15. dd

    Private, I rest my case. The issue is “dumb” Americans in 401k accounts who’ve been told all the fables about “diversification” and “bond safety” are about to understand there is no safety and mutual fund are no haven. Dot com bust shook confidence but this unwind undermines the whole notion of “long term” investing.

  16. Matt Dubuque

    Yves, did you call the Fed letting Lehman fail before me? Thought I was the first, here in this fine blog.
    Just curious.

    I wonder what impact the Bankruptcy “reform” legislation passed in 2006 (2007?) has on this issue of how a bankruptcy stay applies to derivative unwinds in the USA. The abstract of the article stated does not specifically mention the USA.

    Given the proliferation of these swaps written as domiciled in offshore banking facilities (OBFs) the jurisdictional legal maze only adds to the overwhelming complexity at hand.

    Full employment for securities lawyers. As much work as you can handle at $500 an hour. But incredibly tedious and repetitive. Basically assembly line work at $500 an hour.

    I note that the paper referenced was published in by NBER in 2005. I’d like to read it.

    Matt Dubuque

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