$75 Billion Needlessly Lost in Hasty Lehman Bankruptcy Filing?

There is a piece I regard as truly odd in the Wall Street Journal tonight. Either much of what I have read about investment bank bankruptcies is wrong, or something peculiar is at what used to be the house of Lehman.

A Wall Street Journal article, “Lehman’s Chaotic Bankruptcy Filing Destroyed Billions in Value,” comments at length on a report by Alvarez & Marsal for the Lehman board of directors:

As much as $75 billion of Lehman Brothers Holdings Inc. value was destroyed by the unplanned and chaotic form of the firm’s bankruptcy filing in September, according to an internal analysis by the company’s restructuring advisers.

A less-hurried Chapter 11 bankruptcy filing likely would have preserved tens of billions of dollars of value…An orderly filing would have enabled Lehman to sell some assets outside of federal bankruptcy-court protection, and would have given it time to try to unwind its derivatives portfolio in a way that might have preserved value, the study says.

Based on what I had read (and perhaps misinterpreted) at the time of the Bear collapse and the Lehman bankruptcy failing, I had the very strong impression that Chapter 11 simply was not a viable option for a securities firm failure (at least a large one with extensive trading operations). If this is indeed correct, then it begs the question of why the board would engage a consulting firm to spend three months developing a report on a fictive premise (presumably to avoid liability).

Let us review the facts of the case. When Lehman was on the ropes, most commentators assumed that the fundraisings the firm was attempting to get done (the abortive foray with the Korean Development Bank, the sale of the asset management operations) would raise $10 billion, perhaps more, and allow the firm to kick the can down the road at least a couple of quarters. Bearish sorts like yours truly did not see that as a long-term solution, but a lot can happen in six months.

But when Lehman failed, the losses were (very crudely speaking) an order of magnitude greater. We have grumbled that there has been no explanation of this disparity, and that given that the firm was on the rope for nearly six months, the failure of the officialdom to get a better handle on the possible downside of having Lehman fail was a major dereliction of duty.

Some readers have contended that in fact they did but decided to cut the firm loose anyhow. I sincerely doubt that. The SEC did not make an independent assessment (as did the Treasury in the case of Fannie and Freddie). Fuld would never in private have fessed up that things were worse than the financial statements said (aside from his massive ego precluding that, it would have been an admission that the public financials were misleading and/or incomplete, a hugely damaging admission from the standpoint of corporate and personal liability). So where could the Fed and Treasury gotten further insights? In theory Lehman’s counterparties, but if the belief was that Lehman really had a $100 billion hole in its balance sheet (prior to the hasty weekend due diligence by Barclays and Bank of America), how could Paulson been so deluded as to think that he could get anyone in the industry to take on a garbage barge that bad with no government backstop? All it would to was to transfer toxic waste to another party, incurring huge damage to their balance sheet in the process.

Fast forward to the mysterious Alvarez & Marsal report. The premise of the report is that Chapter 11 was a viable option for a considerable portion of Lehman. The Journal discussion does not spell out what the alternative process would have looked like, but does specify some of the damage the Alvarez & Marsal report contends could have been avoided:

Much of the destruction of value came from the bankruptcy filing of the parent guarantor, Lehman Holdings. The filing triggered a cascade of defaults at subsidiaries that held trading contracts. That created what is known as an “event of default” for Lehman’s derivatives. This resulted in a termination of more than 80% of the transactions with counterparties — typically major European and U.S. banks such as J.P. Morgan Chase & Co., said Mr. Marsal. In all, the bankruptcy canceled 900,000 separate derivatives contracts.

The problem for creditors is that this also terminated contracts in which Lehman was owed money. Mr. Marsal said a few extra weeks would have allowed Lehman to transfer or unwind most of its 1.1 million derivatives trades, preserving more cash for creditors.

Overall, the losses from derivatives trades and related claims cost Lehman’s unsecured creditors at least $50 billion, according to the analysis. The findings, yet to be made public, eventually will be presented to the U.S. Bankruptcy Court and to Lehman’s creditors.

“This filing, which was pretty much dictated to the board of directors at Lehman that weekend, occurred with no planning,” said Mr. Marsal, whose New York firm was hired by Lehman’s board around 10:30 p.m. Sept. 14.

Here is where readers are encouraged to correct me if I have something wrong or a bit askew. I was under the very strong impression that securities firms do not decay in an orderly fashion, but instead collapse rapidly once certain triggers are breached, making it well-nigh impossible to contain the unwind. In fact, you’d need pretty substantial changes in both bankruptcy law and the way that trading counterparties deal with each other to have the sort of managed process that the A&M reports argues should have taken place.


1. Once a firm is downgraded beyond a certain threshold, any counterparties that trade with it will be downgraded due to their exposures. And when other firms stop being willing to enter into repos (which do involve a credit exposure) a securities firm is toast. Liquidity is the life blood of a trading firm. And a bankruptcy filing has the same effect. From Jim Bianco:

If Lehman does file, Moody’s has to downgrade their counter-party rating to junk. This forces everyone to stop doing business with Lehman. If you do business with a junk counter-party, you risk your rating falling to junk as well (you are only as good as your shakiest counter-party). Most buy-side accounts have fiduciary rules that bar them from doing business with a junk rated counter-party. Recall that this was the trigger that buried Bear.

No way that Moody’s will agree to keep a bankrupt broker with an investment grade counter-party risk rating.

2. The A&M report appears to have ignored the 2005 bankruptcy law changes that rendered the claim made above, that Lehman could have blocked the unwind of its derivatives book via a Chapter 11 filing, incorrect. From the Financial Times:

Wall Street unwittingly created one of the catalysts for the collapse of Bear Stearns, Lehman Brothers and American International Group by backing new bankruptcy rules that were aimed at insulating banks from the failure of a big client, lawyers and bankers say.

The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.

The new rules were intended to insulate financial companies from the collapse of a large counterparty, such as a hedge fund, by making it easier for them to unwind trades and retrieve collateral.

However, experts say the new rules might have accelerated the demise of Bear, Lehman and AIG by removing legal obstacles for banks and hedge funds that wanted to close positions and demand extra collateral from the three companies.

“The changes were introduced to promote the orderly unwinding of transactions but they ended up speeding up the bankruptcy process,” said William Goldman, a partner at DLA Piper, the law firm. “They wanted to protect the likes of Lehman and Bear Stearns from the domino effect that would have ensued had a counterparty gone under. They never thought the ones to go under would have been Lehman and Bear.”…

The changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG….

Lawyers said the 2005 exemptions also could apply to non-financial companies, potentially complicating the bankruptcy process of any company that uses derivatives. Stephen Lubben, professor at Seton Hall University School of Law, said: “These provisions affect a non-financial firm, such as a car company or an airline, because they also engage in derivatives trading.”.

Now perhaps the Wall Street Journal summary does the A&M report a disservice, and they did correctly parse out any that might have been spared the 2005 bankruptcy law changes. But the FT article gives the impression these changes included most if not all derivatives.

And there is another issue. Chapter 11 filings require debtor-in-possession financing (you need to keep paying bills while holding the creditors at the time of filing at bay). Lehman would have been a very big DIP. The financial community is a really small pond. Word of Lehman attempting to line up a big enough DIP would have lead to an immediate run on the firm. No counterparty wants to risk having trading assets frozen for months, perhaps longer.

So if the logic above is correct, the A&M report looks like a costly ass-covering exercise to protect the board from lawsuits. And the Journal did the board a favor by giving it reasonably prominent placement.

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  1. jm

    Does this not mean that, on the other hand, various counterparties made $75 billion directly or indirectly through the Lehman shutdown?

  2. Bo Peng

    I believe US government specifically decided to let Lehman fail for the purpose of globalizing the crisis; otherwise it would’ve been impossible to manage.


    This may sound a bit like conspiracy theory but, everything considered, it’s the only explanation I can find for the critical event.

  3. Anonymous

    No one recovered any money until the Treasury began handing out aid directly and indirectly through the Federal Reserve.

    Didn’t LB refuse to participate in taking on a share of bankruptcy debt in a previous meltdown? If you don’t play ball they pull the field out from under you.

    This post confirms, without the taxpayer’s aid, the banking system is/was insolvent.

    The ripple effect continues, more like the roof is on fire or burning down the house.

  4. bg

    This is offensive on so many levels. I am not sure about the specifics of ass-covering, but there does seem to be some effort to rewrite history with what-ifs that are built on dubious assumptions.

    But somehow much financial analysis seems to forget there are two parties in every transaction, including BK. Winners and losers.

    So this $50B was lost to Lehmen creditors? Who gained? Was lehmans canceled book net positive? I doubt it.

    The financial industry got smaller because LEH’s ongoing business was liquidated. But it needed to get smaller. Had the mythical alternate universe played out, this would mean that the Lehman bondholders would benefit by keeping the industry too large? I doubt it.

  5. bg

    Bo Peng,

    “it’s the only explanation I can find for the critical event.”

    I believe the Fuld thought he could blackmail Paulson into a favorable bailout, and Paulson was ill displosed to be cornered, and was willing to do a strategic takedown of Fuld.

    Personalities matter in crisis, and I think this is a plausable explanation.

    However Yves was the only one who made the right call on what Paulson would do before it happened. She probably has good insights into why the decision was made the way it was at the time.

  6. bena gyerek

    i don’t know where the 75bn number came from, but i would make the following observation.

    all over-the-counter derivatives are governed by an isda master agreement signed between the relevant counterpart pairing. the isda master specifies that in the case of a default by one counterparty (e.g. bankruptcy filing by its parent) the isda master and all derivatives governed by it will automatically terminate.

    now the important part. when such accelerated termination occurs, the valuation of the derivatives used to calculate the final unwind payment is typically controlled exclusively by the unaffected counterpart (e.g. under the lb – jpm isda master, jpm would determine the unwind payment).

    even at the best of times, valuation of derivatives can involve a considerable amount of uncertainty, and their valuation is therefore a matter of considerable discretion. the valuation of some derivatives (e.g. synthetic cdos – so-called “correlation” products) can vary by a factor of tens of percentage points depending on the assumptions (e.g. the correlation variable) used. in a distressed market, the scope for discretion in valuation will be many times greater.

    when counterparties like lb/jpm unwind a derivative in normal market conditions, they will reach some kind of agreement as to the “fair value” where both counterparts are comfortable they are not being ripped off. in a forced termination, you can bet that jpm and others will consistently choose the most favourable valuation. this is especially likely considering that jpm and others should expect to incur considerable cost in reestablishing their derivatives with new counterparts.

    indeed, to the extent that lb had big net directional positions in its derivatives portfolio, the process of its counterparties reestablishing their derivative hedges could be expected to push the market in an even less favourable direction for lb. e.g. if lb was a big net seller of cds protection on brazil, that means its counterparts were big net protection buyers, and following lb’s bankruptcy these counterparts would have to go into the market and repurchase brazil cds protection from new protection sellers. this process would significantly push up the cost of brazil protection, which would in turn push the valuation of lb’s existing brazil cds’s against lb.

    in other words, i think it is correct to say that in a forced disorderly unwind of lb’s derivatives portfolio where unwind valuations were controlled by its counterparts, it is inevitable that lb would have been bleeding cash all over the place.

  7. Been there


    “I believe the Fuld thought he could blackmail Paulson into a favorable bailout, and Paulson was ill disposed to be cornered, and was willing to do a strategic takedown of Fuld.

    Personalities matter in crisis, and I think this is a plausible explanation.”

    Makes sense if you put it in the context of Jimmy Cayne’s infamous comment about “playing the bankruptcy card” during the Bear Stearns debacle. IMHO that comment was directed not at the firm’s creditors, but at the federal government(and Paulson) from the “too big to fail” perspective. I bet Paulson was still incensed about that even as LB was swirling round and round down the drain.

  8. Unscripted Thoughts

    Perhaps it is just me…but this article has the feel of prepping the ground for the legal beagles. The way it reads and the details provided give me the sense that this was designed to do some CYA for the Board(?), whip some investors into a frenzy and get the law firms phones ringing off the hook. Hey, color me cynical.

  9. Independent Accountant

    Amazing again. I read this piece and underlined most of the sentances you quoted. What do I think happened? You noted A&M was hired at 10:30 PM on Sept. 14. I see A&M with a conflict of interest in writing this report as it was hired pre-bankruptcy. What was (were) the report's purpose(s)? To protect: A&M from a malpractice suit. A&M has 150 employees at Lehman cranking up billable hours. If A&M is so smart, what did it advise Lehman on 14 September? Another purpose: to protect Lehman's board. If the filing "was pretty much dictated to the board", how can it be responsible for the waste of corporate assets? It's Zimbabwe Ben's fault! Last and most importantly: to protect Lehman's counterparties. Will A&M get any more Lehman business? But can A&M get referrals from: Goldman, JPMorgan, etc.?
    This article makes it appear the $75 billion loss was an "Act of God". I have as much confidence in this A&M report as I do KPMG's BCE solvency opinion. Quo bene?
    I may be biased. I seem to see Goldman under every rock.
    Suppose something "fishy" went on at Lehman? Could say the PBGC, an unsecured creditor start looking at the secured creditors? Will the report help protect the counterparties from PBGC litigation?

  10. orderemerges

    Thinking about Lehman's inability to recoup derivative contract profits, I was struck about the justice of all this.

    Basically, the A&M report is a document stating that if Lehman got all the money coming to them and didn't pay any of the money they owed, then Lehman could have screwed the world even better. It still would have blown up, but a higher ratio of pain would have been pushed on outsiders.

    At least when a financial firm blows up, the guys on the inside are just as screwed as the guys on the outside. It is one big game of musical chairs and claiming post hoc that Lehman could have grabbed some extra seats is, in the end, Monday morning quarterbacking. It's over!

  11. Joey

    My father said that in World War II, every time a plane crashed in the Pacific theater, all the stuff people were stealing was reported as on that plane. So, the cargo would suddenly include tons of chocolate or whatever – gone!

    Maybe it’s the same thing here. When a sacrificial lamb like Lehman is killed, it provides an opportunity for these financial scum to loot and sneak junk into the package.

  12. Bo Peng

    bg said
    “I believe the Fuld thought he could blackmail Paulson into a favorable bailout, and Paulson was ill displosed to be cornered, and was willing to do a strategic takedown of Fuld.

    Personalities matter in crisis, and I think this is a plausable explanation.

    However Yves was the only one who made the right call on what Paulson would do before it happened. She probably has good insights into why the decision was made the way it was at the time.”

    I understand how personality quirks could very well shape the course of history. But I find it hard to believe this is the key factor here. All of Washington, including the Congress and Bernanke (and of course the mainstream media), were unanimous in saying Lehman shouldn’t be bailed out. And it was probably true — without globalizing the crisis first, bailing out Lehman would’ve been very damaging to USD and treasuries. Now that the crisis has been exported, everyone is on the same boat and there’s no consequence to printing money.

    My article on SeekingAlpha has more details along this line:

  13. Bill

    what ever happened to that story buzzing around the interweb a couple months ago about an unexplained transfer of funds to jpm from leh in the bk filings… the theory was jpm/fed pulled a line of credit to leh forcing it to collapse and then 70b? ended up at jpm from leh losses…? story was gaining traction then dissappeared. could that be related to this…?

  14. Anonymous

    Independent Accountant:

    …for what it’s worth, you’re not the only one with questions about the integrity of that solvency report.

  15. macndub

    Mr. Marsal said a few extra weeks would have allowed Lehman to transfer or unwind most of its 1.1 million derivatives trades, preserving more cash for creditors.

    Yves, I agree with you and bena gyerek that this sentence is ludicrous and reflects zero understanding of this business. There is no gradual unwind of OTC derivative positions.

    If a position mark is $10 million in LEH’s favour before the bankruptcy, then it’s entirely possible that the proceeds remitted can be $5 million, or even zero after the counterparty unwinds. Tough luck: the trustee can sue if he has a beef.

    But the only way to avoid paying these costs is to NOT DEFAULT. There’s no such thing as partially defaulted in this world and doing a gradual unwind. The counterparty has an obligation to eliminate the burned out exposures immediately.

    Finally, as to the comments about who got the $75 billion, yes, it would have accrued to LEH’s counterparties (to the extent that Lehman’s books didn’t have a hole in them… care to bet on that)? But it’s not real money: they would have a realized gain on fictitious mark-to-market or mark-to-model positions. Cash is still going to LEH.

    The overall impact would get caught in all of the other writeoffs. Plus, you’d never want to disclose that you closed Lehman out below market: that would move you from creative modelling into something worse.

  16. Anonymous

    Concur with your analysis — that there is really no way to run a brokerage once the counterparties to the trades lose confidence in LB.

    Indeed, the crash happened days before the formal filing when in effect, other brokerages like GS stopped trading with them for fear that they will default.

    The whole report is rubbish.

    The larger question it raises is that if AAA rating and beyond, which is absolute trust and faith in their credibility as a counterparty, can such a business be allowed to do anything else beyond a very narrowly defined business like being a brokerage or an underwriter?

    The real story is, they got into far riskier businesses, and did so with abandon.

  17. In a bunker until 2011

    A big reason for the LEH pluge was Fuld himself. He was not well liked and there were few favorable life rafts that were tossed his way during the lead up the filing. Buzz around banking world was also that Paulson couldn't resist the chance to boost his GS buddies, and a LEH failure helped that. GS was poised to be a even more catastrophic failure for two reasons. First, it had more "good" debt that was rotten which would have rocked confidence beyond recovery. Second, and not dissimilarly, is that GS is the cornerstone of wall street from a perception standpoint. If it were to go, there would have been absolute choas.
    Once LEH and Fuld refused the dire lifelines extended, Paulson & Co. were free to let them go. Once the world saw what a mess that created they were able to convince everyone that a GS failure would be even worse – hence their being bailed out via the AIG move – since GS was sitting on about $20B of AIG derivatives.
    As for the A&M opinion, it is just further evidence of how these guys just like to throw good money after bad. If the board wanted a CYA opinion they should have retained bankruptcy counsel earlier, which would have provided two iron clad defenses – (1)Attorney client privilege, and if all else failed (2) advice of counsel. I'm an attorney and I'm pretty sure that opinion of consultant is not the best defense out there, and am hoping that some LEH bondholders read this.

  18. Mark

    Back to the very first comment: Didn’t counterparties gain $75 billion?

    Isn’t it all a zero-sum game in the end? Wasn’t it just a bunch of marks on paper and computer files that changed?

  19. Hemant

    I diasgree with part of Bena’s analysis that the market would have moved as counterparties would have re-enterd their Leh trades (with fresh counterparties)
    Two reasons
    (i) I dont think anyone saw such a move in the weeks after Leh demise
    (ii)In many cases, the book would have been reasonably squarish

    But yes, if a counterparty has two trades outstanding with Leh (in roughly opposite direction), I suspect the unwind value in each would have involved a massive bid / offer . And Leh (creditors) would be out of pocket
    So I dont know if 75 billion is ballpark or not, but some money would have been transferrred to counterparties as a result. The resr, as CNBC says, has gone to dollar heaven

  20. Anonymous

    First of all, if you guys think Bryan Marsal/A&M doesn't know about the changes to US bankruptcy law in 2005, you're absolutely nuts. A&M's core business is advising firms in bankruptcy. This is akin to saying that Citigroup didn't anticipate the changes to securities law that would result from the Gramm-Leach-Bliley law three years after it took affect.

    Second, A&M wasn't hired to write a report – they are in charge of the liquidation of the Lehman estate. You don't need 150 people full time to write a report.

    Finally, Yves, you seem to take it for granted that Lehman had to file for bankruptcy on the 15th. While ratings downgrades (which would have gravely hindered the chances of any recovery) were threatened by the credit rating agencies, those hadn't yet happened. Had Chris Cox not urged Lehman's board to file the night of the 14th and the company instead opened for business that week with the goal of unwinding its derivative exposure, a much different picture might have emerged.

  21. Yves Smith

    Anon os 12:47 PM,

    I can only go on what the Journal reported, and the summary they made of the A&M report contradicts bankruptcy law as applied to derivatives and reportedly keys off the premise that an "orderly" bankruptcy was an option, which per above, it was not.

    Second, as Independent Accountant indicated above, A&M is conflicted in the issuance of any report on the bankruptcy process, given their status as an advisor hired prior to the filing. An independent firm should have been hired and was not. Frankly, they should have recuses themselves (they could have provided data and analysis to a third party which would have made an independent determination).

    Third, if you do not think that firms to not issue client-serving reports from big-billing clients, you are sorely naive. I have seen repeated instances of highly questionable work, to put it politely, done at client request while I was at McKinsey and Goldman, and also have seen numerous instances of dubious reports out of other major consulting firms and accounting firms that I have been asked to review in a professional capacity.

  22. Mitchell

    For the people still asking “why did they let Lehman fail?” – I figured the reason was that the GSE bailout had happened just recently, and Paulson was trying to ensure that people (especially the remaining i-banks) did not get into the habit of expecting bailouts. But then the consequences of Lehman’s failure were so huge that he immediately reversed course.

  23. macndub

    Anonymous 11:50, I think this is the sentence you are referring to: “If the Fed or the Treasury said, ‘Let’s say to Lehman, there’s no bailout, we’re not going to save the company,’ they could have supported an orderly unwinding of all the transactions over a period of months,” he says.

    While I defer to an expert’s knowledge, I’m not certain that he fully understands the details.

    The only way the Feds could have done this was backstopping the transactions. For a variety of reasons, that’s a terrible idea. For one, backstopped transactions in New York will not save the London desk from a quick closeout. I know of a lot of commodity desks that were reading ISDAs very carefully prior to Lehman’s bankruptcy, to ensure that they’d be jumping to termination as soon as legally possible.

    There is no reason to expect that Lehman’s counterparties would have behaved anything other than rationally.

  24. Anonymous

    There are a couple of exagerations in the piece you wrote.

    The securities industry wants these exemptions because without them people would be reluctant to enter into repurchase agreements and derivatives because of the inability to manage risk through collateral.

    Second, Jim Bianco’s statement that your credit rating gets downgraded to that of your weakest counterparty is an exaggeration. Many derivatives contracts are collateralized; a downgrade could prompt the requirement of the weaker counterparty to accept a larger haircut (post more excess collateral) or in some cases allow the trade to be unwounded or reassigned. It would also mean that fewer counterparties would be permitted to trade.

    Second, the change in the bankruptcy law on repurchase agreements is not so malignent as you maintain. Normally counterparties in derivatives contracts and repurchase agreements attempt to limit their losses by requiring each other to post collateral. Under current law and contracts when one party declares bankruptcy the counterparty can typically unwind the trade at market prices and seize collateral up to the amount owed. It appears the law you cite merely expanded the types of transactions exempted. Without such exemptions, the collateral would be frozen in the bankruptcy and the counterparty would be unsure of its recovery and unable to protect itself against possible price movements in the collateral.

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