How did Lehman Manage That ? II

Robert Waldmann

A year and a half ago I speculated as to how Lehman had managed to get it’s unsecured debt to be worth only 12 cents on the dollar. With my tinfoil hat firmly on, I wondered if they had written CDS on themselves. I may just be demonstrating my ignorance of the law and institutions, but I suspect that I was essentially right.
LOUISE STORY and ERIC DASH have an important article in the New York Times in which they allege that Lehman hid investments off its balance sheet using deals with a privately held financial firm Hudson Castle and its subsidiaries.
After the jump I quote them on one huge deal and explain why I think that Lehman, in effect, wrote a CDS on itself.

One of the vehicles that Hudson Castle created was called Fenway, which was often used to lend to Lehman, including in the summer of 2008, as the investment bank foundered.
Lehman itself bought $3 billion of Fenway notes just before its bankruptcy that, in turn, were used to back a loan from Fenway to a Lehman subsidiary. The loan was secured by part of Lehman’s investments with a California property developer, SunCal, and those investments also collapsed. [skip]
Further complicating the arrangement, Lehman later pledged those Fenway notes to JPMorgan as collateral for still other loans as Lehman began to founder. When JPMorgan realized the circular relationship, “JPMorgan concluded that Fenway was worth practically nothing,”

Now my ignorance. I will assume that the loan from JPMorgan was a full recourse full faith and credit loan – that is I will assume that since the collateral turned out to be worth less than Lehman’s debt to JPMorgan, the Lehman estate owes JPMorgan the balance.
It appears that Fenway’s only assets are Lehman debt and SunCal instruments both of which are in default. If I understand the debt contract correctly (and pigs fly) JPMorgan has two claims on Lehman – that is the amount that the Lehman estate theoretically owes JPMorgan is more than the amount it owed before it collapsed.
My guess is that JPMorgan now owns Fenway and therefore Lehman’s debt to Fenway which would cover JPMorgan’s loan to Lehman except for the little problem that Lehman’s debt is now worth 12 cents on the dollar. I guess this debt will be resolved eventually. Let’s say at 12 cents on the dollar. That would only cover 12% of Lehman’s directly contracted debt to JPMorgan (the balance of the loan). If so JPMorgan is theoretically owed 1.88 times the amount Lehman owed it when Lehman went bankrupt. This would mean that JPMorgan will end up with (0.12)(1.88) = 0.2256 times that amount.
If I am right, the point is that bankruptcy caused a sudden increase in Lehman’s theoretical liabilities (that is the face value of its liabilities — that is the denominator of the recovery ratio whose numerator is Lehman’s assets).

This is just what would happen if Lehman wrote a CDS on itself.
Now I might be wrong and JPMorgan agreed that, if it seized the Fenway notes then the loan contract would be terminated (resolved over done) with no further recourse. In that case, the amount Lehman owes JPMorgan is just the amount it owed JPMorgan before going bankrupt.

I hope this is all clear to readers, but I am totally confused.