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.
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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.
I’m confused, too, but I know far less about accounting and finance than you do. Let me approach it from a different perspective.
It seems that Lehman engaged in a fraudulent scheme to double its initial $3B. First, it engaged in a form of accounting fraud to generate a $3B asset (the Fenway note). Then, it actually defrauded JPM by knowlingy using the worthless $3B Fenway note as collateral for the loan from JPM, doubling the initial $3B that it shuffled to another subsidiary through Fenway in order to generate the false asset.
While the fraud worked to Lehman’s benefit in the short run (free money!), I can’t see a bankruptcy trustee or court letting that fraud inure to the benefit of JPM because to do so would be unfair to the remaining creditors. The only claim that JPM has that will stand up in bankruptcy is the claim for the loan. That’s why even JPM has concluded that the Fenway collateral is “practically worthless”: Fenway was just a shell created to perpetrate a fraud.
Tao,
It’s simialr to what Enron did. Get an outsider to create a bunch of shell companies, shift all your loses to those companies while you use them as colateral for loans to make your real balance sheet look good, and then run like hell when the house of cards collapses.
I remember reading an article about Lehman selling CDS on themselves in the week before they went bankrupt, and how that was used as a way to screw their creditors. This is a big loophole in the law as the bankruptcy court have no authority to unwind those transactions. Because JP Morgan is a creditor to Lehman, not a debtor, buying a CDS from Lehman doesn’t make any sense.
There is a simpler way to think about the circular relation. Lehman wanted to borrow 3 billion dollars, but no one wants to lend them the money. So Lehman created this ‘special vehicle’ using Hudson Castle to spin off their Sun Col investment into a ‘unrelated security’, and used that to borrow money from JP Morgan. In the end, JP Morgan is left ‘holding the bag’.
Government will of course continue its long standing reign over the student lending market and make sure all those kiddies stay flush with cash so their voting machine buddy, Education Incorporated, stays happy by being able to jack up tuition prices even more and pick the kids pockets until they become jobless , indentured slaves. Why are people still so protective about the US education system and politically based loan services? Those are the guys rolling around in your money – not banks.