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Bloomberg has a fantastic article today about how Lehman’s decaying corpse is suing a bunch of former clients, many of them wee and sympathetic nonprofits, who hosed Lehman when they terminated swaps in September 2008. Some of these lawsuits turn on disputes over when those clients, or their consultants, should have valued the swaps for termination purposes, and I was looking forward to reading Bloomberg’s account of which of those customers used the SWPM <go> function on their terminals and on what dates, but for some reason that wasn’t mentioned.
The basic story is that clients had trades with Lehman that were in-the-money to Lehman, and when Lehman went bankrupt the clients terminated the trades and wired Lehman termination payments that Lehman now rather belatedly finds inadequate. You could understand why the clients would want to get out of these trades: for one thing, the trades had moved against the clients (thus being in-the-money to Lehman) and seemed likely to move further against them1; for another, if the trades did move back in the clients’ favor, what were the odds that a freshly bankrupted Lehman would pay the clients what they were owed?
Is Lehman right that the clients underpaid? Oh, I mean, of course. I don’t have the details of the trades but you can reason this out from first principles. Here:
- It’s September 15, 2008, and Lehman has just filed for bankruptcy.
- You owe Lehman some money.
- How much you owe them is a somewhat subjective matter that depends on what termination date you pick, what model you use, whom you ask for a quote, etc.
- You know, with some certainty, that everyone at Lehman who knows anything about your trade, and also everyone who doesn’t, has bigger things to worry about, like stealing office supplies on their way out the door.
- You can basically write them a check and enclose a note saying “here’s what we think we owe you,” and see if they write back.
- How big is the check?
It’s small, is the answer.2 You can also reason this out from second principles, which go something like this:
- The basic idea of the swap contracts’ termination provision is: if Lehman goes bankrupt, you replace the contract with an equivalent from another bank, and if the other bank pays you money to get into that equivalent contract, you should really just hand that money over to Lehman.3
- Lehman’s clients had a suspicious habit of entering into equivalent replacement contracts where they got paid $X, and then handing over $Y < $X to Lehman while saying "oh well obviously this isn't the same thing at all."
On September 15, 2008, Lehman Brothers Holdings, Inc. (“Lehman Brothers”) filed a petition for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. We had 87 derivative transactions (interest rate swaps) outstanding with a subsidiary of Lehman Brothers, Lehman Brothers Special Financing, Inc. (“LBSF”), with a total notional principal amount of $5.7 billion. Under the provisions of our master agreement, all of these swaps automatically terminated immediately prior to the bankruptcy filing by Lehman Brothers. The terminations required us to pay LBSF a net fee of $189 million, which represented the swaps’ total estimated market value at the close of business on Friday, September 12. … On Tuesday, September 16, we replaced these swaps with new swaps transacted with other counterparties. The new swaps had the same terms and conditions as the terminated LBSF swaps. The counterparties to the new swaps paid us a net fee of $232 million to enter into these transactions based on the estimated market values at the time we replaced the swaps.
The $43 million difference between the market value fee we paid Lehman and the market value fee we received on the replacement swaps represented an economic gain to us based on changes in the interest rate environment between the termination date and the replacement date.
Note that the replacement date, September 16, was one day after Lehman filed for bankruptcy: Lehman filed, the bank immediately replaced its Lehman swaps with identical swaps, and the counterparties on those identical swaps paid it $232 million. Of which it paid over (effectively) $189 million to Lehman and kept the remaining $43 million.4 Can you blame Lehman for wanting the $43 million?5
None of this is meant as legal analysis, by the way, or to suggest that Lehman will win these cases: while the general intent of the contracts is to make the counterparties pay over to Lehman whatever they got from their new trades, the specific mechanics of those contracts are notoriously convoluted and also generally protective of non-defaulting parties so for all I know zombie-Lehman will be out of luck on these lawsuits too.
Either way, Bloomberg’s fretting about how zombie-Lehman is trying to steal food from nursing homes five years after its bankruptcy is missing a key point, which is: Lehman’s bankruptcy was, at least for the last five years, rather a windfall for those nursing homes. They got out of losing swaps at a big discount! (A discount that they could more or less make up on their own!) Just like the bankruptcy was a windfall for Intel, who grabbed $1 billion in collateral when Lehman went bankrupt for no real reason other than that it could, and just like it might have been for Citi, who could’ve done the same, had they not been so blitheringly incompetent.
That’s maybe unfair. It probably didn’t feel all that much like a windfall at the time: finding a replacement swap counterparty in short order, while interest rates were swinging wildly and the world was, y’know, ending, was probably very stressful and I’m sure that, for instance, the Federal Home Loan Bank of Cincinnati considered that $43 million gain to be only fair compensation for 24 hours of extreme agita. Also, of course, the agita of being sued over it now, when you’d forgotten all about it. And the 14% interest.6 They’re not exactly dancing in the street, there at the nursing home.
The fate of Lehman and its derivatives counterparties reminds me a bit of the Libor scandal, in which a bank would be, say, long $100 billion of Libor and short $99 billion of Libor and would manipulate Libor by a tenth of a basis point to make a few bucks on its net position while vastly greater sums were made and lost by unwitting(-ish) counterparties. The counterparties who lost money are justifiably aggrieved, but they face the problem that they lost much more than the manipulators who manipulated them made. The counterparties who made money aren’t going to give it back, aren’t (publicly, anyway) celebrating their windfall, and in many cases feel hazily aggrieved themselves. It’s a basic PR risk of being a big market-making bank and running a matched book: some of your clients will win, and some will lose, and if you screw up (manipulate Libor, blow up) then some will win a lot and some will lose a lot. The ones who lose will complain, and they’ll have every right to, but you don’t get to complain about the ones who win.
The difference here, though, is that Lehman isn’t complaining. Zombie-Lehman is, and zombie-Lehman is not, like, Dick Fuld, but rather a swarm of lawyers being paid very well to represent the interests of everyone who was on the losing side of the Lehman bankruptcy. And now they’re going after the winners, even the sympathetic winners, because that’s their job. And because a swarm of zombie lawyers doesn’t really feel sympathy.
1. Like if you simplistically assume they were all just interest rate swaps, here’s the 5-year:
So simplistically if you put on a swap where you paid fixed in the previous few years, it was ITM to Lehman before Lehman filed, and then after Lehman filed rates basically plummeted, and looked likely to (and did) stay low, meaning that the swap seemed likely to (and did) become way more of a money loser for you if you kept it. Here’s how that chart continues:
2. For example, if you’ve got a pay-fixed swap, then you’re calculating the size of the check based in part on swap rates, and a higher swap rate makes the check smaller. And let’s say your contract says that the contract terminates “as of the time immediately preceding” Lehman’s bankruptcy, and Lehman filed before the open on Monday, September 15. Do you use a swap quote as of September 15, when the 5-year swap was at around 3.45%, or do you use a quote as of Friday, September 12, the last trading day before Lehman filed, when the 5-year was around 3.85%? The Federal Home Loan Bank of Cincinnati used September 12. Lehman is suing them over, basically, that. The suit is for $63.9 million.
3. This, obviously, abstracts wildly from “Second Method and Market Quotation” but I don’t wanna hear it.
4. Or take Havenwood-Heritage Heights, a retirement community that Bloomberg mentions:
Havenwood-Heritage Heights paid a termination fee of about $420,000 in 2009. The nonprofit disclosed that Lehman wanted another $1.9 million as of Dec. 31 — an amount equal to what the retirement community spent on food and utilities that year, according to its financial statement.
From that financial statement:
On September 15, 2009, the Community gave notice to Lehman that it was in default and designated September 16, 2009 as the early termination date for the swap. During 2009, the Community made a payment of $421,142, which was determined by the outside derivatives consultant to be the estimated final payment for termination and settlement of the swap agreement. This calculation utilized the current mid-market swap rates, as well as adjustments to reduce the swap liability for loss of funding, loss of bargain, the cost of re-establishing the hedge, and professional fees incurred. …
On September 16, 2009, the Community entered into a new interest rate swap agreement on the Series 2009 bonds with RBS Citizens, N.A. holding an original notional amount of $15,675,000. … This interest rate swap agreement effectively fixes the rate of interest on the Series 2009 bonds at 2.775%, through September 1, 2014, which is the termination date of the swap.
The Lehman swap was fixed at 3.937%, versus the 2.775% on the new one.a So H-HH saved 1.16% of $15mm, or about $175k per year, by entering the new swap. Over 5 years, that’s a present value of $700-$800k depending on how you PV – not $420k.
a. There are some other wrinkles ($15,000,000 notional and 2016 maturity in the old bonds/swap, a re-funding, a loan in the new swap) that I’m ignoring here, perhaps wrongly. Also, btw: I have no idea why this all happened in 2009, a year to the day after Lehman filed. Series of typos?
5. I MEAN, you can blame them for wanting the $63.9mm they’re actually suing for. They take sort of opposite-extreme views, demanding payment based on the counterparties’ best possible replacement cost rather than their actual replacement cost (vs. the counterparties using, more or less, their worst possible replacement cost). Also this, per Bloomberg, seems pretty blameworthy:
Lehman tacks on interest of almost 14 percent annually on unpaid swap debts, said Phil Weeber, director of risk management at Kennett Square, Pennsylvania-based Chatham Financial, who is advising corporate clients in mediation with the bank’s estate. The rate is based on Lehman’s cost of funds, which is the London Interbank Offered Rate plus 13.5 percent. Lehman’s claims are now almost double the original amount, based on the interest they’re charging, he said.