As Wall Street plunged headlong into the wreckage left behind by Lehman Brothers in September, 2008, derivatives traders faced a choice. Collectively tasked with valuing 900,000 now-worthless Lehman derivatives, traders could give the deceased bank some leeway. Or they could do what they do best: turn the screws. At Citigroup, which had some 30,000 Lehman-facing derivatives it was suddenly forced to close out, the prevailing attitude was best summed up by Marc Pagano, the bank’s head of emerging markets credits: “Let them come sue us.”
Sue them Lehman did. Citi ended up claiming it was justified in keeping $2.1 billion in collateral for the derivatives Lehman left behind when it went bust, a number Lehman's estate deemed rapacious. Now, more than nine years since the bank’s implosion, the two sides have reached a settlement. On Friday, it was announced that Citi would return $1.74 billion back to Lehman Brothers Holding Co.
Nobody at Lehman is going to say this out loud, since they just signed a bunch of papers officially deeming the matter water under the bridge, but this settlement is sweet vindication for the estate. At trial, Lehman argued that Citi’s request of $2.1 billion was off by a factor of eight. On Friday they settled for $350 million – a sixth of Citi's demand and far closer to Lehman’s $266 million ask.
“After an epic fight culminating in one of the longest and most complex trials we’ve ever seen, we’re gratified to reach a settlement,” said Andrew Rossman of Quinn Emanuel, who represented Lehman and its creditors. “Lehman has had tremendous success in settling these cases and this is the first time someone tested us at trial. We were up for the challenge.”
It’s a significant ruling for a few reasons. For one, as the biggest derivatives dispute ever to go to trial, Lehman-Citi will loom large over any and all similar suits in the future. The settlement also makes clear that judges might not have much patience for the kind of arguments Lehman’s counterparties have tried to sneak by on – essentially that they didn’t have to abide by contractual provisions that their derivative closeouts be done in a “commercially reasonable” manner. In this case, reason prevails.
In brief, the dispute centered on the question of when a bank goes poof, what happens to its derivatives. At any given time, a derivatives contract between two parties has some market value that depends on its maturity, size, reference entity (e.g., Argentina, IBM, the euro), etc. If one counterparty goes kaput, it’s up to the surviving one to come up with a total value of what all the now-cancelled contracts would have been worth.
There’s one big catch here. Counterparties typically have between them numerous different trades that end up canceling each other out from a risk standpoint. For instance, a $10 million long Citi position on Argentina’s debt might be partially netted by a $5 million short position. So instead of replacing both trades, Citi might just have to replace one $5 million Argentina long. Which trades actually get netted depends on a mess of other factors, like how closely the two trades match in maturity, but this is the basic procedure Lehman expected. Netting derivatives also happens to be SOP when it comes to determining risk for a bank’s entire derivatives portfolio, a routine exercise that virtually every bank does virtually every day.
But instead of netting all its Lehman trades, Citi valued them on a trade-by-trade basis, leading to a much higher final bill for the Lehman estate. Moreover, when Citi traders went about determining hypothetically what each of the trades would fetch on the open market, they tended to do so at what Lehman considered the widest possible part of the bid-ask spread.
As Citi’s head of emerging markets credit instructed a subordinate: “Pretend they weren’t a dealer, they were a real money, slow moving deer account.” Translation: When valuing these derivatives, act like you’re trading on behalf of one of Citi’s small-time clients, not a sophisticated broker-dealer capable of understanding when it was getting ripped off.
The final settlement doesn’t provide any detailed insight into where Lehman had the upper hand on these various points of contention. And (notwithstanding Citi’s opening position that its closeout procedures didn’t have to be commercially reasonable) reasonable people can disagree on the particulars.
But it’s clear that by the time the settlement was being drafted, Citi didn’t find its negotiating position as strong as it was coming into the case. It’s even worth asking whether Citi would have gotten a better deal if it had just taken the industry-wide settlement framework that Lehman reached in 2011 with ten other banks. (If you have any insight on this point, you know what to do.)
Now there’s just one major derivatives claim left on Lehman’s assets: the $1.1 billion claimed by Credit Suisse. And given Citi's settlement, there might be some tough conversations happening today in Zürich.