Derivatives Pose New Wrinkle in Lehman Case
'A Huge Amount of Uncertainty'
By JULIE SATOW, NY Sun September 25, 2008
nysun.com
Bankruptcy lawyers and law professors are preparing for a journey into uncharted territory as the credit default swaps market gets dragged into the Lehman Brothers bankruptcy proceeding.
"The courts have dealt with credit default swaps very infrequently, and certainly not at the scale they are now out there," a lawyer at Washington, D.C.-based Caplin & Drysdale, James Wehner, said. "We have a new law and a new financial phenomenon, so there is a lot of uncertainty."
In recent weeks, regulators and the financial press have zeroed in on credit default swaps, a type of private contract that insures a bond in case of default. As of the first quarter of this year, more than $16 trillion worth of bonds were covered by credit default swaps, according to the Office of the Comptroller of the Currency. The trade group the International Swaps and Derivatives Association places that number much higher, at $62 trillion, and estimates that about one-third of the credit default swaps contracts lack collateral, that is, the issuers of the contracts failed to set aside assets in case the bonds default. Concern yesterday that a $700 billion federal bailout may not pass Congress and worry over the health of the financial industry sent the cost of protecting Morgan Stanley's and Wachovia's bonds from defaults, or their credit default swap rates, soaring.
Meanwhile, two of the largest players in the credit default swaps market, American International Group and Lehman, issued billions of dollars of these insurance contracts over the past several years, and also issued billions of dollars in bonds on which other firms had issued credit default swaps. Market insiders had fretted that were the companies unable to cover the insurance contracts they had issued, or were they to default on their bonds, it would create waves of losses. While the federal government stepped in to save AIG with an $85 billion loan, Lehman had no such luck.
The investment bank, which filed for Chapter 11 last week, was one of the 10 largest parties in the credit default swaps market, according to Fitch Ratings. Lehman's exact exposure to credit default swaps is unknown, but the firm's bankruptcy is apparently the first large-scale default of a major credit default swaps player.
One of the most pressing issues is the new bankruptcy law enacted in 2005. While claims from bondholders, shareholders, and others are frozen once an entity like Lehman declares bankruptcy, holders of derivatives are exempt from this mandatory stay under the revised code.
"Most of these exotic financial derivative products are exempt from the bankruptcy laws, and this is creating a huge amount of uncertainty," a professor of law at the University of Texas, Jay Westbrook, said. "In bankruptcy, there is a freeze, an automatic stay, creating an element of order and control, even transparency. That isn't true with these financial assets."
The exemption means that investors who own credit default swaps on Lehman bonds can immediately claim the bonds, leaping in front of the traditional bondholders who must wait until the bankruptcy filing is settled. It also means that funds that bought credit default swaps from Lehman, which are now busted because the bank is unable to cover the insurance, can immediately claim assets from Lehman as collateral.
This exemption raises a number of questions, people said. For example, while it might sound like a good deal for holders of credit default swaps to jump the line in front of bondholders and receive a Lehman bond, "my guess is that bondholders will get little or nothing," Mr. Westbrook said.
And for those funds that own credit default swaps they bought from Lehman, and are now able to collect collateral, many are reportedly waiting it out, fearful that if they were to seize Lehman's collateral and sell it, it would create a fire sale and drive down the prices of the bank's assets.
A professor of corporate law at the University of Pennsylvania Law School, David Skeel, who specializes in derivatives, said he is fielding calls from lawyers at major firms confused as to how to handle these issues. "I just keep telling them that I myself am still trying to figure it out," Mr. Skeel said.
There are other complications, including the interconnected web of derivatives that make it nearly impossible to know which funds own which credit default swaps, and the value of these instruments.
"Some hedge funds have entered into so many different contracts with Lehman that no one knows what the net positions are," a professor of law at Columbia Law School, Edward Morrison, said.
There is also the issue of speculative credit default swaps, where hedge funds and others bought credit default swap contracts for bonds they didn't own. With this in mind, the trade group ruled that the parties didn't need to present a physical bond to settle the contract. Known as a cash settlement, versus a physical settlement, it has become increasingly popular, making it even harder to value or track the instruments.
"Cash settled credit default swaps don't have the same relationship to the bankruptcy process as physically settled credit default swaps, where the party essentially just becomes a bondholder," Mr. Skeel said. "It is unclear what will happen in these instances."
There is also confusion about the effects of the potential $700 billion federal bailout. If the federal government buys much of the toxic mortgage debt that the banks hold, it is not clear what will happen to the credit default swaps written to insure these mortgage bonds, Mr. Morrison said.
With so much remaining unclear, it is likely just the beginning of an arduous process, market insiders said. As Lehman's defaults trigger more defaults, and the slowing economy puts additional pressure on hedge funds, the bankruptcy court will be forced to contend with more of these instruments.
"We don't know how deep this goes, which hedge funds have big stakes in credit default swaps, but it is certain this will be the next thing we will have to contend with," Mr. Skeel said. "A hedge fund is going to pose all these same nuclear problems as we are seeing with Lehman, and there won't be much the federal government can do about it. At least with investment banks the federal government was in a position to respond." |
