Lehman: One Big Derivatives Mess

Enron may look tame compared with this: a fight over billions of dollars posted as collateral, then used in a tangled web of deals

by Matthew Goldstein and David Henry

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Warren Buffett called derivatives "weapons of mass destruction" back in 2003. AFP/Saul Loeb

In 2003, legendary investor Warren E. Buffett called derivatives "weapons of mass destruction." Buffett predicted that the complex financial instruments would morph, mutate, and multiply "until some event makes their toxicity clear." The failure of Lehman Brothers (LEHMQ) may have been the disaster he imagined.

How lethal was the investment bank's derivatives portfolio? Just look at the long line of banks, hedge funds, and other big investors trying to get their money back. Lehman's bankruptcy threw into jeopardy derivative deals with a staggering 8,000 different firms that had paid Lehman billions of dollars in collateral. Now some trading partners are calling on state and federal courts to reclaim their assets, which have been frozen since the Sept. 15 bankruptcy filing. It will be a "very awesome task to try to unwind all of that," says Lehman's lead bankruptcy attorney, Harvey R. Miller, a partner at Weil, Gotshal & Manges.

It turns out that Lehman, like other big dealers, was running a perfectly legal but highly risky game moving money from firm to firm. It used the collateral from one trading partner to fund more deals with other firms. The same $100 million collected in one deal can be used for many other transactions. "Firms basically can use [the money] as their own collateral for anything they want," says Kenneth Kettering, a former derivatives lawyer and currently a professor at New York Law School. But when the contracts terminate as the result of bankruptcy, the extra collateral is supposed to be returned.

Lehman's travails are only adding to the worries shaking the financial system. Not only has Lehman's debacle snagged the portfolios of such big traders as hedge fund firm Harbinger Capital Partners—it has also helped push global short-term lending markets into a deep freeze. It's enough to make some market watchers wonder if Lehman was too big for the U.S. Treasury and Federal Reserve to let fail.

Derivatives contracts—whose value is tied to the performance of an underlying security or benchmark over a specific period—are designed in part to help firms minimize losses from interest rate fluctuations, corporate bond defaults, and other events. The contracts were a big business for Lehman: When the firm went under in September, roughly 1 million derivative deals had its name on them.

Welshing on Deals

As part of those transactions, buyers had put up collateral in the event of losses. But weeks after Lehman's demise, large sums of leftover collateral have yet to be returned to the trading partners. Bank of America (BAC) executives tried several times to persuade Lehman officials via e-mail and phone calls to fork over funds, according to a suit. But BofA was rebuffed. In one e-mail exchange, a Lehman employee wrote to BofA: "All activity has been suspended until further notice."

Nasreen Bulos, a lawyer for one of Dubai's sovereign wealth funds, got the same chilly response. The Global Strategic Equities Fund of Dubai, part of the gulf state's $12 billion investment portfolio, gave Lehman $40 million in June as part of a deal pegged to energy giant BP's (BP) stock. According to an affidavit, Bulos started contacting Lehman on Sept. 15 to get back $27 million in collateral. Four days later, Lehman told Bulos it would not honor the request or say anything further on the matter.