BusinessWeek Logo
News October 8, 2008, 6:48PM EST

Lehman: One Big Derivatives Mess

(page 2 of 2)

Both BofA and the Dubai fund have filed suit against Lehman. They're not alone. Some two dozen Goldman Sachs (GS) hedge funds say in a suit that Lehman owes them "hundreds of millions of dollars." Others trying to get their collateral back in court: ING (ING), Schroders (SDR), Federal Home Loan Bank of Atlanta, the Federal Home Loan Bank of Pittsburgh, and oilman T. Boone Pickens.

Where all that money ended up is a mystery. After Lehman used the collateral for its own deals with other firms, they could have used the money for their own purposes. The International Swaps & Derivatives Assn. (ISDA) estimates that investment shops have collected nearly $2 trillion in collateral as part of derivatives agreements—money that in some cases is used several times over. That's up from $700 billion in 2003, the year Buffett made his prescient prediction. "This has been standard practice for many years, and it is very helpful in contributing to the efficiency of the collateral market," says Richard Metcalfe, ISDA's global head of policy.

In rare cases dealers agree to cordon off the collateral—but even that doesn't mean the money is safe. The Federal Home Loan Bank of Pittsburgh, a government lender to small and community banks, appears to have paid extra to keep its collateral in a segregated account, a precautionary measure designed to avoid this kind of mess. Now it's worried the money may have been lumped in with the Lehman assets sold to British bank Barclays.

Free-flowing, promiscuous money from derivatives helped spur the credit boom to new heights. By using their customers' collateral as their own collateral, Lehman and other firms could borrow more money, using the proceeds to buy the kind of high-risk securities that are now imploding. "It was one way for the leverage bubble to grow," says Christian Johnson, a law professor at the University of Utah.

In theory, Lehman's bankruptcy shouldn't have caused such a stir. When a party goes belly up, derivatives contracts are designed to end immediately and get settled outside of court proceedings. But problems can arise when the amount of collateral exceeds the value of the agreements, which can deteriorate over time.

The Missing Money

Many of the firms now filing claims against Lehman face just that situation. For instance, the Federal Home Loan Bank of Atlanta had a long­standing derivative deal with Lehman to protect against interest rate changes. When Lehman collapsed, the Atlanta bank's agreements were worth $757 million. But it had put up $936 million as collateral. According to court documents, Lehman ignored management's demands to return the extra $179 million.

There's speculation that JPMorgan Chase (JPM), Lehman's primary clearinghouse for trades, may have its hands on some of that money. Lawsuits filed by BofA and others allege that Lehman socked away their collateral in accounts at JPMorgan. After the bankruptcy, JPMorgan grabbed $13 billion that Lehman had pledged as guarantees. BofA and others are wondering whether some of that money is rightfully theirs. JPMorgan declined to comment.

It could take a while to hash this out, since the bankruptcy court has never had such a disaster on its docket. Derivatives disputes, at a judge's behest, could end up in mediation. It happened in Enron's bankruptcy back in 2001. But untangling Lehman's web could prove more tedious. The failed energy giant, then considered a big player in derivatives, had contracts worth about $22 billion. Lehman's tally as of its last annual report: $738 billion.

Goldstein is a senior writer at BusinessWeek. Henry is a senior writer at BusinessWeek.

Reader Discussion

 

BW Mall - Sponsored Links