Lehman's Derivative Portfolio

Abstract

In the Fall of 2008, Lehman Brothers had a $35 trillion derivatives portfolio, representing about 5% of the worldwide derivatives market. It was a party to approximately one million trades, under more than 6,000 ISDA master agreements.

Lehman’s derivatives were not the direct cause of its failure, but its derivatives, and the growth of the derivatives markets in general, led to the assumption of outsized risks and systemic weaknesses that did facilitate the crisis.

In addition to the systemic problems caused by Lehman’s derivatives portfolio, derivatives have also been identified as a key source of value loss in the bankruptcy.

The singular losses caused to Lehman’s bankruptcy estate by Lehman’s derivatives portfolio came from the safe harbors and the system of closeout netting the safe harbors support. While the safe harbors have been thoroughly studied and debated in the abstract, a close look at Lehman’s experience provides important insights for the future. In particular, the largest part of Lehman’s derivatives portfolio shows how financial institutions will again suffer when resolution is attempted in the traditional bankruptcy system. As such, I question the Dodd-Frank Act’s professed preference for “normal” bankruptcy process over specialized insolvency regimes like the new “Orderly Liquidation Authority.”

And the abrupt closeout of Lehman’s cleared derivatives portfolio by CME, which Lehman’s examiner noted as the source of several obvious losses to the bankruptcy estate, also provides important insights, given Dodd-Frank’s strong preference for central clearing going forward.

This paper looks at both issues, and suggests that the continuation of the safe harbors “as is” renders chapter 11 nonviable for larger financial institutions, and recent contractual attempts to work around the safe harbors are insufficient to solve the problem, while the increased role of clearinghouses in financial institution failures will force regulators to confront difficult choices. In short, the regulators will have to balance two competing systemic risks: the risk of an unruly resolution of the financial institution, balanced against increased risk to the clearinghouse.

Keywords: Lehman, Dodd-Frank, swaps, derivatives, safe harbors, systemic risk, clearinghouses, CFTC, OLA, SPOE