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Lehman On The Hot Seat


Lehman Brothers is the Hot Topic of Discussion Today at the Fed/Treasury in the US. Shall we cut it, break it, fold it or let it die? The question is no longer about giving it credit, hoping it will come back or how to make it recover. It’s about what’s in the ashes, because the building has burnt down.

Lehman’s gone through a heck of a lot, from a trading company to a major player in the securities business. Lehman was not just Lehman, it had at one point taken over Kuhn Loeb (another big company pre-60s), then merged with Shearson to be become Shearson Lehman/American Express, and was even Shearson Lehman [E.F.] Hutton. It demerged in 94, and went public as Lehman Brothers Holdings (LEH).

But sometimes, bets go off. LEH focussed on Commercial Real Estate (CRE) assets which have only been sliding down in value after the real estate meltdown. This is a seriously leveraged business so Lehman’s short a lot of capital now. No one wants to give it capital. Hank Paulson, the treasury secretary, can’t find a reason to fund Lehman anymore after all the drama he’s done for Bear Stearns, Fannie Mae and Freddie Mac. He’s literally begging anyone to please go buy Lehman.

Problem is, everyone’s going to want the same kind of deal JP Morgan got with Bear Stearns. The government funds the losses after a certain point. Given that was a bad example in the first place, the government will likely say No. And that’s not good for the future of what used to be Lehman.

Look at the CDS spread. From 33 basis points (33,000 per 10 million $ debt) in March 2007, spreads have gone up to a ridiculously high 800 basis points as of Sep 11, 2008. That’s 800K to insure 10 million in debt, and as high as that sounds, it may look like a bargain if LEH declares bankruptcy.

Question is: what happens if LEH goes under? First, its partners get limited control of its assets. So they may have Lehman collateral or own Lehman debt but they will need to go through bankruptcy protection laws to be able to sell or liquidate.

Second, the CDS writers – typically trading arms of other banks, or monoline insurers like Ambac and MBIA – get hit badly because they are required to insure the debt. If LEH decides to pay out only 10 cents to the dollar, Mr. CDS Writer is required to pay the other 90 cents. I don’t know the extent of this, and I would not be surprised to know that CDS written on LEH debt exceeds the size of LEH debt by a factor of 10 or something. It’s happened before. What happens then is that the CDS writers are utterly destroyed. This is a consequence, and will only be evident to most of us after the fact.

(Note: If Ambac or MBIA go under because of this and WaMu/AIG going down, life is going to be very very very very bad)

RGE Monitor’s article suggests that Lehman is itself a major player in the CDS counterparty business. The impact of unwinding a dealer default of this scale can both deleverage or bankrupt a large number of other players.

That’s assuming LEH declares bankruptcy. If it hurts too many others, someone may end up buying – with some guarantee from the Fed/Treasury. But how long will that continue? Answer: Till it can. No one will be able to stop this because it’s gone too far already.

In India, LEH has a lot of investments through hedge funds. I counted, in an online spreadsheet, about 1011 cr. of public investments where Lehman has declared more than a 1% exposure. (Source: They obviously own a lot of other stock, which might be worth say $2 billion or so. That’s good capital, but in the list I’ve got, their stake is many times the average daily turnover of these stocks, and the impact cost of unwinding it all is huge. I think they’ll do a fire sale of these assets in block deals.

Lastly, they’ve just made a deal with Unitech to invest $700 million for two projects. I doubt that will happen. Was Unitech depending on this cash flow? Time will tell.

The final touches to a behind-closed-doors deal for the future of Lehman are currently being applied. Stay tuned, there will be more to come.


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