The Collapse of Lehman Brothers (2008)

This event matters for risk management that monitors counterparty credit risk and for operations that terminate and settle contracts. When Lehman Brothers failed, many contracts had to be terminated and settled at once, and the regulation of OTC derivatives changed afterward.

What happened

At 1:45 a.m. on September 15, 2008, Lehman Brothers Holdings Inc. (LBHI) filed for Chapter 11 of the U.S. Bankruptcy Code¹. It was reported as the largest bankruptcy proceeding ever filed². The history of the failure was set out in a report by the Examiner, Anton R. Valukas, whom the court assigned to investigate ten matters³.

In Japan, the failure of Lehman is sometimes called the "Lehman shock"⁴. English-language sources call it the failure of Lehman Brothers or the Lehman bankruptcy, and call the broader crisis the financial crisis⁵.

For derivatives, Lehman was a party to a large number of OTC derivatives. After the failure, the contracts had to be terminated and settled all at once.

Background

According to the Examiner's report, Lehman had about USD 700 billion of assets and about USD 25 billion of capital. Its assets were mostly long-term and its liabilities mostly short-term, and it borrowed much of its daily funding in the short-term repo market. If lenders lost confidence and refused to roll over their loans, Lehman could not raise funds and could not keep operating⁶. Dividing assets by capital gives about 28 times (a calculation)⁷.

In March 2008, Bear Stearns was brought to the brink of failure. This showed that Lehman's growth strategy had been flawed and put its survival in question⁸.

Around the same time, the market for credit default swaps (CDS) was growing rapidly⁹. A CDS is a contract in which the seller covers the losses if a bond or a loan defaults. A 2009 paper from the Federal Reserve Bank of New York points out that the opaqueness of this market leaves participants unsure of the true exposure of sellers in a crisis, which adds uncertainty. It also points out that trading in the market has implications for systemic risk (the risk that the flow of financial services is disrupted and the real economy is seriously harmed)¹⁰.

Timeline

The main events of September and October 2008 followed the order in Figure 1. The table gives the details of each event.

Figure description

The timeline runs from the fall in Lehman's share price through the holding company's filing, the AIG rescue, the group company's filing, and the CDS auction. The filled circles mark the holding company's filing and the CDS auction. Within a month of the filing, a group company filed and the auction was held.

Over the weekend ending September 14, the government brought the parties together for a meeting. Baxter told the Examiner that Paulson, then the Treasury Secretary, described the purpose of the meeting as brokering a purchase of Lehman or, failing that, dealing with the consequences of a failure. According to the report, the government's analysis was that the federal government had no authority to invest directly in Lehman, and that Lehman's assets were not enough to support a loan of the size needed. Paulson told the Examiner that he concluded he had no authority¹⁷.

On the night of September 14, Christopher Cox, Chairman of the US Securities and Exchange Commission (SEC), called Lehman's board and told it that the government was urging action before the markets opened¹¹.

The Examiner says that sorting out whether the turmoil after September 15 was a direct result of Lehman's filing was beyond the scope of the investigation. The Examiner then cites the fall in the Dow, the rescue of AIG, and the Primary Fund's loss of principal as facts that show the weight of the filing¹³. The report says that the cost of the AIG rescue was ultimately about USD 182 billion¹³.

What happened to the derivative contracts

Lehman held its derivatives in two forms: bilateral contracts, and contracts cleared through a central counterparty. The treatment after the failure differed greatly between the two.

Bilateral contracts

Lehman's derivatives were entered into under the ISDA Master Agreement. LBHI was the credit support provider for the obligations of Lehman group companies in almost all of these trades, so the LBHI bankruptcy filing was an event of default under the ISDA Master Agreement¹⁸. How a contract is terminated and settled is covered in Close-Out Netting.

The numbers are as follows. More than 6,000 derivative claims were filed against Lehman and its affiliates, covering more than 900,000 trades¹⁹. Depending on the source and the date, the number of trades ranges from about 900,000 to about 1.18 million, and the number of contracts from about 6,100 to about 6,400, so the counts are not consistent¹⁹.

Termination went quickly in terms of numbers. Of the more than 900,000 trades, 733,000 were terminated automatically by November 13, 2008. About 80% of LBSF's counterparties terminated under the ISDA Master Agreement within five weeks of the filing. The New York Fed paper calls this the largest-ever termination of derivatives transactions²⁰.

Settlement after termination, on the other hand, took time. After termination, Lehman's side had to match the trades of each counterparty, value them one by one, and negotiate the settlement amounts. The share of ISDA contracts that had been settled was 6% in July 2009 and 46% in September 2010²¹. The contracts of large counterparties were a minority by number but a large share by value, and termination alone took years²².

Contracts cleared through a central counterparty

Contracts such as futures that were cleared through a central counterparty were handled outside the bankruptcy proceedings. For accounts in which Lehman acted for customers, the central counterparties closed them or transferred them to other brokers. Many central counterparties closed Lehman's own positions. The central counterparties halted or limited the access of Lehman entities to the market within hours and were able to deal with many of the positions without large losses. The response of the Chicago Mercantile Exchange (CME) was debated²³.

The CDS auction

CDS referencing Lehman were settled in an auction on October 10, 2008. 358 parties took part through 14 dealers. The final price was 8.625 per 100 of face value, so CDS sellers paid 91.375% of the notional amount (a calculation: 100 − 8.625)¹⁶.

Right after the failure, market participants worried that CDS sellers would bear large losses based on the gross total of the CDS notional amount. In practice, long and short positions offset one another, and the net amount was far smaller. According to figures from DTCC (Depository Trust & Clearing Corporation), the gross notional amount of Lehman CDS was about USD 72 billion, and the net payment from sellers to buyers through the auction was about USD 5.2 billion²⁴.

Only about one third of Lehman CDS could have been written as a hedge of bonds. The other two thirds were pure derivative positions, not hedges of bonds²⁵.

The New York Fed paper also says that Lehman's inadequate pre-bankruptcy planning may have greatly reduced the value of the Lehman estate and may have led to many disputes with creditors. This concerns the handling of Lehman's bankruptcy as a whole, not only derivatives²⁶.

Causes

The Examiner's report says that there were many reasons Lehman failed and that responsibility is shared. According to the report, Lehman was more the consequence than the cause of a deteriorating economic climate. Three things made the situation worse.

• The actions of Lehman's management
• An investment bank business model that rewarded excessive risk-taking and leverage
• The response of government agencies, which themselves acknowledge that they could have better foreseen or softened the consequences²

The business model was not unique to Lehman. The major investment banks ran similar high-risk, high-leverage business models⁶.

As an example of management's actions, in 2006 Lehman decided to pursue an aggressive growth strategy, take more risk, and increase leverage on its capital. In 2007, as subprime mortgages moved from a problem to a crisis, Lehman did not scale back its business and instead sought profit with a countercyclical strategy. During this period Lehman exceeded its own risk limits many times²⁷.

What changed afterward

In September 2009, the G20 leaders set out the direction of OTC derivatives reform in the statement from the Pittsburgh Summit. The statement said that standardized OTC derivatives should be traded on exchanges or electronic trading platforms where appropriate, and cleared through central counterparties, by the end of 2012 at the latest. It also said that OTC derivatives should be reported to trade repositories and that higher capital requirements should apply to trades that are not centrally cleared²⁸.

In October 2009, the International Monetary Fund (IMF), the Bank for International Settlements (BIS), and the Financial Stability Board (FSB) reported guidance requested by the G20. The guidance concerns assessing the "systemic importance" of financial institutions, markets, and instruments²⁹.

The Dodd-Frank Act was enacted in the United States in July 2010, and EMIR was signed in the EU in July 2012.

The G20 reforms as a whole, including margin requirements, are covered in The G20 OTC Derivatives Reforms.

What this page does not cover

The causes of the financial crisis as a whole, such as the housing market and securitization, are not covered on this page.

Notes

1. Valukas report (Volume 1), page 13 (PDF page 56). Footnote 50 of the report gives the filing as Voluntary Petition (Chapter 11), Docket No. 1, Lehman Brothers Holdings Inc., Case No. 08-13555 (Bankr. S.D.N.Y. Sept. 15, 2008). ↩

2. Valukas report (Volume 1), pages 2–3 (Introduction; PDF pages 45–46). It gives the January 29, 2008 high as USD 65.73 per share and the September 12 close as under USD 4, a fall of about 95%. For the statement that this was the largest bankruptcy proceeding ever filed, footnote 7 of the report cites a news report (Bloomberg). ↩ ↩² ↩³

3. Valukas report (Volume 1), page 15 (PDF page 58), I. Executive Summary. The order appointing the Examiner assigns ten matters for the Examiner to investigate. ↩

4. The Japanese name is "リーマン・ショック" (Rīman shokku). Speech by Masaaki Shirakawa, then Governor of the Bank of Japan, "中央銀行の役割、使命、挑戦" (The role, mission, and challenges of central banks, in Japanese), January 25, 2013. Under that heading, the speech discusses the failure of Lehman Brothers in September 2008, and later uses the term for this event, as in "six years before the Lehman shock" (translated from the Japanese). ↩

5. The English names are based on the title of the New York Fed paper, "The Failure Resolution of Lehman Brothers", and on the usage of "the Lehman bankruptcy" and "the financial crisis" within the paper. ↩

6. Valukas report (Volume 1), pages 3–4 (PDF pages 46–47). Lehman held about USD 700 billion of assets, and the corresponding liabilities, on about USD 25 billion of capital (footnote 8). Assets were mainly long-term and liabilities short-term, and Lehman had to roll over tens to hundreds of billions of dollars each day. ↩ ↩²

7. About USD 700 billion ÷ about USD 25 billion = 28. This is a calculation on this site using the approximate figures in the report. The report does not state 28 times. ↩

8. Valukas report (Volume 1), page 4 (PDF page 47). ↩

9. Federal Reserve Bank of New York, "Credit Default Swap Auctions" (May 2009), abstract (PDF page 1) and page 1 (PDF page 3). The abstract describes the rapid growth of the CDS market, and page 1 describes a CDS as essentially an insurance policy on corporate debt. ↩

10. The same paper, page 1 (PDF page 3). The opaqueness of the market means participants often do not know the true exposure of CDS sellers, creating further uncertainty at times of crisis, and trading in the market has implications for systemic risk. ↩

11. Valukas report (Volume 1), pages 11–13 (PDF pages 54–56). Early on September 14, a deal with Barclays appeared to be coming together, but it fell apart because the FSA did not waive the shareholder approval requirement. That night Chairman Cox called the board (footnote 49). ↩ ↩²

12. New York Fed paper "The Failure Resolution of Lehman Brothers" (December 2014), pages 183–185 (PDF pages 9–11), footnote 19. That the day was a Sunday comes from the title of the Reuters article (September 14, 2008) cited in footnote 19. ↩

13. Valukas report (Volume 1), pages 13–14 (PDF pages 56–57). The filing came at 1:45 a.m. on September 15, the Dow fell 504 points, AIG was on the brink of failure on September 16, the cost of the government's rescue was ultimately about USD 182 billion (based on the news report cited in footnote 52), and the Primary Fund (a USD 62 billion MMF) announced that it had "broken the buck." The report says that sorting out whether the turmoil was a direct result of Lehman's filing was beyond the scope of the Examiner's investigation. ↩ ↩² ↩³ ↩⁴

14. New York Fed paper, page 185 (PDF page 11), footnote 20. LBSF did not file for bankruptcy until October 3, 2008. ↩

15. Valukas report (Volume 1), page 14 (PDF page 57). On October 3, 2008, Congress passed the USD 700 billion TARP. ↩

16. New York Fed, "Credit Default Swap Auctions", pages 20–21 (PDF pages 22–23), "Box 1: Lehman Brothers as an illustration of the CDS auction mechanism". The auction was held on October 10, 2008, 358 parties took part through 14 dealers, and the final price was 8.625. ↩ ↩²

17. Valukas report (Volume 1), pages 11–12 (PDF pages 54–55), text and footnotes 44-45. The purpose of the meeting is from Baxter's statement to the Examiner in footnote 44. The conclusion that there was no authority for a direct investment is from Paulson's statement to the Examiner (footnote 45). ↩

18. New York Fed paper, page 185 (PDF page 11). LBHI was the credit support party for almost all of the trades, and its bankruptcy filing was an event of default under the ISDA Master Agreement. The report uses the term "credit support provider", and the New York Fed paper uses "credit support party". ↩

19. New York Fed paper, page 185 (PDF page 11), text and footnote 21. The reports of the Lehman estate give different figures at different times: about 906,000, 930,000, and 1,178,000 trades, and 6,120, 6,340, and 6,355 contracts. ↩ ↩²

20. New York Fed paper, page 185 (PDF page 11), and Table 2, Panel B, on page 184 (PDF page 10). The assessment of the largest-ever termination cites the U.S. Government Accountability Office (2011). ↩

21. New York Fed paper, page 185 (PDF page 11). The Lehman estate needed three steps: matching trades with counterparties, valuing them, and negotiating settlement amounts. On December 16, 2008, the court approved the settlement procedure. 6% had been settled by July 2009 and 46% by September 2010. ↩

22. New York Fed paper, page 178 (PDF page 4). The derivatives of counterparties such as large institutional investors were a minority by number but a large share by value, and termination alone took years. ↩

23. New York Fed paper, Appendix B (page 196; PDF page 22). The central counterparties halted or limited the participation of Lehman entities in the market within hours, and closed many customer and house positions without large losses to the central counterparties. The CME's response was debated. ↩

24. New York Fed, "Credit Default Swap Auctions", page 10 (PDF page 12). According to DTCC figures, the gross notional amount of Lehman CDS of USD 72 billion became a net cash flow of USD 5.2 billion from sellers to buyers in the auction. ↩

25. New York Fed, "Credit Default Swap Auctions", around page 4 (PDF page 6). About one third of Lehman CDS could have been written as a hedge of bonds, and the other two thirds were pure derivative positions, not hedges of bonds. ↩

26. New York Fed paper, abstract (PDF page 1). The authors' view, covering the handling of Lehman's bankruptcy as a whole, not only the settlement of derivatives. ↩

27. Valukas report (Volume 1), page 4 (PDF page 47), footnotes 12-14. They cite material from a 2006 strategy meeting, the board minutes of March 2007, and the monthly average amounts by which risk limits were exceeded. ↩

28. "G20 Leaders Statement: The Pittsburgh Summit" (September 2009, Pittsburgh Summit), paragraph 13. ↩

29. IMF, BIS, and FSB, "Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations" (October 2009), cover letter. A report on guidance requested by the G20 leaders in April 2009. ↩