Saturday, October 11, 2008

Lehman Brothers accelerates cascading failures on Wall Street

Its often said that one bad apple spoils the whole basket. Very true indeed, as it turns out that Lehman Brothers' story didn't end with just a bankruptcy. Severe repercussions are to follow :

Many investment funds and financial institutions took on insurance policies on Lehman's debt. This meant, that if Lehman were to default on its payment (which it already has), its insurers are to step in and pay approximately $600 billion in claims.

The chances of payment of such a huge sum seem grim, as these insurance products were 'Over-the-counter' products with no or little regulation. This may just prove to be the last straw for the unregulated market for CDS (Credit Default Swaps). Even if they were to pay the claims, they'll be paying billions of dollars for assets that have considerably reduced in value, and will eventually color their balance sheet red with losses.

The latest auction on Friday, 10th October, saw Lehman's bonds diminish to 8 cents on a dollar. This effectively means that 8 cents will be contributed by Lehman and the other 92 cents by various counter-parties and insurers that had placed bets against the debt of Lehman.       A paradox : High value of credit default swaps, but the low price paid by Lehman in the bond's auction mean that the other players in the financial markets (counter-parties and insurers) have billions of dollars in obligations.

Moreover, these swaps are highly intricate and private contracts between the bank and a counterparty so no regulator or clearing house keeps track of them. The real estimate of the CDS Market is therefore not known, and we can just guess the magnitude of Lehman's undoing in this financial turmoil.

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  1. yes CDs was one of the main contributor to the crisis starting with the sub prime crisis.

  2. Chirag, Lehman is a fine example of how pure financial research in investment strategies can fall short. Besides financial research, i also try to stay in touch with the company's governance processes. This entails understanding the composition of the Board of Directors, their powers and the quality and structure of the company's policies and processes. This is a great long term investment tool that a prudent investor should not miss.

    For example: When Lehman fired its Chief Risk Officer in Sept'07 for warning them about their highly leveraged and risky assets, an investor with knowledge of this fact would atleast have scrutinized it carefully and perhaps would have offloaded their investments much before the bankruptcy proceedings. Non financial investment research is the key to sustainable investment in today's falling markets.

    I have posted a series of instances where Financial Companies are missing Critical Senior leadership Oversight on my blog ( I hope you get a chance to check it out.