Lehman Brothers, 2008

At a glance

What happened

Lehman Brothers ran high leverage funded short-term, with large holdings of property and mortgage assets that lost value through 2007 and 2008. After Bear Stearns was rescued in March 2008, confidence drained, attempts to find a buyer failed over the weekend of 13 and 14 September, and the holding company filed for bankruptcy on 15 September. It was counterparty to roughly 900,000 derivative trades, and its failure triggered default under nearly every ISDA agreement it had signed.

Why it went wrong

Close-out netting let each counterparty terminate everything under its agreement and arrive at a single net amount, which stopped one failure turning into hundreds of thousands of separate claims. But each bilateral counterparty valued its own book, on its own chosen date, in violently moving markets, and disputes over those values ran for more than a decade. Lehman's cleared swaps at LCH, about $9tn notional, were a different story: they were hedged and auctioned to other members within weeks, using well under half the margin Lehman had posted.

What it teaches

Netting works, but valuing a whole book in a dislocated market, each party on its own terms, does not work cleanly. A clearing house with margin and a rehearsed default process absorbed the cleared book with no loss to anyone else. That contrast led directly to the G20's 2009 commitment to clear standard derivatives, to margin on uncleared trades, and to protocols that pause termination rights when a large bank is resolved.

Key terms

Event of default

A failure listed in the ISDA, such as bankruptcy of a party or its credit support provider, that lets the other side terminate.

Close-out netting

Terminating every trade under one agreement and reducing them to a single net amount owed one way.

Close-out Amount

The 2002 ISDA valuation standard: what it would cost to replace the terminated trades, determined in good faith.

Section 2(a)(iii)

The ISDA condition that a party need not pay while an event of default by the other is continuing.

Default management

A clearing house’s process for hedging and auctioning a failed member’s portfolio, funded first by that member’s margin.

Rehypothecation

A broker reusing client assets it holds as collateral, which turns them into a claim if the broker fails.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of counterparty risk, close-out netting and central clearing. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

The instruments behind it

OTC Learn lessons on the products this case turns on:

• The ISDA ArchitectureThe paperwork that makes every other product possible
• Central ClearingA central counterparty steps into every trade
• Collateral and the CSAThe cash and bonds that back an OTC exposure