Lehman Debt: When a Senior Bond Is Very Junior

Many people are baffled by how Lehman senior debt has been trading after they filed for Chapter 11 protection, as I illustrated in a previous article. Turns out Robert Waldmann at AngryBear has an excellent analysis on the same topic, only earlier.

But, after some more research, I realized it's more general than Lehman selling CDS protection on itself, although the irony makes it more interesting. Generally speaking, in bankruptcy code, derivatives counterparty claim can go right through Chapter 11 protection and force liquidation. Chicago Fed in fact had a research paper in 2004 (thanks to Seeking Alpha reader emrald) analyzing the original rationale behind and the unintended consequences -- cliche of the month? -- of this exceptional treatment of derivatives.

So, what does it mean? If you buy senior debt from a company with significant activity in the derivatives business, your senior bond is in fact subordinate to all such counterparty claims. In case of Lehman, it's not hard to imagine how counterparty claims could easily eat up all that's left. I'm just surprised the market thinks there would still be around 10 cents on the dollar left when all counterparty claims are settled.

If you think only financials are involved in significant derivatives trading, you'd be wrong. Virtually all big companies today are neck deep in this business.

This is arguably one of the biggest stealth dilutions (to bond/equity holders) in today's capital markets. The other one would be off-balance-sheet but that belongs to another day.

Market CDS spreads often imply significantly higher default probability than historical data suggest. There're a plural of potential justifications for this apparent "discrepancy". But I tend to think a big part of it is not that market is implying higher default probability. It's lower recovery that market has been trying to say all along.

So, how did such bonds ever get the "senior" label? Did the rating agencies take this into account when rating them?

These are $700B questions, in court. (Not that I'm trying to be dramatic, it's just that anything less than $700B doesn't carry any weight nowadays...)

Comments

[whidbey:]

Very interesting. I would never have dreamed that CDS, especially those off balance sheet, would be senior to bonds. In fact I still don't believe it and I will read the paper you cite. This will come as a shock to many experienced bankruptcy lawyers who would have guessed the CDS being contractual agreements would unsecured creditors at very best. How anything more can be justified in the US Code is worth knowing. I suspect the answer lies in a hidden rider that amended the Code. Government by secret agreements is the rule these days. I wonder how a federal trail judge will rule on the preference?

2008 Oct 14 08:04 PM

[Bo Peng:]

Whidbey, my understanding is general counterparty claim is equal to unsecured subordinated debt, but derivatives is an exception. This is not my expertise, so I'm open to correction.

2008 Oct 14 08:14 PM

[emerald @ao...:]

www.nysun.com/business.../-- read this. sheds some more light on the expemption's implication

2008 Oct 14 09:56 PM

[Fred78:]

To the extent Lehman wrote CDS on its own senior bonds increases the % the junior bondholders get because the subordination adjustment is reduced when the senior is delivered back and cancelled? I'm so confused!

2008 Oct 15 07:58 AM

[Bo Peng:]

Emerald, you're an excellent source of info!

Fred78, CDS and other derivatives counterparty claims don't help anybody. They dilute recovery for all debt holders. However, if you bought bonds as well as CDS on Lehman from Lehman, then your loss on bonds will be compensated by the super-seniority of your CDS claim. Depending on recovery of CDS and the ratio of your bond vs CDS positions, you could even be over-compensated, recovering >100% of your bond. Self-referencing CDS is basically an accounting scam and should be banned, IMO.

2008 Oct 15 04:54 PM

[Kinabalu:]

Wow! Very interesting. This should have been a major rating company issue. I believe repurchase agreements are also exempt from the bankruptcy courts automatic stay. What's left for the senior debt?

I wouldn't be surprised, if, behind this strange bankruptcy code drafting, is a nice benefit to some very happy special interest with a good lobbyist.

2008 Oct 18 02:31 AM