4.2 Effects of the Lehman Collapse on Different Counterparties
4.2.1 Third-Party Creditors: Exposures and Expectations
The Lehman bankruptcy implicated a vast number of affiliated and third-party creditors with a dizzying array of connections to the failed firm. The Modified Third Amended Plan dictates how Lehman’s assets are to be distributed and thus provides a reasonable
baseline for expected losses. Table 4.1 illustrates the Modified Third Amended Plan’s projected recoveries and losses for key creditor groups, totaling $135 billion, a modest
number especially considering that it was not concentrated in any systemic firm.
Table 4.1 Projected recoveries of key creditors under modified third amended plan (USD in billions)
Note: See Disclosure Statement for Third Amended Plan, supra note 190, Exhibit 4. In this table and the text and tables that follow, all claims and recovery data for the Modified Third Amended Plan are based on information from the disclosure statement for the Third Amended Plan.
The projections in the table are, however, of limited value, as potential recoveries may diverge due to the uncertainty of the realizable values of Lehman’s assets.66 To say claims proved to be modest is less important than gauging how great such claims were estimated to be at the time of the Lehman bankruptcy. This subsection therefore focuses on the magnitude and nature of third-party exposures to LBHI and its Chapter 11 affiliates and, to some degree, the recoveries that third parties expected or had reason to expect from the estate, concluding that the potential exposure of $150–250 billion was not
destabilizing and that creditors could have reasonably expected to recover on a nonnegligible portion of their claims.
The claims data from the Initial and Modified Third Amended Plans provide a clear picture of the magnitude and sources of potential third-party exposure to Lehman. As table 4.2 indicates, $1.162 trillion in claims were initially filed against LBHI and its
affiliated US debtors,67 but, for several reasons, this number is at least around four times higher than the most relevant real exposure figure.
Table 4.2 Claims filed against LBHI and affiliated Chapter 11 debtors (USD in billions)
Note: Numbers may not add up due to rounding or, in the case of the Third Amended Plan, the exclusion of (a negligible amount of) priority and secured claims. See Alvarez & Marsal, Lehman Brothers Holdings Inc.: The State of the Estate 23 (Sep. 22, 2010) (for the first three columns); Disclosure Statement for Third Amended Plan, supra note 190, Annex A-2, A-3 (for the final two columns).
a. Claims data have been made available only for the Third Amended Plan, but the Modified Third Amended Plan is presumably based on the same claims data as the Third Amended Plan. Thus, in the claims context, all references in this report to the Modified Third Amended Plan are based on information from the disclosure statement for the Third
Amended Plan.
First, only about 50 percent of the initially filed claims—around $570 billion—were actually brought by actual third parties as opposed to Lehman affiliates.68 The claims of Lehman entities in Chapter 11 against other Lehman entities (the bulk of which were also in Chapter 11)69 have no direct impact on the overall recovery of third parties and are thus of limited value in assessing the fallout from LBHI’s filing. However, claims of Lehman entities not involved in the Chapter 11 proceedings, such as those filed by foreign
affiliates, are relevant.
Second, third-party claims tend to overstate exposures. Many third-party claims were filed twice—once as a primary claim against an LBHI affiliate and once as a so-called third-party guarantee claim against LBHI pursuant to its guarantee. Underscoring the extent of such double filing, approximately $144 billion in primary third-party claims were initially filed against an LBHI affiliate,70 and $255 billion in third-party guarantee claims were filed against LBHI.71 Regardless of the propriety of permitting third-party guarantee claims—an issue that was at the core of the substantive consolidation debate—
it is clear that when the same underlying obligation supports multiple claims, total claims overstate total underlying obligations.
Third, invalidly filed claims further contribute to the general overstatement of third- party exposure. In the First Amended Plan filed in January 2011 (“the First Amended Plan”)72, the estate reduced the $775 billion in total then-filed claims to a $367 billion
“estimate of claim amounts” on grounds that many filed claims were inappropriate
because they were duplicative, overstated, or unrelated to any liability of a Lehman debtor in Chapter 11.73 Obviously some creditors filed inflated claims to maximize their recovery even though they knew such claims exceeded their actual losses.
Focusing solely on the subset of third-party claims deemed valid by the estate,74 only
$242 billion in unsecured third-party exposure remains.75 Moreover, as third-party
guarantee claims constitute $95 billion of this amount76 and as most of these claims were also filed as primary claims, the amount of unique third-party claims—and thus the true level of third-party exposure is closer to $150 billion. This relatively low amount of third- party exposure may be attributed to Lehman’s capital structure, especially its use of
secured financing arrangements. As of August 31, 2008, Lehman had approximately $157 billion of repo obligations and $35 billion of securities lending obligations, which
together eclipsed the firm’s approximately $136 billion of long-term unsecured debt and
$4 billion of commercial paper.77 Creditors in these transactions had collateral and were thus not significantly exposed to Lehman’s failure. Had Lehman financed a greater share of its borrowings with unsecured debt, third-party claims would have been larger. Thus Lehman’s capital structure arguably mitigated systemic risk. That said, the probability of failure in the first place might have been lower had Lehman been less reliant on short- term secured financing and instead relied more on long-term unsecured funding.
Long-term, unsecured financing, principally in bonds, is nevertheless the largest source of third-party creditor exposure. The Modified Third Amended Plan estimates that
approximately $84 billion in claims were validly filed on account of senior unsecured debt securities issued by LBHI.78 Not only is this exposure small relative to the firm’s repo exposure, but it was also likely spread across a wide variety of parties at the time of LBHI’s filing. Standard & Poor’s estimates that, as of the filing date, “a broad range of institutions, not just large capital markets players, ... [held] ... this paper.”79
Relative to bonds, exposure to loans and other debt not classified as securities
(accounting for about $20 billion of initially filed claims80) appears to have been more concentrated before the filing, with a large amount of such debt seeming to have
originated from loans made by major Japanese banks.81 Japanese banks and insurers announced a combined $2.4 billion in potential losses from their holdings during the week following LBHI’s filing.82 The Bank of Japan, however, did not view this sum as sufficiently large to threaten the stability of the Japanese financial system.83
Aside from senior unsecured debt securities, OTC derivatives accounted for the largest source of third-party exposure. In fact derivatives claims were filed in greater amounts than unsecured debt claims, although they have also been reduced to a much greater degree. According to the Initial Plan, about $150 billion in derivatives claims were filed, half as primary claims against an LBHI affiliate and half as guarantee claims against LBHI.84 Apart from the fact that these claims are duplicative, both the Initial Plan and, to a greater degree, the Amended Plans indicate that the filings significantly overstate
exposure, because many might have been exaggerated or invalid. The estate significantly reduced estimated primary and guarantee derivatives claims, cutting the former to $30
billion in the Modified Third Amended Plan.85 More on the significance of derivatives claims below.
Another important class of claims involves instruments with embedded derivatives, including structured securities issued in connection with Lehman’s European Medium Term Note (“EMTN”) Program.86 According to the estate’s estimates, about $30 billion of these securities were issued by Lehman Brothers Treasury Co. N.V. (“LBT”), a Dutch affiliate, and about $5.5 billion were issued directly by LBHI.87 A large number of third parties filed claims relating to these products in Lehman’s US proceedings, either because the instruments were issued by LBHI directly or because they were guaranteed by
LBHI.88 Such claims suggest a substantial level of exposure, but the instruments did not in fact pose systemic risk because of their broad retail investor base and small
denominations.
Two other types of third-party claims bear mention, although the estate greatly reduced the estimated amounts of both. First, more than $73 billion in claims were filed in
connection with Lehman’s obligations either to repurchase residential mortgage loans or to indemnify loan purchasers against losses arising from breaches of loan purchase and sale agreements.89 The estate asserted, however, that these repurchase and indemnity claims were significantly duplicative, overstated, and unsubstantiated.90 The Modified Third Amended Plan accordingly estimates that exposure from these claims amounted to only about $10.4 billion.91 Second, approximately $22 billion in claims were filed against LBHI and its affiliated Chapter 11 debtors in connection with prime brokerage
agreements, typically involving LBI or LBIE.92 The Modified Third Amended Plan does not deem any of these claims to be valid.93 Unlike mortgage-related claims, however, the estate’s main contention is not that parties do not stand to suffer the alleged losses but rather that their claims are not actionable against LBHI and its affiliated Chapter 11 debtors, because these entities were not part of the agreements at issue.94
In sum, third-party exposure to LBHI and its US debtor affiliates could not and did not have a systemically significant destabilizing effect. This conclusion does not depend on estimates of the value of the Lehman estate. Even if parties had reason to assume that the estate entirely lacked assets to provide for recoveries, asset connectedness would still not have been a significant problem in the immediate aftermath of LBHI’s filing.
Another way to assess the exposure of creditors is based on the expectation of creditor recoveries as reflected in the Lehman bond prices. Figure 4.1 illustrates that even at their lowest point, prices of LBHI bonds and, by extension, LBHI senior unsecured claims were always well above zero in the aftermath of LBHI’s filing.
Figure 4.1 Representative LBHI senior unsecured bond trading prices
Sourced from Bloomberg
Parties holding claims guaranteed by LBHI had even more reason for optimism. In the months leading up to the September 2009 claims deadline, expected recoveries on LBSF claims backed by LBHI guarantees rose from approximately twenty cents to forty cents, as market participants believed that they would be able to seek recovery from both
entities.95 The effect of this early optimism was particularly significant, because sellers of LBSF claims during this period were primarily large broker-dealers, while buyers were hedge funds specializing in distressed debt.96 The buoyant market thus allowed for systemically risky institutions (large broker dealers) to off-load Lehman exposure at meaningful recovery levels and—with transfers of Lehman claims totaling approximately
$4.4 billion in 2009, $28.7 billion in 2010, and $32.4 billion in 201197—in substantial amounts. Liquidation would generate about $59 billion and an orderly liquidation would produce about $76 billion in distributable value.98