Lehman Brothers Files for Chapter 11 in the Biggest Bankruptcy

question 51

Short Answer

Lehman Brothers Files for Chapter 11 in the Biggest Bankruptcy in U.S. History
A casualty of the 2008 credit crisis that shook Wall Street to its core, Lehman Brothers Holdings, Inc., a holding company, announced on September 15, 2008, that it had filed a petition under Chapter 11 of the U.S. Bankruptcy Code. Lehman's board of directors decided to opt for court protection after attempts to find a buyer for the entire firm collapsed. With assets of $639 billion and liabilities of $613 billion, Lehman is the largest bankruptcy in history in terms of assets. The next biggest bankruptcies were WorldCom and Enron with $126 billion and $81 billion in assets, respectively.
None of the holding company's subsidiaries was included in the filing, enabling customers of Lehman's brokerage, Neuberger Berman Holdings, to continue to use their accounts to trade. Furthermore, by excluding its units from the bankruptcy filing, customers of its broker–dealer operations would not be subject to claims by LBHI's more than 100,000 creditors in the bankruptcy case.
Prior to the Dodd-Frank Act of 2010 (see Chapter 2) limiting such rights, counterparties could cancel contracts when a financial services firm went bankrupt. Lehman would normally hedge or protect its investments by taking opposite positions to minimize potential losses in its derivatives portfolios. Derivatives are financial instruments whose value changes in response to the value of the underlying assets over a specific period. For example, if the firm purchased a contract to buy oil at a specific price at some point in the future, it would also sell a contract at a somewhat lower price to another party (called a counterparty) to minimize losses if the price of oil dropped. Thus, the bankruptcy filing left Lehman's investment positions unprotected.
On September 20, 2008, Barclays PLC., a major U.K. bank, acquired Lehman's broker–dealer operations for $250 million and paid an additional $1.5 billion for the firm's New York headquarters building and two New Jersey–based data centers. Coming just five days after Lehman filed for bankruptcy, the deal reflected the urgency to find buyers for those businesses whose value consisted primarily of their employees. Barclays did not buy any of Lehman's commercial real estate assets or private equity and hedge fund investments. However, Barclays did agree to take $47.4 billion in securities and assume $45.5 billion in trading liabilities. On September 24, 2008, Japanese brokerage Nomura Securities acquired Lehman's Japanese and Australian operation for $250 million. Lehman's investment management group, Neuberger Berman, was sold in late December 2008 to a Neuberger management group for $922 million. Under the deal, Neuberger's management would own 51 percent of the firm, and Lehman's creditors would control the remainder. Other Lehman assets, consisting primarily of complex derivatives ranging from oil price futures to credit default swaps (i.e., debt insurance) to options on stock indices, with more than 8,000 counterparties, were expected to take years to identify, value, and liquidate. The firm also could expect to face numerous lawsuits.
The October 18, 2008, auction of $400 billion of Lehman's debt issues was valued at 8.5 cents on the dollar. Because such debt was backed by only the firm's creditworthiness, the buyers of the Lehman debt had purchased insurance from other financial institutions to mitigate the risk of a Lehman default. The existence of these credit default swap arrangements meant that the insurers were required to pay Lehman bondholders $366 billion (i.e., 0.915 × $400 billion). Purchasers of this debt were betting that, following Lehman's liquidation, holders of this debt would receive more than 8.5 cents on the dollar and the insurers would be able to satisfy their obligations.
Hedge funds also were affected by the Lehman bankruptcy. Hedge funds borrowed heavily from Lehman, putting up certain assets as collateral for the loans. While legal, Lehman was using this collateral to borrow from other firms. By using its customers' collateral as its own collateral, Lehman and other firms could borrow more money, using the proceeds to make additional investments. When Lehman filed for bankruptcy, the court took control of such assets until who was entitled to the assets could be determined. Moreover, while derivative agreements were designed to terminate whenever a party declares bankruptcy and be settled outside of court, Lehman's general creditors may lay claim to any collateral whose value exceeds the value of the derivative agreements. Disentangling these claims will take years.
In early 2010, a report compiled by bank examiners described how Lehman manipulated its financial statements, leaving the investing public, credit rating agencies, government regulators, and Lehman’s board of directors totally unaware of the accounting tricks. By departing from common accounting practices, Lehman appeared to be less levered than it actually was. It was pressure from speculators, sensing that the firm was in disarray, which uncovered the scam by selling Lehman’s stock short and accomplishing what the regulators and credit rating agencies could not. See the Inside M&A case study at the beginning of Chapter 2 for more details on Lehman’s accounting practices.
-Why did Lehman choose not to seek Chapter 11 protection for its subsidiaries?

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