Lehman Gets Piece of All the Action

The financial alchemists on Wall Street keep coming up with new and more exotic ways to generate trading profits. A case in point is the rise of something called a preferred-credit derivative swap.

A PCDS is a relatively new financial product that Lehman Brothers(LEH) sells as a trading hedge for investors in an equally new line of hybrid securities that share the characteristics of a stock and a bond.

Lehman is peddling the newfangled derivative to hedge funds and other institutional investors jumping into the fast-growing market for perpetual-trust preferred securities -- a new breed of high-yielding hybrids that enables companies to raise cash without affecting their credit ratings. Not surprisingly, Lehman also is one of the big underwriters of perpetual hybrids.

A credit derivative is a sophisticated financial contract that's often used as way to hedge against the decline in value of a bond, stock or commodity. The value of a PCDS, as with any credit derivative, is closely tied to the underlying asset, which in this case is a perpetual hybrid.

This year, Wall Street is looking for a surge in perpetual-hybrid offerings from banks, insurers and other companies looking for a cheaper way to pay for stock buybacks and acquisitions. Investment bankers are betting that hybrids will take off as rising interest rates make traditional bond offerings less attractive to companies and investors searching for higher-yielding securities.

Lehman, meanwhile, is looking for a corresponding rise in the demand for PCDSs as investors in perpetual hybrids begin searching for ways to hedge themselves against potential defaults and other bad outcomes.

"My personal view is you could see $50 to $70 billion of new hybrid issues this year, and that means you would see a lot more PCDSs being traded," says Thomas Corcoran, the head of Lehman's hybrid capital group.