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Lehman Gets Piece of All the Action

It's selling a credit derivative to hedge risk in a breed of hybrid securities it also underwrites.

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


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.

Corcoran is looking for trading in PCDSs, which totaled $6 billion in 2005, their debut year, to quadruple in 2006.

By comparison, U.S. companies sold a little under $10 billion in perpetual hybrids in 2005. But there has already been $8 billion in perpetual hybrid deals this year, including big ones by


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Washington Mutual

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Perpetual hybrids are so named because they have no maturity date. The elimination of the maturity date on the bonds is significant -- it persuaded the big credit-rating agencies to treat perpetual offerings as a sale of stock rather than a sale of debt.

A stock deal has no direct impact on a company's credit rating. When a company issues traditional corporate bonds to pay for a stock buyback, it often results in a credit downgrade -- an event that can increase its borrowing costs down the road.

"There was a need for PCDSs,'' says Corcoran. "Until PCDSs came to the marketplace, there was no way to hedge at the preferred level of the capital structure."

Of course, what Lehman is trying to do with hybrids is have its cake and eat it, too. It's seeking to cash in on both ends of the hybrid market by serving as underwriter on a bond offering and then as the primary market maker for the PCDS that's linked to a particular hybrid offering.

Critics point out that this dual role is one of the problems with the booming $12 trillion market for credit derivatives: Wall Street banks control much of the playing field.

"How does one price them? Well, let me give you a peek behind the curtain. There is only one man manipulating the levers,'' says Janet Tavakoli, a Chicago-based structured-finance and derivatives consultant.

Currently, Lehman is making a market in 75 different PCDSs. Other Wall Street firms, including

Bear Stearns



JPMorgan Chase

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, also are making markets in PCDS trading. But Lehman is the dominant player.

With any kind of credit derivative, the Wall Street firms that make a market for these exotic financial products exercise tremendous control over pricing. But critics say the situation is particularly problematic in a new market, such as the one Lehman is trying to build for PCDS.

"Pricing on these instruments is difficult to model,'' says Tavakoli. "This is an illiquid market, and there will be a problem the minute there is a bump in a road.''

A hiccup in the market for PCDSs is probably of little concern to most retail investors. The main buyers, sellers and traders of PCDSs and other credit derivatives are hedge funds.

But regulators are increasingly concerned that, given the explosive growth in credit derivatives, hedge funds are overlooking the risks associated with these products.


Federal Reserve

, for instance, has been particularly concerned about the unbridled growth of the credit-derivatives market and has been working with banks and brokers to bring more clarity to this esoteric business. One thing the Fed is concerned about is the possibility of a systemic meltdown in the sector in the event of a major market selloff.

Much of the growth in the credit-derivatives market has come in the past three years, as stocks have headed higher and corporate defaults have neared all-time lows. In 2001, for instance, total trading in credit derivatives was less than $1 trillion.

The problem is, no one knows how things will shake out in this relatively new market when stocks head south and corporations start defaulting on their bonds.