Lehman Creditors Face Complex Unwind

Updated from 5 a.m. EDT

With Lehman Brothers' ( LEH) bankruptcy filing Monday, the global financial system has entered into uncharted territory, and the potential repercussions are difficult to measure.

Lehman Brothers had $639 billion worth of assets at the time of its Chapter 11 filing, making it the largest bankruptcy in history. The previous holder of that dubious title, WorldCom, had $107 billion worth of assets.

Moreover, Lehman, with subsidiaries and offices around the globe, is such a central player in financial markets that sorting through the various claims of its creditors and trading partners is a daunting task to say the least.

" Enron is the most complex bankruptcy we've ever worked on, but it's possible that the bankruptcy of Lehman Brothers may involve even more convoluted financial issues and relationships," says Jeff Werbalowsky, CEO of Houlihan Lokey, the investment bank that also advised the official unsecured creditors committee for bankruptcy cases involving WorldCom, Conseco and Refco.

In addition to creditor-related issues, the Lehman Brothers default will present a historic challenge to the credit default swaps industry -- a multi-trillion dollar private market in which large institutions insure themselves against the risk of default by their debtors.

Lehman Brothers is one of the largest participants in the credit default swaps market in the world, and it was the fear of what would happen in this market if a major player defaulted that led the Federal Reserve to backstop $29 billion in Bear Stearns securities in orchestrating the firm's fire sale to JPMorgan Chase ( JPM) in March. Now, the appetite for government bailouts has diminished, taking this option off the table for Lehman.

In an attempt to resolve some of the issues in the credit default swaps market, traders worked on Sunday to "facilitate an orderly resolution" of trades involving Lehman Brothers, according to a press release issued by several banks Sunday night.

"The current environment is obviously a difficult period for industry participants," said Eraj Shirvani, chairman and managing director of the International Swaps and Derivatives Association (ISDA) in a press release Monday. "ISDA believes, however, that the industry's progress in building a strong foundation for our business will enable it to successfully address current issues. The privately negotiated derivatives business -- including the credit default swaps business -- continues to function well in these times."

By filing for Chapter 11 protection from its creditors, Lehman has a chance to continue to pay employees and conduct business while trying to sell assets. However, it will have to get court approval to do so. Though only the holding company filed for bankruptcy protection, the assets are held by subsidiaries that did not file for bankruptcy protection. That means that Lehman's creditors may not have control over what gets sold and how.

Lehman's largest unsecured creditors include Aozora Bank, a Japanese bank owned by U.S. private equity firm Cerberus Capital Management, and Mizuho Bank, also located in Japan. Aozora owns $463 million of unsecured bonds, while Mizuho owns $289 million.

While Lehman's bankruptcy filing lists Citigroup ( C) unit Citibank as its largest creditor with $138 billion in Lehman debt, Citi's role "is administrative in nature and does not represent exposure for Citi to Lehman," according to a statement released by Citigroup to address confusion about the issue.

Citigroup's unsecured creditors are scheduled to meet Tuesday to form an official committee to represent their interests. Citi's unsecured debt was trading for around 34 cents on the dollar on Monday.

In the meantime, Lehman is taking steps to sell assets. It said in a press release Monday it is trying to sell its broker-dealer unit and is continuing negotiations to sell its investment management division, which includes its prized Neuberger Berman subsidiary.

The Wall Street Journal said Neuberger was believed to be worth $5 billion. But given the current turmoil in the market, valuing any financial asset is extremely difficult. Neuberger was not part of the bankruptcy filing, which was made by Lehman Brothers Holdings.

Barclays ( BCS) confirmed that it is interested in acquiring some assets of Lehman Brothers, the Associated Press reports.

"Barclays confirms that it is discussing with Lehman Brothers the possible acquisition of certain Lehman Brothers assets on terms that would be attractive to Barclays shareholders," the company said in a brief announcement to the London Stock Exchange, the AP reported.

Sanford Bernstein analyst Brad Hintz estimates that 55% of Lehman's balance sheet can be quickly liquidated, particularly such assets as receivables and short-term loans known as repurchase agreements. There are about $269 billion in securities that are "another story," Hintz wrote in a report released Monday. He estimates 27% of the $269 billion is in mortgages, 17% in derivatives, and 8% in real estate.

"Liquidation of these positions will not be easy to achieve," he writes.

As Lehman winds down and creditors mobilize themselves, financial institutions around the world will be assessing their exposure to Lehman, both direct and indirect, and working to stave off potential aftershocks.

One company that jumped out in front in this respect was Merrill Lynch ( MER), which agreed to sell itself to Bank of America ( BAC), to save itself from potentially sharing Lehman's fate.

Indeed, the fortunes of financial companies are more closely tied to those of their competitors than is the case in other industries.

"Lehman's bankruptcy will have a ripple effect on competitors, and that has the potential to bring them down because they may not be able to honor their contracts with somebody else," says Sreedhar Bharath, assistant professor of finance at the University of Michigan's Ross School of Business.

Like an increasing number of observers, Bharath does not rule out the possibility of this crisis causing a 1930s style crisis, or worse, given the effects of globalization.

"The effects in 1930, perhaps you could argue, were contained in the U.S., but now the potential for something like this is going to be many more times magnified," he says.

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