What is Prime Brokerage 1

Three effects of the Lehman bankruptcy on the markets

(Excerpt from pages 19-21 of the BIS Quarterly Review, December 2008)

On September 15, 2008, Lehman Brothers Holdings Inc. (LBHI) filed for Chapter 11 bankruptcy protection and reported consolidated bank and bond debt of over $ 600 billion a few days later, Barclays acquired the broker-dealer subsidiary of Lehman in the USA. This was the first major investment bank insolvency since Drexel Burnham Lambert's collapse in February 1990. Lehman's problems arose from extensive losses and high write-downs on distressed assets, and concerns that future losses would undermine Lehman's previous efforts to widen the equity base would be wiped out (Graph A, middle). The bankruptcy therefore re-raised questions about the investment banks' heavily leveraged balance sheets and their corresponding reliance on wholesale finance, as raised by the near-collapse of Bear Stearns in early 2008. When confidence in the continued existence of Lehman then waned (Figure A, left), the institute was also barred from access to the wholesale customer market and bankruptcy was inevitable.1

Given the size of the company and its central position as a dealer and counterparty in numerous financial markets, an event of such importance inevitably drew wide circles. This box examines three specific effects of the Lehman bankruptcy on the markets that had the potential to cause system-wide liquidity shortages: 1) the effects on the CDS market, 2) the closure of money market funds due to losses on claims Lehman and 3) the consequences of bankruptcy for the company's prime brokerage clients.

(1) CDS market

In the days of filing for bankruptcy, the potential impact of Lehman's bankruptcy on the $ 57.3 trillion stood. comprehensive CDS market2 the focus of attention. Lehman's central role as a major counterparty and reference entity in this market was of particular concern. It was known that a bankruptcy petition would have two immediate effects: on the one hand, default clauses would be triggered in CDS contracts referenced on Lehman, and on the other hand, the contracts with Lehman as the counterparty would be terminated. It was assumed that netting, settlement and replacement of the affected positions would involve operational risks. More importantly, however, there was a lack of reliable, publicly available information on the total volume of CDS contracts referenced on Lehman and the net amounts required for settlement at the time of filing for bankruptcy. This information deficit led to great uncertainty regarding the ability of the already strained money markets to meet the expected liquidity requirements.

There were various initiatives to deal with the situation and the uncertainty. First, an emergency trading meeting was scheduled for Sunday, September 14, just before the bankruptcy filing. It should give the most important CDS dealers the opportunity to netting their counterparty positions vis-à-vis Lehman and to clean their balance sheets through substitute transactions. Second, on October 10, an auction was held among CDS traders in accordance with established procedures of the ISDA (International Swaps and Derivatives Association) in order to determine the return flow rate that should be used for cash settlement of the CDS contracts referenced on Lehman, and thus the Amount of the amounts to be paid out.3 Third, the DTCC (Depository Trust and Clearing Corp.) announced that it estimates the volume of such open CDS contracts at $ 72 billion and the corresponding net equalization payments at $ 6 billion. Finally, on October 21, net payments of $ 5.2 billion were made on these contracts (Graph A, right). These relatively small volumes no longer had any noticeable impact on the liquidity situation at the time of settlement, but the previous uncertainty regarding these claims may have contributed to the volatility in the money markets after the bankruptcy application. Additional burdens from a possible collapse of the insurance company AIG could only be averted by a state rescue operation.

(2) Money Market Funds

A major source of funding for Lehman was the issuance of commercial paper and other forms of short-term bonds. These stocks were attractive to money market funds because of their high ratings and spreads over US government bonds. In addition, investors in money market funds felt safe from losing their capital because the fund managers were subject to regulatory restrictions and had been able to avoid losses in the past.

After Lehman's bankruptcy, 25 money market funds took steps to protect their investors against losses due to Lehman's holdings. Nevertheless, the net asset value of a public money market fund, Reserve Primary, fell below $ 1.00 per share. As a result, the Fund was liquidated and distributions to investors were made in cash, corresponding to the influx of cash as stocks in the portfolio mature or when they are sold.

The liquidation of Reserve Primary led to massive redemptions of shares in other US money market funds, especially so-called prime funds that invest in commercial paper. To stop the run on these money market funds, the US Treasury Department launched a limited-term guarantee program for investors in money market funds. The Federal Reserve joined in with rescue programs aimed at the direct purchase of commercial paper and short-term bonds from the holdings of money market funds (see Box 2 on government rescue programs)

(3) Prime brokerage business

Lehman was managed as a global company, which in particular brought the centralization of its financing activities in the USA with it. Despite the company's global structure, Lehman offices outside the United States and its parent company in New York filed for separate bankruptcy. The filing of applications in different countries made the Lehman bankruptcy the first truly global bankruptcy of a large and complex financial institution. The complexity of the Lehman business and the acquisition of the broker-dealer subsidiary in the US immediately after filing for bankruptcy raised questions about different legal processes in different countries for an insolvent company that had previously been run on the basis of global product strategies. The corresponding problems become clear, among other things, with Lehman's prime brokerage business.

Lehman was the prime brokerage service provider for a large number of hedge funds. As part of these prime brokerage relationships, hedge funds placed assets with Lehman's broker-dealer units in various countries. These assets, which were deposited as collateral for financing, could then be reused by Lehman as part of a rehypothecation to meet its own obligations. Lehman's bankruptcy caused many of its prime brokerage customers to be lost for the duration of the In insolvency proceedings suddenly their access (and possibly also their entitlement) to the assets deposited as collateral. As a result, they were forced to keep positions with fluctuating values, the later availability of which depended on the outcome of various legal proceedings and contractual agreements in different countries led to adjustments in the scope and location of the hedge funds' dealings with their prime brokers, the reallocation of funds between different countries combined with efforts to reduce leveraged exposures could result in potentially significant asset sales and the withdrawal of funds from the respective prime broker. B. Trigger rokerage account. These transactions, in turn, added to the pressure on the finance and securities lending markets created by the Lehman bankruptcy.


1 For similar cases of effects on the financial markets comparable to a bank run, see C. Borio, "Market distress and vanishing liquidity: anatomy and policy options", BIS Working Papers, No. 158, July 2004.
2 The volume of the CDS market is usually measured in nominal values, whereas the replacement costs can be better captured by the gross market value (estimated in mid-2008 at a total of 5.5% of the nominal market volume).
3 In the auction process, which was carried out according to the Lehman CDS protocol of the ISDA from 2008, a return rate of 8.625% was determined for the Lehman bonds on the basis of the bids submitted by 14 traders. Since the Lehman bonds have been trading continuously lower since the bankruptcy filing, the auction price was only marginally below the bond prices immediately before the auction, so that the risk of a market price discrepancy in connection with the auction was limited.