The bankruptcy of Lehman Brothers has pushed counterparty risk back to the top of the buy-side trader’s agenda. According to Ian Yuill, a consultant at Investit, the fallout from the US Treasury Department’s refusal to bail out the US investment bank could haunt the financial markets for the next five years.
“Enron took six years to sort out and Lehman Brothers is considerably more complex,” says Yuill.
While many asset managers wound down their exposure to Lehman Brothers as the bank’s troubles mounted in the second quarter of the year, few expected it to be allowed to collapse. “A lot of asset managers viewed the event as a kind of business continuity issue. But although they practice IT breakdowns regularly, they probably hadn’t rehearsed a counterparty going bankrupt,” says Yuill. “There’s no manual for managing your exposure when a bank as big as Lehman Brothers goes bust.” As a result, there are many unanswered questions.
The first step for asset managers is to get a grip on their overall exposure. Not easy, says Yuill, if the bankrupt bank was a counterparty for cash equity trading, OTC derivatives, stock lending and prime brokerage services. In many cases, the process has taken several days. And even once you are confident you have nailed the exposure, what can you do about it? Much depends on the actions of the administrator. “The unfortunate truth is that, in some cases, you just have to wait for the administrator to decide when positions can be unfrozen,” says Yuill.
One area of contention is unsettled transactions. If you sold RBS shares through Lehman, then found you had to re-book them again a week later, the price and the associated cost differences could be substantial. “We’re in uncharted territory in terms of who picks up the cost for this,” says Yuill. “Of course, this is more of an issue if you had to re-sell a position in a financial stock in the falling post-Lehman market, rather than re-booking a purchase.”
While relatively few asset managers invest in single-name credit default swaps (CDSs), use of CDS indices of which Lehman was a component is more common.
Many buy-side firms are facing losses following the auctions organised by the International Swaps and Derivatives Association earlier this month to establish recovery prices for Lehman CDSs, which marked the beginning of the unwinding process. “Although the CDS settlement day cleared up some anxieties by setting default terms, there are still potential knock-on effects,” says Yuill. “The true impact of the losses incurred won’t be known for several months, until companies release their next earnings figures.”
Resolution of such issues is causing concern among Investit’s asset management and hedge fund clients, according to Yuill, prompting the consultancy to produce a white paper on handling counterparty risk, scheduled for release in the new year.
Asset managers that held commission sharing agreements (CSAs) are among those queuing up to see Lehman Brothers’ administrator, PricewaterhouseCoopers. “The terms of a CSA might be impossible to enforce unless the administrator agrees with them,” says Yuill. This means the freeing up of funds held under CSA agreements might be difficult. “Administrators are making margin calls on positions that have been frozen. But the counterparties they’re calling margin from can’t liquidate positions because the underlying assets have been frozen. This could take a long time to unwind.”
So what risk management lessons can asset managers
learn from the Lehman Brothers collapse? Certainly reliance on credit ratings will decrease; Lehman Brothers was still A-rated weeks before its demise. Unsurprisingly, Yuill says asset managers are paying far closer attention to the share price movements, CDS spreads and funding structures of potential counterparties.
But should the buy-side trader concentrate order flow with fewer, stronger counterparties, or spread his exposure wider? Each firm will need to decide on the risk/reward balance that best fits its needs, says Yuill, who admits that difficult decisions lie ahead. “A hedge fund with a single prime broker arrangement might be feeling very exposed right now, but spreading business between multiple counterparties brings difficulties,” he says. “First, there is the administrative burden of setting up the necessary processes and procedures with new counterparties. But there is also the concern that, by sharing volume between multiple prime brokers, you end up giving none of them the volumes to justify the high level of service you used to get from a single provider.”