P.R.I.M.E. Finance Panel of Recognized International Market Experts in Finance Lehman Derivatives Settlements Presentation by Schuyler K. Henderson 2016 P.R.I.M.E. Finance Annual Conference 25 & 26 January, Peace Palace, The Hague

Disclaimer Comparison of Lehman CCP/exchange-traded settlements and Lehman OTC settlements Valukas Report (2010) and NY Fed article (Fleming and Sarker)

CME: Exchange-traded Proprietary positions and customer positions – Lehman had put up $2 billion in collateral for each – All counterparties came out whole through application of margin – Proprietary positions transferred to Barclays, Goldman, and DRW Trading Loss of $1.2 billion over value and $100 million over actual margin requirements

LCH.Clearnet: CCP $9 trillion notional amounts; 66,390 trades Settled by October 4, “well within Lehman margin held” – Returned at least £217 million to Lehman liquidator; returned over half of initial margin – The other half would have been a direct loss, transfer of cash assets, to whomever took over portfolio

OTC Big job on the OTC side – $35 trillion notional amounts; 921,000 transactions; 6,120 master agreements Mostly ISDA 1992 or 2002 Master Agreements – Top 25 counterparties by number of deals: banks a financial dealers Deutsche Bank, 59,000; JP Morgan, 53,000; UBS, 45,000; Morgan Stanley, 40, had Credit Support Annexes; – Top 24 by exposure, 15 had Credit Support Annexes – Only Deutsche Bank, JPMorgan and Morgan Stanley on top 25 exposure – Governments (Ministry of Italy) and SPVs

May 31, 2008: net value was $21 billion (around 3.3% of total assets) – $25.8 billion liabilities, $46.9 billion assets November 30, 2007: $13 billion – $31.6 billion liabilities, $44.5 billion assets

Recovery Percentages NY Fed study – “Recovery rates varied across creditor groups. Creditors of two Lehman derivatives entities received full recovery on their claims, while customers of centrally cleared securities were mostly made whole. In contrast, most counterparties of Lehman’s OTC derivatives suffered substantial losses.” – Payout ratios of 21% – This number appears to be way too low in general

Reasons for low recoveries 2(a)(iii) cases: “In particular, Lehman’s counterparties used the safe harbor provisions to terminate contracts when they stood to gain and to keep alive contracts when they were out-of-the-money. Further, they refused to make required periodic payments to Lehman on out-of-the-money contracts on the grounds of Lehman’s default under the ISDA Master Agreement.” BUT: resolved in States; peanuts in the UK

Self-determination of gains/losses – Nomura example: – Astonishing methodolgy used; very creative – Claims inflated, payments over reduced – Inflated claim reduced from $100 million to $50 million, and receives $25 million Is that a 25% recovery or a 50% recovery

Credit Support Annexes – Actual extent of collateral is disputed – Lehman did not post initial margin – “Some in-the-money counterparties suffered losses when, under the credit support annexes included in their derivatives contracts, Lehman affliates either were never required to post collateral or did not post sufficient collateral” – Over collateralisation and commingling; $60 million mistake

Top 25 counterparties by number of deals (banks); 24 had Credit Support Annexes; Top 24 by exposure; 15 had Credit Support Annexes Example: Counterparty A has $300 million exposure, $200 million “collateral” (usually cash) Close-out netting: ETA is $300 million due and payable; “collateral” applied, setoff, remaining claim $100 million; distribution of $21 million. Is recovery rate 74% or 21%? Credit Support Annexes

OCC comparison of losses on derivatives and on Commercial and Industrial Loans 4th quarter 2008 charge-offs: Derivatives $840 million and C&I Loans $5.5 billion

OCC collateral coverage