Stephen J. Lubben

Lehman's Derivative Portfolio

In the Fall of 2008, Lehman Brothers had a

The Microeconomics of Chapter 11

35 trillion derivatives portfolio, representing about 5% of the worldwide derivatives market. It was a party to approximately one million trades, under more than 6,000 ISDA master agreements.Lehman’s derivatives were not the direct cause of its failure, but its derivatives, and the growth of the derivatives markets in general, led to the assumption of outsized risks and systemic weaknesses that did facilitate the crisis.In addition to the systemic problems caused by Lehman’s derivatives portfolio, derivatives have also been identified as a key source of value loss in the bankruptcy.The singular losses caused to Lehman’s bankruptcy estate by Lehman’s derivatives portfolio came from the safe harbors and the system of closeout netting the safe harbors support. While the safe harbors have been thoroughly studied and debated in the abstract, a close look at Lehman’s experience provides important insights for the future. In particular, the largest part of Lehman’s derivatives portfolio shows how financial institutions will again suffer when resolution is attempted in the traditional bankruptcy system. As such, I question the Dodd-Frank Act’s professed preference for “normal” bankruptcy process over specialized insolvency regimes like the new “Orderly Liquidation Authority.”And the abrupt closeout of Lehman’s cleared derivatives portfolio by CME, which Lehman’s examiner noted as the source of several obvious losses to the bankruptcy estate, also provides important insights, given Dodd-Frank’s strong preference for central clearing going forward.This paper looks at both issues, and suggests that the continuation of the safe harbors “as is” renders chapter 11 nonviable for larger financial institutions, and recent contractual attempts to work around the safe harbors are insufficient to solve the problem, while the increased role of clearinghouses in financial institution failures will force regulators to confront difficult choices. In short, the regulators will have to balance two competing systemic risks: the risk of an unruly resolution of the financial institution, balanced against increased risk to the clearinghouse.

The Direct Costs of Corporate Reorganization: An Empirical Examination of Professional Fees in Large Chapter 11 Cases

Several recent studies have put the level of professional fees in large chapter 11 cases at about 2.5 percent of assets or less. This compares favorably with other significant corporate transactions. But little attention has been given to the issue of how professional fees are allocated within chapter 11 cases. Examining this issue is important because a significant strain of bankruptcy scholarship is premised on the notion that chapter 11 is excessively expensive, notwithstanding the existing evidence that suggests otherwise. In particular, these theorists employ the long-recognized principle that lenders will recoup anticipated losses through higher ex ante interest rates to support the argument that altering or even replacing chapter 11 will reduce the costs of debt financing and thus promote efficiency. But if most of the supposed costs of chapter 11 are in fact exogenous to the Bankruptcy Code, reductions in the cost of chapter 11 may have only a modest correlation with reductions in the cost of financial distress. This paper thus offers the first look at the intra-debtor distribution of professional fees. I analyze a new sample of almost 4,000 attorney time entries, from more than 30 law firms, in 27 very large chapter 11 cases filed between 2001 and 2003 to look at several basic questions regarding the allocation of attorneys fees within chapter 11 cases. I find that up to 60% of the professionals fees in a bankruptcy case may be exogenous to chapter 11. I then develop the broader argument that ex ante costs are virtually irrelevant to current discussions of chapter 11.