Lehman Brothers, 2008

Nine hundred thousand trades, closed out at once

Lehman Brothers Holdings filed for bankruptcy on 15 September 2008 with about $639bn of assets, the largest bankruptcy in US history. It was counterparty to roughly 900,000 derivative transactions, and its failure was an event of default under nearly every ISDA it had signed. What followed was the largest close-out the market had ever run — bilateral counterparties valuing and terminating on their own terms, and a clearing house managing the cleared book through its default process. The two halves went very differently, and the difference reshaped the market.

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What the lesson covers

1. What happened
2. The derivatives book
3. The close-out
4. What it cost
5. What it teaches

Key terms

• Event of default — A failure listed in the ISDA, such as bankruptcy of a party or its credit support provider, that lets the other side terminate.
• Close-out netting — Terminating every trade under one agreement and reducing them to a single net amount owed one way.
• Close-out Amount — The 2002 ISDA valuation standard: what it would cost to replace the terminated trades, determined in good faith.
• Section 2(a)(iii) — The ISDA condition that a party need not pay while an event of default by the other is continuing.
• Default management — A clearing house’s process for hedging and auctioning a failed member’s portfolio, funded first by that member’s margin.
• Rehypothecation — A broker reusing client assets it holds as collateral, which turns them into a claim if the broker fails.

Every key term, A to Z

In practice

The legacy is the market structure most desks now work inside: standardised swaps cleared through central counterparties with rehearsed default auctions, variation and initial margin on uncleared trades, close-out valuation procedures written down before they are needed, and the ISDA resolution stay protocols that stop counterparties terminating en masse when a large bank fails.

Read next

• The ISDA Architecture — The paperwork that makes every other product possible
• Central Clearing — A central counterparty steps into every trade
• Collateral and the CSA — The cash and bonds that back an OTC exposure

In the app, Lehman Brothers, 2008 carries a five-step lesson, a worked example and a bank of twelve questions drawn differently every sitting.

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Educational content only. Nothing here is financial advice, an offer to trade, or a recommendation to buy or sell any instrument.