photo: Tambako the Jaguar via Flickr

The lawsuit (pdf) filed by the bankruptcy estate of Lehman Brothers against JPMorgan Chase contains yet another description of a giant bank eating a customer. And just as you would guess, the heart of the problem is derivatives.

The complaint begins by explaining the relationships between Lehman and JPMorgan. Lehman was a full-service stock broker. JPMorgan provided clearing services for Lehman’s securities business. JPMorgan was the lead lender and administrator on a $2 billion unsecured revolving line of credit. Lehman also had a large derivatives portfolio with Jamie Dimon’s bank.

The clearing relationship was governed by a Clearance Agreement dated in 2000. When clients buy securities, JPMorgan lends Lehman the money to pay the seller. This is called “intra-day exposure”, because JPMorgan is making an unsecured loan to Lehman for a few hours, until the securities are delivered. Almost all trades clear, that is, the securities are delivered and payment is made, by the end of the day, so there is very little overnight exposure. To cover intra-day exposure, the Clearance Agreement required Lehman to post collateral with JPMorgan. Lehman was allowed to use that collateral overnight, when the intra-day exposure, if any, is miniscule. This was important because it enabled Lehman to count the collateral towards its capital position for regulatory purposes.

In the August, 2008, JPMorgan insisted on amending the Clearance Agreement. It required Lehman to guarantee all intra-day exposure of its subsidiaries, and required additional collateral to support those guarantees. The amendments did not change Lehman’s access to its collateral overnight.

In early September, 2008, JPMorgan, which already had intimate knowledge of the business and prospects of Lehman, learned a lot more about Lehman’s ability to survive. That new information came from its status as clearing institution and lender and its efforts to become the agent for a potential purchaser of Lehman. Lehman gave JPMorgan access to its people and records and an early look at its third quarter financial statements, hoping to borrow more money.

Most important, Jamie Dimon, CEO of JPMorgan, and other senior bankers were meeting with government officials, including Fed Chairman Ben Bernanke and Secretary of the Treasury Henry Paulson, where they learned that Lehman would not be protected by the government.

With this information in hand, on September 9, 2008, JPMorgan insisted that Lehman sign further agreements, under which Lehman guaranteed all obligations of its subsidiaries, including obligations under derivatives, and lost the ability to access its collateral overnight. That jeopardized the capital position of Lehman.

Then JPMorgan demanded even more collateral, finally winding up with some $8.6 billion in cash and liquid securities (paragraph 72) which made it wildly over-secured not only as to the minimal intra-day exposure, but even as to JPMorgan’s share of the unsecured line of credit and any reasonably estimated obligations with regard to derivatives.

On September 12, JPMorgan refused to give Lehman access to its collateral. Lehman collapsed into an uncontrolled bankruptcy, with little cash and less planning.

Why did JPMorgan do this? if Lehman was going into bankruptcy, why grab collateral in excess of reasonable exposure? All that would do is make everyone angry, and complicate the bankruptcy, because JPMorgan would have to give back any excess collateral.

There are only ugly explanations. One involves derivatives. The complaint says that JPMorgan admits that the additional collateral was not needed to cover exposures under existing agreements such as the unsecured loan agreement and the Clearance Agreement. It says that the purpose was to collect “… on the possibility of closing out derivatives contracts on favorable terms in the event of a [Lehman] bankruptcy.”

… JPMorgan has since asserted that the September Agreements guarantee and secure over $3 billion in purported derivatives obligations of [Lehman] subsidiaries that were previously unsecured, as well as approximately $720 in claims arising out of losses incurred not by JPMorgan, but by its customers who invested in JPMorgan funds. (para. 51, emphasis in original.)

Lehman held a net positive position in derivatives with JPMorgan, that is, if the derivatives terminated, JPMorgan would have to pay Lehman more than $1 billion. Given time, Lehman could have tried to screw JPMorgan by selling positive derivatives and then filing bankruptcy, still holding the loss derivatives. Those losing derivatives would be an unsecured claim, paid less than the total amount owed. But, if Lehman filed bankruptcy before it could sell the positive derivatives, that would be an event of default on all of the derivatives, allowing JPMorgan to terminate them and collect termination fees from Lehman. In the usual case, the termination fees would be unsecured, but due to the excess collateral, JPMorgan could claim that the collateral covered the termination fees. At worst, it would be able to net the derivative positions out, and only owe the net amount.

The complaint says, in so many words, that JPMorgan was at least partially responsible for the sudden collapse of Lehman into an uncontrolled bankruptcy. The purpose was to prevent Lehman from selling its credit default swaps and other derivatives for the benefit of Lehman’s unsecured creditors, and as a side benefit, giving JPMorgan the chance of making a bunch of money for itself and its customers.

Mission accomplished: Lehman eaten, unsecured creditors screwed, legal fees for all.
Wonky additional note: JPMorgan in fact made the claims described in the paragraph quoted from the complaint. Proof of Claim 23009 (pdf) filed by an affiliate of JPMorgan is an example. A proof of claim is a sworn statement filed in Bankruptcy Court asserting that the bankrupt entity owes money to entity that filed the claim. It says that Lehman owes JPMorgan money arising from derivatives, including credit default swaps, and asserts that the claim is secured. In other proofs of claim, JPMorgan asserts that funds it manages are secured by the excess collateral.