Monday, October 13, 2008

When Senior Bond Is Very Junior

Many people are baffled by how Lehman senior debt has been trading after they filed for Chapter 11 protection, as I illustrated in a previous article. Turns out Robert Waldmann at AngryBear has an excellent analysis on the same topic, only earlier.

But, after some more research, I realized it's more general than Lehman selling CDS protection on itself, although the irony makes it more interesting. Generally speaking, in bankruptcy code, derivatives counterparty claim can go right through Chapter 11 protection and force liquidation. Chicago Fed in fact had a research paper in 2004 (thanks to SeekingAlpha reader analyzing the original rationale behind and the unintended consequences -- cliche of the month? -- of this exceptional treatment of derivatives.

So, what does it mean? If you buy senior debt from a company with significant activity in the derivatives business, your senior bond is in fact subordinate to all such counterparty claims. In case of Lehman, it's not hard to imagine how counterparty claims could easily eat up all that's left. I'm just surprised the market thinks there would still be around 10 cents on the dollar left when all counterparty claims are settled.

If you think only financials are involved in significant derivatives trading, you'd be wrong. Virtually all big companies today are neck deep in this business.

This is arguably one of the biggest stealth dilutions (to bond/eqquity holders) in today's capital markets. The other one would be off-balance-sheet but that belongs to another day.

Market CDS spreads often imply significantly higher default probability than historical data suggest. There're a plural of potential justifications for this apparent "discrepancy". But I tend to think a big part of it is not that market is implying higher default probability. It's lower recovery that market has been trying to say all along.

So, how did such bonds ever get the "senior" label? Did the rating agencies take this into account when rating them?

These are $700B questions, in court. (Not that I'm trying to be dramatic, it's just that anything less than $700B doesn't carry any weight nowadays...)

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