It is conventional wisdom that in the days leading to Lehman's bankruptcy filing on the night of September 15, 2008, sheer panic and utter confusion ruled ever back- and middle-office, over concerns that a counterparty, any counterparty, but especially Lehman, would end up being "not money good", and the result was that trigger-happy margin clerks had the potential to make or break a company, by demanding just enough variation margin that would send the notice recipient promptly into bankruptcy. It is also conventional wisdom, that it was precisely several such margin calls mostly out of JPMorgan that precipitated the Chapter 7 filing by Lehman brothers, as the firm was finally unable to mask the fact that it was terminally overlevered, and even more terminally illiquid. It is certainly conventional wisdom, that Lehman was certainly massively overlevered, holding billions of overmarked CMBS on its balance sheet, and was doing everything in its power to hold on to precious liquidity, taking every opportunity to window dress its balance sheet as far better than it truly was (Repo 105 at the end of every quarter promptly comes to mind), over fears of avoiding precisely such a margin call onslaught, where the first margin call would cascade into many, likely lethal, margin calls.
Which is why, over four years after the filing of Lehman's bankruptcy and the fight for who was responsible for what in the Lehman Chapter 7 saga still waging, most actively between the Lehman creditor estate and tri-party repo stalwart JP Morgan, we were not surprised to learn that the Lehman estate had attempted to force yet another sworn testimony from a (former) employee of JP Morgan, in hopes of catching the firm as engaging in a malicious act of defrauding Lehman of precious liquidity in its final hours, or said in layman's terms, forcing it to liquidate.
What did catch our attention was that Lehman named the infamous JPM Chief Investment Office, and specifically its very infamous trader Bruno Iksil, accountable along with others for the London Whale fiasco, as the person responsible for an initial margin call to the tune of $273.3 million, made the same day "that JPMorgan made its first of two demands that week each for $5 billion of extra cash collateral that it had no right to obtain and that drained Lehman of $8.6 billion" (as per the Lehman filing). One could make the argument that this initial margin call was the straw that broke the camel's back, as in the avalanche of money requests, every dollar flowing out of Lehman may have been the one that pushed it under.
If, of course, the Lehman estate claim was credible.
At this point, virtually everyone in the media said "no way" and moved on: this has to be just another desperate attempt by the Lehman unsecureds to force a settlement from JPM, and a few more cent recovery on the bonds. After all, how on earth can someone hold now former JPM employee Bruno Iksil accountable for what he did nearly 5 years ago (however still within the statute of limitations). We, too, almost ignored the story as just too incredible to be true.
And then we decided to do some digging.
What we found was stunning, and frankly shocking, because it appears that the Lehman estate was absolutely correct.
In other words, a chronological forensic analysis of the events surrounding the margin call in question confirm, beyond a shadow of a doubt that the margin call issued by JP Morgan's CIO unit was absolutely unwarranted.
But it gets worse - because the mistake that led to the issuance of what may have been the defining margin call that was the beginning of the end of Lehman, was so ridiculously naive, and idiotic, that we have a hard time believing it was made in good faith, even if it JPMorgan tries to put the blame on some 19 year old NYU intern as being responsible. In fact, we have an easier time believing that the margin call was purposeful, malicious and made with full intent to destroy Lehman, which in turn would mean that, despite the repeated mockery of even the sophisticated media, Lehman may well have been the mark of a JPM-spearheaded campaign to force the bank to shutter as margin call after margin call led it to lose all liquidity.
So what exactly happened? Here are the events as seen by the Lehman side:
On September 9, 2008, the same day that JPMorgan made its initial demand for $5 billion of additional collateral and extracted new one-sided legal agreements from Lehman, JPMorgan also insisted that Lehman post $273.3 million before close of business as derivatives variation margin. The $273.3 million derivative margin demand was primarily attributable to three disputed trades which Mr. Iksil managed or discussed with Lehman. Lehman was certain that JPMorgan's marks were erroneous and that in fact Lehman owed no additional margin. All three CDS referenced a well known and liquid index for which readily-available third party valuations corroborated Lehman’s marks, not JPMorgan’s, which were off by $273.3 million. Nevertheless, Lehman bowed to pressure from JPMorgan executives, including Investment Bank Chief Risk Officer John Hogan, to accept JPMorgan's marks and immediately post the requisite collateral. Accordingly Lehman sent the $273.3 million demanded. That JPMorgan was able to force Lehman’s compliance is particularly telling considering JPMorgan’s marks were so clearly wrong.
The trades primary responsible for the $273.3 million derivatives margin dispute were 3 CDS index tranche trades booked through JPMorgan’s CIO, two of which were managed by Mr. Iksil. Lehman had repeatedly asked Mr. Iksil to correct the mark on the third large disputed trade throughout August and early September without success. Contemporaneous emails attached here reflect how JPMorgan’s mismarks grew into a multi-month ordeal due to the inaction and unresponsiveness of JPMorgan, and of Mr. Iksil in particular.
On September 10, 2008, Lehman’s relationship, operations, and trading personnel mobilized to resolve the mismarks of Mr. Iksil’s trades and secure the return of the nearly 300 million dollars in excess collateral they had been pressured to post to JPMorgan the day before.
Late in the morning on September 10, Lehman reached out once again to Mr. Iksil to request that he correct his marks. This time, Mr. Iksil immediately referred Lehman to a JPMorgan colleague who conceded within minutes that Lehman's marks were correct and an error on JPMorgan's side had caused the problem. Less than an hour later JPMorgan agreed in full to Lehman's September 10 collateral call, which included JPMorgan returning the entire $273.3 million Lehman had delivered to JPMorgan the day before.
That JPMorgan would run roughshod over Lehman’s objections and insist on getting collateral immediately based on marks that were so quickly seen to be erroneous provide a window into JPMorgan’s mindset and operating procedures the week prior to LBHI’s bankruptcy: Get cash now, ask questions later. JPMorgan has taken the position in this litigation that JPMorgan was solicitous of Lehman’s welfare and demanded collateral only after carefully calculating the amount required. Yet, JPMorgan failed to correct its marks despite weeks of requests to do so and allowed a valuation dispute to fester for nearly a month. And on September 9, 2008, although even the most minimal diligence would have revealed JPMorgan was in the wrong, JPMorgan demanded that Lehman accept JPMorgan’s marks and post $273.3 million in disputed collateral overnight. That demand came on the very same day that JPMorgan made its first of two demands that week each for $5 billion of extra cash collateral that it had no right to obtain and that drained Lehman of $8.6 billion.
What, specifically, were the CDX trades in question? They were all three different CDX HY8 5 year 0-10 tranche index trades, which Lehman had bought from Bruno Iksil. Here they are, from one of the exhibit emails, also showing the massive MTM diveregence between the JPM and Lehman marks.
Although perhaps the best way to show this is from this table which summarizes the email from Lehman's CDX trader (24 year old) Zahid Hassan who shows the drastic change in MTM between Lehman and JPM on the CDX tranches:
Basically, what any credit trader can figure out happened here after looking at the table above for more than 5 seconds, and looking at the variation in Leh vs JPM marks, is that whereas Lehman was marking its HY8 exposure correctly, and in line with where MarkIt and other pricing databases would have it, what JPM did was take the upfront priced index and price at 1 par minus price! In other words, where Lehman had it priced at 83.05%, what JPM wanted to do was express a price of 1-19.42%, or 81.58; instead the JPM front, middle and back office chain of command made a mistake so rookie it is impossible it was an error, and it appears to have been maliciously intended to force a liquidity event. Because what drove this massive margin call on this very liquid (at the time) index is because JPM had it suddenly repriced in MTM from 83 to 19 when what JPM really wanted was to reprice it from 83 to 81!
In other words, literally overnight, instead of pricing Lehman's paid upfront collateral at Price, JPM decided, for whatever reason, to revalue it at 1-Price!
The result, had JPM correctly calculated the MTM, would have been a variation margin call of just $6 million: some $257 million less than what JPM demanded from the cash-strapped company!
While we do not know if the $257 million extra in cash that Lehman would have retained on its books would have avoided the subsequent $10 billion in JPM margin calls, or if it would have avoided the firm's bankruptcy as the final outcome, we know we are, and Lehman, are right in alleging that it was JPM's fault in completely screwing up the calculation that led to the massive margin call. Here is the Bloomberg Chat transcript (Lehman Exhibit M) between Lehman (again very, very young CDX trader) Zahid Hassan, and Bruno Iksil first, and then Iksil's supervisor in London, Luis Buraya:
The chat above took place at 11:40 am on Wednesday, September 10: two days before the weekend which was Lehman's last. What we learn from the transcript is threefold: first Lehman was incorrectly margined to the tune of $263 million. JPMorgan admits as much; second, by the time JPM admitted it was wrong, the margin request had already been satisfied, and margin clerks in other divisions were scrambling to come up with other comparably fictitious variation margin demands, such as those which saw JPM demanding extracting nearly $10 billion in liquidity from Lehman in the next 48 hours which culminated with Lehman's Chapter 7. FInally, the "guy" responsible was not "collateral" but CIO, meaning the division that was supposed to hedge, but did anything but when it blew up after attempting to corner the HY9 market last year, had other less noble uses too: to destroy the competition by commencing an avalanche of unjustified margin calls!
Lehman's filing summarizes it as much in the following:
The $273.3 million collateral dispute is highly relevant to this litigation over JPMorgan’s improper cash collateral demands that same week, which deprived Lehman of desperately needed liquidity and precipitated Lehman’s exigent bankruptcy filing. First, the backdrop to the dispute illustrates that there was a well developed market-standard practice for the calculation and exchange of collateral in support of derivatives transactions, which is specified in the ISDA Master Agreement and Credit Support Annex (“CSA”) executed between the parties and involves daily exchange of collateral based on the current net mark-to-market value of the positions. The daily collateral calls under the CSAs which were made and met throughout the week, and the procedures by which the $273.3 million dispute was ultimately resolved, indicate that during the week of September 8 – 12 JPMorgan adhered to the CSA framework for the collateralization of counterparty derivatives exposure to Lehman. Even the $273.3 demand, an example as unreasonable as they come, was tied to the marks (albeit incorrect) on particular trades and posted and returned via the CSA framework. JPMorgan’s demand for $5 billion on September 9, which JPMorgan claims it made in significant part to collateralize its purported derivatives exposure to Lehman, was entirely outside the ISDA/CSA framework and represented a dramatic departure from commercial practice for collateralization of derivatives exposure. Second, the episode shows that during the week of September 8 – 12 JPMorgan was willing to override standard commercial procedure by insisting that any collateral disputes be immediately resolved in its favor. Third, it illustrates Lehman’s complete vulnerability to JPMorgan’s bullying behavior. Just as with the $8.6 billion, Lehman lacked any choice other than to capitulate to demands it knew were baseless, in light of JPMorgan’s power to deal Lehman a death blow by ceasing to trade or clear. Finally, it shows that JPMorgan’s exposure calculation methods were highly suspect – a point with obvious relevance to this litigation over two demands for collateral in round $5 billion increments, unaccompanied by any calculation or documentation of exposure.
To conclude: a variation margin call, which we now know beyond a reasonable doubt, was erroneous and had no basis in reality, launched by JPM's CIO is what started the cash outflow from Lehman, and was followed by two other comparable $5 billion margin calls, which may well have had the same totally erroneous justification to them. But Lehman had no choice: even then saying no to the uber-behemoth and tri-party repo guardian JPM was tantamount to suicide anyway.
Any by the close of trading on Friday everyone else on Wall Street was doing what JPM did: demanding hundreds of millions and billions in margin from Lehman, at which point seeking the culprit for what 48 short hours later would be the biggest bankruptcy in history, was a moot point.
By then the game was over, and JPM's CIO had won, courtesy of a ruse so pathetic it was either outright idiotic, or conceived with the most despicable of destructive intentions. And then we remember that it is the same uber-sophisticated CIO unit that for years was misreporting its VaR because of a simple excel transposition error which nobody had bothered to check!
So we wonder: should we attribute to malice and Jamie Dimon's bloodthirst what sheer, brutal JPMorganite incompetence can explain far more simply? But then we also wonder: is it also purely a coincidence that JPM's largest gold vault in the world is located inches away from the gold vault of the New York Fed...
And everything is once again crystal clear.