Did John Paulson Receive Preferential Terms From Dealers When Selling Lehman Bonds?

Last night, the FT penned a rather curious, not to mention 2 month delayed, PR puff piece, discussing Paulson's success in investing in Lehman bonds, ostensibly to offset the firm's recent horrendous investing performance (Sino Forest, Bank of America and Premier Foods to name a few). While it is true that Paulson was one of the very first investors in Lehman bonds following the banks bankruptcy on September 15 some of the math in the FT piece is rather misleading. We will present a detailed analysis and a more objective version of Lehman bond trading history when we bring to our readers the complete breakdown of trading as disclosed in the Lehman 2019 ad hoc committee response (thank you Northwest airlines) that hit the Lehman docket on April 19. However, in the meantime we wanted to bring to both readers', and regulators' attention one rather peculiar piece of information that has emerged as a result of the trading disclosure provided by the firms in the Lehman ad hoc creditor committee, in this case Paulson and Taconic, which hold over $4 billion and just under $2 billion in face value of Lehman General Unsecured Claims. Specifically, it appears that when trading out of Lehman bonds, Paulson may have obtained highly preferential terms which were certainly not available to other hedge funds, beginning the question: were (are?) dealers willing to assume losses on transactions with Paulson (to the detriment of other market players), simply to be in the hedge fund manager's good books? We don't know. But here is the data.

As anyone who has traded corporate bonds knows, a market making dealer run on any issue will always indicate a bid and an ask, sometimes accompanies by size on either side, or both, which the dealer is willing to commit. For example a market represented as 20x22 would mean the dealer can sell a bond at 22 and buy it at 20 (and inversely for the client, who would be able to sell at 20 and buy at 22). Which, as the right side of the table below shows, is precisely what Taconic likely saw when it tried to buy $25 million worth of face Lehman bonds on January 6, 2010: at a prevailing price of 20.13, Taconic was likely seeing indications of something like 18x20, meaning the dealer had bonds to sell at around 20 cents on the dollar.

So far so good.

Yet where it gets odd is when John Paulson tried to sell $400 million face of the same issue, on the same day, courtesy of a massively accumulated position over the past year, which at one point hit a cumulative total of $6.4 billion in April 2009. So Paulson proceeded to sell, and while on would expect that the price he should get based on the Taconic clearing price would be well south of 20, he in fact, sold this massive amount, at 23.0%, meaning somehow JP found a broker who is either willing to take a big loss, by having a market that had a 23 bid, and who knows what offer, or there was a massive disconnect in the Lehman bond market on January 6.

The table below shows all of Paulson's January 6, 2010 Lehman bond transactions, incidentally all sales, and compares them to Taconic's full January 6, 2010 Lehman bond transactions, all buys. The table says it all. This is just one daily snapshot. This pattern recurs all over the calendar, with Paulson constantly appearing to get preferential terms to other cross-referenced dealer clients.

The simple math is that the worst bid/offer in the Lehman GUC market on January 6, 2010, was something like 18 by 25, a ridiculous spread that should raise every red flag with the regulators, yet which of course won't.

If nothing else, perhaps some non-porn addicted SEC overseer should inquire just how the dealer bid could have been over 10% above the offer, in the same market, in the same day, and in the same issue.

We won't hold our breath.

We will shortly present our other findings from the Lehman bond trading history, which will demonstrate without a shadow of a doubt how prominent hedge funds engage in daily churn of bonds merely to create a fake perception of interest into which they then promptly proceed to dump their holdings, all within the same day.