If Lehman Had “No Idea,” Who Else is Clueless?

Here’s a zinger of a news story:


Barclays Plc had no idea how big Lehman Brothers Holdings Inc.’s futures-and-options trading business was when it considered taking over the defunct bank’s derivatives trades at exchanges in 2008, a Barclays executive said.


“Lehman’s books were in such a mess that I don’t think they knew where they were,” Elizabeth James, a director of Barclays’s futures business, testified today in U.S. Bankruptcy Court in Manhattan. James worked on Barclays’s purchase of Lehman’s brokerage during the 2008 financial crisis.


Source: http://www.bloomberg.com/news/2010-08-30/lehman-derivatives-records-a-mess-barclays-executive-says.html


I’ve railed for months that the central issue surrounding the Financial Crisis (derivatives) was not only misunderstood but completely ignored by the mainstream financial media. Here we are, nearly two years after Lehman Brothers went bust, and they’re telling us that Lehman had “no idea” what its options and futures exposure was.


Let’s put this into perspective.


The notional value of the derivatives market at the time that Lehman went bust was somewhere between $600 trillion and $1 Quadrillion (1,000 trillions). It was a market of inter-linked paper contracts entangling virtually every financial institution (including some non-financials), country (Greece, Italy used derivatives to get into the European union), and county (Birmingham Alabama is one example) in the world. As a market it was at least 20 times larger than the world stock market and somewhere north of 10 time World GDP.


In other words, this was the giant white elephant in the living room.


And here’s Lehman brothers, one of Wall Streets’ finest, most respected financial institutions which had been in business for over 150 years announcing that it had “no idea” “if it had sold $2 billion more options than it had bought, or whether it owned $4 billion more than it had sold.”


In today’s world of trillion dollar bailouts, $2-4 billion doesn’t sound like much, so let’s give some perspective here… in its golden days, Lehman Brother’s market cap was roughly $47 billion. So you’re talking about bets equal to an amount between five and 10% of its market cap. Not exactly chump change.


And Lehman had no idea where it was or how much it really owed.


Mind you, we’re only addressing Lehman’s options and futures derivatives, we’re completely ignoring its mortgage backed securities, collateralized debt obligations (CDOs), and other Level 3 assets. Options and futures are literally the “tip of the iceberg,” the most visible portion of the behemoth that was Lehman’s off balance sheet derivative issues.  After all, these are regulated securities unlike most derivatives.


Now, if the above statement doesn’t send shivers down your spine, have a look at the notional value of derivatives exposure at the top five financial institutions in the US (mind you, this chart is denominated in TRILLIONS).



If Lehman had “no idea” what it owned even when it came to options and futures (regulated derivatives), what are the odds that these other firms, whose derivative exposure is tens if not hundreds of times larger than that of Lehman’s, might similarly be “in the dark’ regarding their risk?


Moreover, who on earth might be on the opposite end of these deals? Other US counties like Birmingham Alabama (which JP Morgan transformed into 3rd world country status)? Other countries like Italy or Greece (who used Goldman’s financial engineering to get into the European Union)? My next-door neighbor’s house? Tim Geithner’s long-lost tax returns? WHO KNOWS?


The point is that the very same issues that nearly took the financial world under in 2008 still exist today. In fact, this time around the systemic risk is even more severe.


Consider that the Credit Default Swap (CDS) market which nearly took the financial system down in 2008 was roughly $50-60 trillion in size. In contrast, the interest rate based derivative market is in the ballpark of $500+ trillion.


Indeed, US commercial banks alone have $182 TRILLION in notional value of interest rate based derivatives outstanding right now. To put that ridiculous number in perspective it’s 13 times US GDP and roughly three times WORLD GDP.


Fed Chairman Ben Bernanke has promised to maintain Zero Interest Rate Policy (ZIRP) for as long as possible. Now you know why. But even this guarantees nothing because at some point the bond vigilantes that visited Greece, Hungary, and Ireland will set their sights on the US. When that happens, inevitably interest rates will rise and the financial system will once again begin to implode only on a scale TEN TIMES that of 2008.


I realize this may sound ridiculous now, but all warnings of doom sounded ridiculous in 2008 right up until the world imploded (I was warning as far back as April 2008 that a full-scale Crash was coming). Again, remember Lehman Brothers had “no idea” what its options and future positions were… again, these were for regulated derivatives… do you think this ignorance was somehow a special or unique?


Or do you think Lehman’s admission is just a taste of what’s to come?

Good Trading!

Graham Summers


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