Friday, October 17, 2008

Lehman's Fall Highlights Dysfunctional Derivatives

CNBC's Jim Cramer reported that Wall Street sold $365 billion in credit default swaps on Lehman's $190 billion in liabilities, of which $104 billion is in short and long term debt. Investors were able to buy coverage for more than twice the amount of debt and they didn't need to hold it. An analogy is buying homeowner's insurance for a neighbor's house at twice it's appraised value. If an arsonist came along, you'd get a fat check, but your neighbor would be hosed.

Compounding the problem, Lehman purchased derivatives of all types, 1.5 million of them. Ex-SEC Chair and Carlyle Group Senior Adviser Arthur Levitt called derivatives "leverage on leverage." These bets need to be unwound. The bankruptcy court is now the House, trying to settle up. Hank Paulson said the Treasury would purchase derivatives. What if investors owing on failed Lehman credit don't make good on October 21? How much credit junk will pass through Hank's bank window, and will any of it be associated with Lehman?