When derivatives go bad

July 2, 2009

THUD! That’s the sound a busted derivative trade makes when it lands at the courthouse steps.

Drake Capital Management, once a highflying hedge fund manager that is now winding down its operations, claims it’s still owed some $102 million on a derivatives trade that went kablooie when Lehman Brothers filed for bankruptcy. Like most of Lehman’s thousands of creditors, the New York hedge fund hasn’t been paid a penny.

So Drake has filed a weighty 543-page document in bankruptcy court to press its point. A close look at the Drake filing shows why the Obama administration’s proposal to regulate and rein in these often exotic financial instruments may be easier said then done.

Only five pages of the filing are devoted to the so-called proof of claim, where Drake co-founder Steven Luttrell explains why the hedge fund is still owed money. Most of the remaining 538 pages are what constitutes the actual derivative — the various contractual agreements spelling out the terms of the trades between Drake and Lehman. The agreements date back to August 2004.

To be precise, there wasn’t just a single derivatives trade between Drake and Lehman. In fact, there were many different trades involving a whole assortment of underlying assets including foreign currencies, municipal bonds, corporate bonds and sovereign debt. Drake kept expanding its trading relationship with Lehman by adding on one derivative transaction after another.

So by the time Lehman collapsed in September, Drake and the investment bank had entered into interest-rate swaps based on the Australian dollar, the yen and the pound. Drake also sold and bought credit default swaps on debt issued by Hertz, GMAC, HCA and the Republic of Kazakhstan–among others. Drake’s $102 million claim is a combination of the money the fund made on some of those trades and the excess collateral the hedge fund was required to post with Lehman as a condition of doing the trades.

The multi-layering of derivatives trades is actually commonplace in this shadowy market. To date, Drake’s $102 million claim is one of the larger ones filed in the Lehman bankruptcy. But many of the derivative-related claims filed by other Lehman trading partners that have incurred smaller losses are no less voluminous and complex.

It’s simply easier for a hedge fund that has an existing trading relationship with a Wall Street bank to keep adding on additional derivatives trades — especially if the fund already has posted a sizable sum of collateral with the bank. And that’s why the Obama administration’s plan to require so-called standard derivatives to be traded on centralized exchanges — an attempt to bring some order to this unruly market — will be hard to institute.

It’s not clear if the transaction between Drake and Lehman would classify as a standard transaction, or a harder-to-regulate non-standard, or customized transaction.

Taken individually, each trade between Drake and Lehman might be standardized enough to be cleared and processed through a regulated exchange. But if the transaction is taken as a whole, does it morph into a hard-to-regulate customized derivative? It’s not certain.

In June, Christian Johnson, a derivatives scholar and law professor at the University of Utah, told the House Financial Services Committee that one of the “unanswered questions” with the Obama administration’s proposal is that it’s not clear when a derivative becomes “sufficiently standardized” to be traded on an exchange.

In his prepared testimony, Johnson noted that one reason derivatives “are not currently being cleared is due to their inherent complexity and non-standardized terms.”

When I spoke to Johnson by phone the other day, he reiterated his concern that everyone is talking about regulating derivatives without dealing in specifics. “This is incredibly slippery because they won’t tell you what they are talking about,” Johnson says. “The devil is in the details.”

That’s a problem for the Obama administration. But it’s also one for Wall Street. If the regulators, the math wizards and trading geeks can’t come up with a good definition of what constitutes a standard derivative, it’s very well possible some legislators will start calling for the banning of whole classes of derivatives.

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[...] important since the crux of the Obama plan is for regulating standard derivatives. A week ago I pointed that the Obama administration had failed to explain the difference betwee the two. And Geithner [...]