Contrarian Capital…not so much

July 8, 2009

With a name like Contrarian Capital one would think this Greenwich, Conn. hedge fund would have been savvy enough to sniff-out the impending trouble at Lehman Brothers. But apparently, the managers of Contrarian weren’t contrarian enough.

A week ago, Contrarian filed a rather large $100 million notice of claim in the Lehman bankruptcy, an indication that it was a bit too bullish on the failed investment house. But what makes the claim really interesting is that it stems from losses on Lehman-issued structured notes–something often sold to retail investors.

I’ve been writing a lot about structured notes being a terribly flawed investment product. The main problem with structured notes is that they generate big fees for investment banks and often are falsely pitched as conservative investments. Many are described as being “principal protected.” But as the Lehman experience has shown, that guarantee means nothing if the issuer goes bust.

Additionally, the main feature of a structured note–an embedded derivative that tries to capture the price increase in an underlying basket of stocks, commodities or a particular index–is something that often can be replicated by a investor without the aid of an investment bank. And the embedded derivative is notoriously complex and simply adds more counterparty risk into the financial system. 

Yet structured notes, up until the financial crisis, were a big business for banks in Europe and Asia. The main buyers: retirees and average investors.

And here’s what really interesting about the notes purchased by Contrarian–they were issued by a little-known Lehman subsidiary in Amsterdam that sold some $35 billion in these now worthless securities. Back when I was a reporter for BusinessWeek, I wrote a long article about this Lehman subsidiary with my former colleague David Henry. In the story, we described how dubious products like structured notes had imperiled the concept of global banking and posed a big problem for regulators trying to tackle the derivatives mess.

It’s been nine months since Lehman collapsed and the bankruptcy case is quickly fading from the headlines. But it shouldn’t. In many ways, the Lehman case is just getting going as the battle over the fallout from the messy unwind of Lehman’s hefty derivatives book is just getting started.

A week ago, I wrote about another large $102 million claim filed by Drake Capital Management stemming from the collapse of a series of derivatives trades it had Lehman. The claim, all 543-pages of it, illustrates just how complex these esoteric transactions are and why regulating derivatives won’t be easy.

A lot can be learned by picking through the Lehman rubble to see how the world’s bank got us into this mess and how we might be able to stop the next mess from occurring.

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