Commentaries

When derivatives go bad

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.