10-2-17 8:33 PM EDT | Email Article
By Andrew Scurria 

Citigroup Inc. will hand over $1.74 billion to walk away from disputes with now-defunct Lehman Brothers Holdings Inc., a deal that cuts short an autopsy of the banks' crisis-era derivative-trading practices.

A deal announced Friday concludes several outstanding disputes between Citi and a team of Lehman Brothers bankruptcy administrators, most notably a $2 billion lawsuit over the cost of replacing derivatives trades terminated upon Lehman's bankruptcy on Sept. 15, 2008.

Since April, U.S. Bankruptcy Judge Shelley Chapman has heard 42 days of evidence and testimony in the case, in which 170 people gave depositions and 30 witnesses wrote expert reports seeking either to justify or discredit Citi's calculation of what it was owed.

Pending approval of the deal, the judge won't have to decide the critical question of how banks should determine their damages when the institution on the other side of its derivatives positions shuts its doors.

Lehman had derivatives trades with roughly 6,700 counterparties when it entered bankruptcy. With Citi's deal, only one holdout counterparty, Credit Suisse, hasn't settled with the bankruptcy estate.

A Citi spokeswoman said the settlement "furthers management's goals of resolving legacy matters stemming from the financial crisis and focusing on Citi's strategic business objectives."

Citi had more than 30,000 derivatives trades on its books facing Lehman. The trial was supposed to determine Citi's proper compensation for having to replace the economic terms of those positions. It shed new light on the frantic weekend before Lehman went under, and the immediate aftermath, when traders allegedly used chaos in the marketplace to justify running up huge transaction fees that Lehman said were disconnected from actual replacement costs.

A standard promulgated by the International Swaps and Derivatives Association, the self-governing body for derivatives markets, days before Lehman's collapse says only that participants should act in a commercially reasonable manner when determining their damages, known as closeout amounts.

The dispute raised "the factual question of how closely your calculation of a closeout with a bankrupt counterparty tracks your normal course of business," said Joshua Dorchak, a lawyer with Morgan Lewis & Bockius LLP who has advised other institutions caught up in Lehman's collapse. "And the legal question of whether those difference are so substantial that your closeout was commercially unreasonable or in bad faith."

The judge heard recorded phone calls from the head of Citi's emerging-markets trading group, Mark Pagano, including one instructing a colleague calculating a closeout amount to "pretend they weren't a dealer, they were a real-money, slow-moving deer account."

The "slow-moving deer" reference, Lehman's attorneys argued, showed that Citi ignored the lower transaction costs available to market-making dealers such as itself and based its claim on what ordinary participants would have paid. Citi argued that all derivatives counterparties should recoup the same amounts following a bankruptcy whether they are dealers or ordinary market participants.

Derivatives are used by corporations, financial services firms and other institutions to mitigate their exposures to fluctuations in interest rates, currencies and commodities and to hedge credit risks on corporate borrowers. Trades can overlap, or offset, each other, meaning the notional amount outstanding doesn't reflect an institution's true exposure. Citi took the position that it could charge Lehman for the cost of replacing its 30,000 contracts individually, without "netting out" the offsetting contracts.

The bank also said it was entitled to recoup transaction costs, including the difference, or "spread," between the bid price and the offer price, despite the usual accounting practice of valuing trades at a midmarket price. Two days after Lehman's bankruptcy, Mr. Pagano was asked by a colleague whether traders should continue marking their books using bid-ask spreads.

"That was one night," he said, according to a recorded call that was played at trial. "One night only."

Lehman offered its largest derivatives counterparties, dubbed the "big-bank counterparties," the chance in 2011 to settle their claims under a stipulated valuation method, in exchange for not seeking to reduce those claims further in what would undoubtedly be lengthy, expensive litigation. About 30 large financial institutions filed $22 billion in derivatives claims against Lehman and its derivatives subsidiary. Under the settlement framework, Lehman estimated those claims would total around $10 billion. Citi, which rejected the offer, now stands to keep $350 million out of $2.1 billion in cash that Lehman had on deposit before the bankruptcy. Judge Chapman conferred with the banks during negotiations, according to the settlement.

Some Lehman counterparties knew they were "pushing the envelope" with their closeout calculations, "and some tried to get everything precisely right," said Mr. Dorchak, the Morgan Lewis & Bockius lawyer.

Losses from terminated derivatives trades cost Lehman's bankruptcy estate at least $50 billion in value, according to a 2008 report by restructuring adviser Alvarez & Marsal. The over-the-counter derivatives market that has emerged since 2008 has been reformed by Dodd-Frank regulations and central clearinghouses to try to avoid a repeat.

The size of the OTC derivatives market has shrunk since the financial crisis, according to the Bank for International Settlements. The reduction in size is in part because of trade compression, whereby banks replace offsetting derivatives contracts with a new trade containing the same net exposure. But it "hasn't been acid-tested yet," said Peter Bible, chief risk officer of accounting firm EisnerAmper LLP, because it hasn't had to absorb a default of a large financial institution. Investors had $484 trillion of contracts outstanding in the second half of 2016, down 20% from 2008. Settlements of derivatives claims have been a significant source of cash for hedge funds that snapped up unsecured claims against Lehman in the last nine years. It has been a fruitful bet. Lehman said last week it would hand out another $2.4 billion to creditors, bringing the total payout from the chapter 11 proceedings to about $119 billion. Senior unsecured creditors, bondholders who were estimated to receive about 21 cents on the dollar, will have recovered more than double that amount when the next distribution is completed.

 

(END) Dow Jones Newswires

October 02, 2017 20:33 ET (00:33 GMT)

Copyright (c) 2017 Dow Jones & Company, Inc.
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