There is a piece I regard as truly odd in the Wall Street Journal tonight. Either much of what I have read about investment bank bankruptcies is wrong, or something peculiar is at what used to be the house of Lehman.

A Wall Street Journal article, “Lehman’s Chaotic Bankruptcy Filing Destroyed Billions in Value,” comments at length on a report by Alvarez & Marsal for the Lehman board of directors:

As much as $75 billion of Lehman Brothers Holdings Inc. value was destroyed by the unplanned and chaotic form of the firm’s bankruptcy filing in September, according to an internal analysis by the company’s restructuring advisers. A less-hurried Chapter 11 bankruptcy filing likely would have preserved tens of billions of dollars of value…An orderly filing would have enabled Lehman to sell some assets outside of federal bankruptcy-court protection, and would have given it time to try to unwind its derivatives portfolio in a way that might have preserved value, the study says.

Based on what I had read (and perhaps misinterpreted) at the time of the Bear collapse and the Lehman bankruptcy failing, I had the very strong impression that Chapter 11 simply was not a viable option for a securities firm failure (at least a large one with extensive trading operations). If this is indeed correct, then it begs the question of why the board would engage a consulting firm to spend three months developing a report on a fictive premise (presumably to avoid liability).

Let us review the facts of the case. When Lehman was on the ropes, most commentators assumed that the fundraisings the firm was attempting to get done (the abortive foray with the Korean Development Bank, the sale of the asset management operations) would raise $10 billion, perhaps more, and allow the firm to kick the can down the road at least a couple of quarters. Bearish sorts like yours truly did not see that as a long-term solution, but a lot can happen in six months.

But when Lehman failed, the losses were (very crudely speaking) an order of magnitude greater. We have grumbled that there has been no explanation of this disparity, and that given that the firm was on the rope for nearly six months, the failure of the officialdom to get a better handle on the possible downside of having Lehman fail was a major dereliction of duty.

Some readers have contended that in fact they did but decided to cut the firm loose anyhow. I sincerely doubt that. The SEC did not make an independent assessment (as did the Treasury in the case of Fannie and Freddie). Fuld would never in private have fessed up that things were worse than the financial statements said (aside from his massive ego precluding that, it would have been an admission that the public financials were misleading and/or incomplete, a hugely damaging admission from the standpoint of corporate and personal liability). So where could the Fed and Treasury gotten further insights? In theory Lehman’s counterparties, but if the belief was that Lehman really had a $100 billion hole in its balance sheet (prior to the hasty weekend due diligence by Barclays and Bank of America), how could Paulson been so deluded as to think that he could get anyone in the industry to take on a garbage barge that bad with no government backstop? All it would to was to transfer toxic waste to another party, incurring huge damage to their balance sheet in the process.

Fast forward to the mysterious Alvarez & Marsal report. The premise of the report is that Chapter 11 was a viable option for a considerable portion of Lehman. The Journal discussion does not spell out what the alternative process would have looked like, but does specify some of the damage the Alvarez & Marsal report contends could have been avoided:

Much of the destruction of value came from the bankruptcy filing of the parent guarantor, Lehman Holdings. The filing triggered a cascade of defaults at subsidiaries that held trading contracts. That created what is known as an “event of default” for Lehman’s derivatives. This resulted in a termination of more than 80% of the transactions with counterparties — typically major European and U.S. banks such as J.P. Morgan Chase & Co., said Mr. Marsal. In all, the bankruptcy canceled 900,000 separate derivatives contracts. The problem for creditors is that this also terminated contracts in which Lehman was owed money. Mr. Marsal said a few extra weeks would have allowed Lehman to transfer or unwind most of its 1.1 million derivatives trades, preserving more cash for creditors. Overall, the losses from derivatives trades and related claims cost Lehman’s unsecured creditors at least $50 billion, according to the analysis. The findings, yet to be made public, eventually will be presented to the U.S. Bankruptcy Court and to Lehman’s creditors. “This filing, which was pretty much dictated to the board of directors at Lehman that weekend, occurred with no planning,” said Mr. Marsal, whose New York firm was hired by Lehman’s board around 10:30 p.m. Sept. 14.

Here is where readers are encouraged to correct me if I have something wrong or a bit askew. I was under the very strong impression that securities firms do not decay in an orderly fashion, but instead collapse rapidly once certain triggers are breached, making it well-nigh impossible to contain the unwind. In fact, you’d need pretty substantial changes in both bankruptcy law and the way that trading counterparties deal with each other to have the sort of managed process that the A&M reports argues should have taken place.

Specifically:

1. Once a firm is downgraded beyond a certain threshold, any counterparties that trade with it will be downgraded due to their exposures. And when other firms stop being willing to enter into repos (which do involve a credit exposure) a securities firm is toast. Liquidity is the life blood of a trading firm. And a bankruptcy filing has the same effect. From Jim Bianco: If Lehman does file, Moody’s has to downgrade their counter-party rating to junk. This forces everyone to stop doing business with Lehman. If you do business with a junk counter-party, you risk your rating falling to junk as well (you are only as good as your shakiest counter-party). Most buy-side accounts have fiduciary rules that bar them from doing business with a junk rated counter-party. Recall that this was the trigger that buried Bear. No way that Moody’s will agree to keep a bankrupt broker with an investment grade counter-party risk rating. 2. The A&M report appears to have ignored the 2005 bankruptcy law changes that rendered the claim made above, that Lehman could have blocked the unwind of its derivatives book via a Chapter 11 filing, incorrect. From the Financial Times: Wall Street unwittingly created one of the catalysts for the collapse of Bear Stearns, Lehman Brothers and American International Group by backing new bankruptcy rules that were aimed at insulating banks from the failure of a big client, lawyers and bankers say. The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors. The new rules were intended to insulate financial companies from the collapse of a large counterparty, such as a hedge fund, by making it easier for them to unwind trades and retrieve collateral. However, experts say the new rules might have accelerated the demise of Bear, Lehman and AIG by removing legal obstacles for banks and hedge funds that wanted to close positions and demand extra collateral from the three companies. “The changes were introduced to promote the orderly unwinding of transactions but they ended up speeding up the bankruptcy process,” said William Goldman, a partner at DLA Piper, the law firm. “They wanted to protect the likes of Lehman and Bear Stearns from the domino effect that would have ensued had a counterparty gone under. They never thought the ones to go under would have been Lehman and Bear.”… The changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG…. Lawyers said the 2005 exemptions also could apply to non-financial companies, potentially complicating the bankruptcy process of any company that uses derivatives. Stephen Lubben, professor at Seton Hall University School of Law, said: “These provisions affect a non-financial firm, such as a car company or an airline, because they also engage in derivatives trading.”. Now perhaps the Wall Street Journal summary does the A&M report a disservice, and they did correctly parse out any that might have been spared the 2005 bankruptcy law changes. But the FT article gives the impression these changes included most if not all derivatives.

And there is another issue. Chapter 11 filings require debtor-in-possession financing (you need to keep paying bills while holding the creditors at the time of filing at bay). Lehman would have been a very big DIP. The financial community is a really small pond. Word of Lehman attempting to line up a big enough DIP would have lead to an immediate run on the firm. No counterparty wants to risk having trading assets frozen for months, perhaps longer.

So if the logic above is correct, the A&M report looks like a costly ass-covering exercise to protect the board from lawsuits. And the Journal did the board a favor by giving it reasonably prominent placement.