When you are "too big to fail"

Like other financial institutions, Lehman’s problems stemmed from borrowing too much to finance too many hard-to-sell investments, such as mortgage-backed securities, that were declining in value as a result of the deteriorating real estate market. Lehman was different because the government let it declare bankruptcy, meaning the company’s creditors were wiped out as well as its stockholders.

Willard Scolnik, a 78-year-old retired architect in Palm Harbor, Florida, who said he had $400,000 in Reserve Primary that he needed to help pay for a lung transplant for his son, was one of the unlucky ones. He couldn’t get his money out. Neither could Akron, Ohio-based Goodyear, the largest U.S. tiremaker by revenue, which had $360 million stuck in the fund.

Another loser was Colorado Diversified Trust. Municipalities park their cash in the trust before shelling out for projects such as a new road or sewer improvements. Boulder County was forced to write off $687,000, its share of the trust’s losses, according to Bob Hullinghorst, the county treasurer. That would have paid for 20 new health-care employees, he said.

“It makes me mad,” Hullinghorst said. “We thought our money was safe.”

The run on money market funds, considered the safest investments after bank deposits and the major buyers of commercial paper, sent shivers through the global economy. World stock markets lost $2.85 trillion, or more than 6 percent of their value, in three days. Banks’ cost of borrowing overnight from other banks, as measured by the London Interbank Offered Rate, or Libor, jumped 4.29 percentage points between Friday, Sept. 12, and Tuesday, Sept. 16.

The disintegration of the commercial-paper market came around to bite banks such as Morgan Stanley and Citigroup, whose CEOs, John J. Mack and Vikram S. Pandit, were at the weekend meetings. It sapped them of the capital they needed to extend credit, even to one another.

“The fear factor that went through the markets was pretty amazing” as credit concerns caused banks to stop lending to each other, Fox said. “The ripple effect was huge.”

The ripples reached as far as Hong Kong, where Lehman’s default on commercial-paper debt paralyzed payments on so-called minibonds, structured notes sold in $5,000 denominations and guaranteed by Lehman.

Sun Kwan, 58, a retired parks worker, said he invested $285,000, most of his life savings, in Lehman minibonds. He was among an estimated 43,000 in the city who bought $1.8 billion of the notes, according to the Hong Kong Monetary Authority. Sun lost it all and has taken part in protests since October, rain or shine, trying to get his money back.

Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies, commodities or linked to specific events such as changes in interest rates. Lehman had made about 1 million such bets in the over-the-counter market, according to a person with access to that information.

The unregulated $592 trillion market for over-the-counter derivatives, 41 times the size of the U.S. economy, contributed more than half of some banks’ trading revenue and had never been tested by the bankruptcy of a major Wall Street firm.

Swaps are a way for investors to gamble on whether companies will continue making debt payments or for lenders to buy insurance against borrowers who stop paying. If the company defaults, one side in the bet pays the buyer face value of the debt in exchange for the underlying securities or the cash equivalent.

Taken from Bloomberg.com