Municipal bond world still feels impact of Lehman collapse
A decade after Lehman Brothers collapsed, the courts are still working on remnants of the largest bankruptcy in U.S. history as the municipal bond industry continues to feel the effects.
“For the muni market, Lehman was a domino,” said Nicholos Venditti, managing director at Thornburg Investment Management. “In and of itself, Lehman wasn’t a huge deal. But everything it knocked down with it, that’s another story.”
On Sept. 15, 2008, after 157 years of continuous operation beginning as a cotton trading firm in Montgomery, Alabama, Lehman Brothers Holdings declared Chapter 11 bankruptcy with nearly $700 billion in reported debt. Subsidiaries filed separate bankruptcies over the following weeks.
The first filing came a year after the U.S. housing market began to crumble, taking most bond insurers and numerous banks and mortgage lenders with it. The fact that Lehman was allowed to fail after the U.S. Treasury Department organized rescues for “too big to fail” Bear Stearns, which was half Lehman’s size, and Merrill Lynch, shocked world financial markets.
“It was not just the largest case in history but also a case that truly tested the capacity of the U.S. bankruptcy system for its mass of complexity and mass of scale,” said James Peck, the bankruptcy judge who presided over the case in the Southern District of New York, who is now with the law firm Morrison & Foerster. “Never before had there been a case at this level of global significance.”
For Paul Wageman, then chairman of the North Texas Tollway Authority, the collapse of Lehman added an air of unreality to a year that had already gone sideways. At the time, NTTA was lining up long-term financing for the largest project in its history, a $3.2 billion development of State Highway 121 in the suburbs north of Dallas. NTTA’s top underwriting pool consisted of Citi, Bear Stearns and Lehman Brothers.
“I was in Phoenix, Arizona, and I got a call that Bear Stearns was disappearing and I just couldn’t believe it,” Wageman recalls. “Just a week and one day before, we had closed on a more than $2 billion refinancing of bond anticipation notes with Bear Stearns. One week later, they were gone. We still had more than $1 billion to refinance, and who was our lead bank to do it? Lehman Brothers. The bankers that we used in the syndicate never got paid because it was tied up in the bankruptcy.
“Basically we lost two banks within a few weeks. We looked at the one remaining bank in the pool, Citi, and its stock was trading for around $2 per share,” he said.
“It was an extraordinary time; I was very concerned about our access to capital,” said Wageman, who now serves on the board of the Dallas Area Rapid Transit Authority. “For those who lived through it, it changed the way they view the world.”
Since the Lehman collapse, the muni bond industry has changed dramatically, said Noe Hinojosa Jr., founder and chief executive of the advisory firm Estrada Hinojosa & Co.
“You’ve had a lot of mergers, a lot of people leaving the business in general,” Hinojosa said. “When I started the business in the late 1980s there were over 10,000 broker dealers. Today, there are about 3,200.”
The regulatory regime that tightened control of the muni market players also made access to capital more challenging for small issuers, Hinojosa said.
While Lehman’s role in the municipal market represented just one facet of the complex bankruptcy, Peck recalls local governments seeking favorable terms in unraveling interest-rate swaps that included the bankrupt investment bank as a counterparty.
“At least in respect of the derivative book of Lehman, the collapse had a very significant impact on those issuers that had interest-rate swaps, some of them in the money, some not,” Peck told The Bond Buyer.
One of Peck’s most significant rulings came on Dec. 19, 2013, involving the application of safe harbor provisions of the Bankruptcy Code to an interest-rate swap agreement. The Michigan State Housing Development Authority emerged the winner when Peck ruled that contractual provisions specifying the method of calculating the settlement amount under a swap agreement are protected by the Bankruptcy Code’s safe harbors. The decision followed the reasoning of an amicus brief filed by the International Swaps and Derivatives Association.
At the time of its first Chapter 11 filing, Lehman was party to more than 900,000 derivative contracts.
Until Lehman’s collapse effectively closed all credit markets, the average synthetic fixed-rate interest rate swap had saved 52 basis points for a double-A-minus rated municipal issuer, Scott Fairclough, managing director at Topstone Capital Advisors Inc., wrote in a 2010 commentary in The Bond Buyer.
When interest rates flat-lined, tilting the swaps in favor of the banks, issuers faced millions of dollars in termination fees.
The state of New York, San Francisco International Airport and the East Bay Municipal Utility District in California, the North Texas Tollway Authority, Georgetown University, and St. Louis University were just a few of the muni issuers caught in interest-rate swap agreements with Lehman. Although Lehman’s swaps entities were not part of the original bankruptcy filing, they later filed separately.
Most terminations cost muni issuers money because local governments and hospitals entered into swaps to hedge variable-rate debt payments when fixed rates were higher. With short-term rates low, the issuers were paying more on the fixed-rate side of the trade than they were receiving on the variable-rate side.
New York State owed about $20 million for its mandatory termination in September 2008, according to the state Division of Budget. The state made the payment out of its debt reduction reserve fund.
New York had about $552 million of interest rate swaps outstanding with Lehman swap entity LBDP, including $215 million on personal income tax bonds, $119 million of mental health bonds, and $220 million of appropriations-backed bonds.
Steve Weyl, an attorney with Butler Snow in Boston, represented about a dozen clients, mostly small 501(c)3 nonprofits in New England that had swaps with Lehman and ratings below investment grade. Of those, one is still in the swap today, which is guaranteed by Deutsche Bank.
“The more creditworthy the borrower, the more options they had to replace the swap,” Weyl said.
State and local governments were exposed not just to swaps with Lehman but also with investments, particularly those needed for short-term liquidity.
The bankruptcy of Lehman “cut the heart out of the commercial paper market,” Robert Hullinghorst, then treasurer for Boulder County, Colorado, told the House Financial Services Committee on May 9, 2009.
At that hearing, representatives of local governments that lost an estimated $1.7 billion in holdings through Lehman sought legislation to be reimbursed for their losses through the Trouble Asset Relief Program signed into law 18 days after Lehman filed for Chapter 11. Local officials noted that they had bought highly rated instruments in a responsible way and that if they had purchased riskier investments through Bear Stearns, Merrill Lynch or insurance giant AIG they would have lost nothing because those firms were bailed out by taxpayers.
“There are affected communities in at least 20 States, from Alaska to Washington to Massachusetts,” said Rep. Jackie Speier, D-Calif. “Some of the losses are relativelysmall, but Minnesota lost more than $56 million. Missouri lost $50 million. Oregon lost $173 million. Washington lost $130 million, and Florida, already hit hard by two natural disasters and a recession, lost more than $465 million.”
Christopher Thornberg, economist with Beacon Economics, told the committee that San Mateo County, California, public agencies lost about $155 million in investments due to the Lehman bankruptcy.
“These financial losses mean the loss of approximately 1,660 local jobs, approximately one-half of 1% of the county’s overall employment base,” Thornberg said. “It will suffer an overall loss of $216 million in output in the local economy, including $100 million in worker income. Not to mention, of course, the major delays in the completion of projects necessary for the growth of the economy.”
When Lehman emerged from bankruptcy in 2012 as a reorganized entity designed to service its remaining obligations, creditors were expected on average to receive well below 50 cents for each dollar of their claims.
But the litigation stemming from the bankruptcy is still in the courts, Peck noted.
In June, Lehman settled a $1.2 billion derivatives lawsuit with Credit Suisse Group, one of the largest remaining legal battles. Creditors were expected to recover about $280 million of Credit Suisse’s derivative claims. That settlement came under Peck’s successor Judge Shelley C. Chapman.
“It will probably take another year or two to resolve the remaining claims,” Peck said.
"That’s a long period of time, but it's a case that’s in a class by itself. It’s a case that’s unique.”