When Hedges Fail

Here's a gentle reminder for CFOs and risk officers at major international banks: if you hedge your position but you don't hedge it 100%, then you haven't fully hedged your position.

Last month, it was UBS, which made a decision based on "statistical analyses of historical price movements" that if it hedged its super-senior bonds against a price fall of somewhere between 2% and 4%, then those bonds were fully hedged. Now, it's Lehman Brothers:

Erin Callan, Lehman chief financial officer, has said publicly that Lehman's previously successful hedges, which included bets against indexes such as the CMBX, which tracks the performance of commercial mortgage backed securities, are no longer performing well...
Any second-quarter loss would be driven by both a reduction in the value of those holdings as well as the less effective hedging.

Many hedges are limited: they give you protection against some of the possible downside, but not all of it. That's clearly what's happening here - as the holdings continue to decline in value, the hedges have essentially been used up.

The worrying thing is that Lehman has some seriously enormous exposures here:

At the end of the first quarter, Lehman said it had exposure of $36.1bn to commercial mortgages and related securities and $31.8bn in exposure to residential mortgages and securities.

Add those two together and you get $67.9 billion, which is three times Lehman's market capitalization and (since the bank is trading on a price-to-book ratio of 1) three times its book value, too.

Maybe it's time to revisit Jesse Eisinger's column about Lehman's balance sheet.