Lehman and the Failed Hedges

It looks as though Lehman Brothers is going to lose money in the second quarter. That's partly because the second quarter, for banks, includes March, which was a particularly brutal month in the capital markets. But it's also because the finance wizards at Lehman seem to be incapable of hedging their positions:

During the second quarter, Lehman was stung by hedges used to offset losses in real estate and other securities, according to people familiar with the matter. The firm bet that indexes tracking markets such as real-estate securities and leveraged loans would fall. If that happened, it would book profits that would make up some of its losses from holding these securities and loans.
However, in an unexpected twist, some of the indexes rose, even as the assets they were supposed to hedge against continued to lose value or stayed relatively flat.

We've seen this movie before, most memorably at Bear Stearns. The fact is that during a credit crunch, when you're stuck with illiquid assets, you can't hedge them. You can sell them, at a loss. But just as short positions in CDO equity tranches turned out to be a really bad hedge for long positions in super-senior tranches, short positions in broad credit indices are not a great hedge for specific loans which have turned sour.

Ironically, it was Bear Stearns who had at least some people, led by mortgage head Tom Marano, who understood this. They knew that the big risk to the firm was chaos in the financial markets, so they put on a "chaos trade" which would make lots of money in such an event, and very broadly hedge the risks the bank faced. But CEO Alan Schwartz, in a fateful decision, reversed that trade. As Kate Kelly reported,

he wanted specific pessimistic plays that would offset specific optimistic bets, rather than the broader hedges Mr. Marano had employed.

Explains Dear John Thain:

Matching your hedges to your positions one-to-one is fine, until you realize that it's impossible to do this in a liquidity-challenged market.

It seems that Schwartz, an investment banker by trade rather than a trader, didn't understand this:

Clearly this requires a deeper understanding of how interconnected markets are and exactly how they work together-potentially a leap of faith or a layer of complexity the firm wasn't willing to bet on.

Could it be that Lehman, even after seeing what happened at Bear, is making the same mistakes? That it's trying to hedge its positions discretely, even in market which has systematically slaughtered anybody who's tried to do that for the past year? If so, the firm truly faces some rocky times ahead.

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