Lehman's carcass has handed huge profits to distressed funds

RHB Economics Research said the highest recorded CDS spread was in October 2008 at 491 basis points, following the Lehman Brothers incident

NEW YORK: It was a bold move: buy at Lehman Brothers’s darkest hour. But a decade after Lehman’s collapse, a handful of hedge funds that bought up the bank’s debt for pennies on the dollar have made even more money than seemed possible.

More than US$124.6bil has flowed to Lehman creditors, and a further US$1.4bil may yet be coming. At least US$92.2bil has gone to those last in line: unsecured creditors. Some of the largest and earliest buyers, according to people familiar with the case, were distressed debt hedge funds Elliott Management Corp, Paulson & Co, Baupost Group LLC, and Varde Partners.

Expected to recover just 21 cents on the dollar when the reorganisation came together in 2011, they’ve so far received 45 cents. In Lehman’s UK unit, senior claims have gotten 140 cents on the dollar.

While Lehman’s bankruptcy, the largest in history, with US$613bil in debt, was a boon to the funds, it’s not unprecedented. After Enron Corp’s 2001 bankruptcy, unsecured creditors eventually got returns of 53 cents on the dollar, triple that projected by the plan.

“Lehman was a catastrophe,” said James Peck, who presided over the early years of its bankruptcy. But reaching a resolution in 2011 went relatively smoothly. The big reason: Hedge funds had a strong incentive to resolve issues because they had bought claims at a deep discount and wanted to see them gain value, he said.

The original investors, such as pension funds or Lehman’s business partners, walked away with immediate money but with less than they would have if they’d held on.

The recoveries since defy early expectations amid what was known as the “fog of Lehman”. Banks like Goldman Sachs Group Inc and Citigroup Inc had huge derivatives-related claims with Lehman that would prove nightmares to quantify. At first, some thought there would be nothing for unsecured creditors.

“We had no information, literally,” recalled Shai Waisman, an initial lawyer on the case.

Then, the hedge funds came, racing to figure out where assets were, even before Lehman’s advisers at Alvarez & Marsal did so. Elliott bought Lehman bonds within days, one of the people said. Soon after, it began buying claims on the secondary market at a deep discount.

The bonds had traded at around 8.625 cents on the dollar at the outset. They have now appreciated to 47.5 cents. Claims traded anywhere from 10 cents to 30 cents in the early years, a source familiar with the prices said.

One of the biggest legal fights was over whether to view Lehman’s assets and debts as pooled at the holding company or belonging to its warren of subsidiaries and foreign affiliates. Dan Kamensky, who had just joined Paulson from Lehman, giving him insights into how the company ran itself, pushed the consolidated position. His view was eventually echoed by Bryan Marsal, the restructuring officer in charge of Lehman, and Pacific Investment Management Co and the California Public Employees’ Retirement System, which also had claims against the holding company.

“The marketplace was trying to analyse each box within the Lehman complex,” recalled Kamensky, who now runs Marble Ridge Capital. “But the math became simple when you started thinking about it as a consolidated entity.”

That view pitted it against hedge funds that were more diversified in their Lehman holdings. These funds included Elliott, Baupost, King Street Capital Management, Davidson Kempner Capital Management and CarVal Investors. The source spoke on condition of anonymity because the claims trades are private. Elliott, Varde, CarVal and Baupost declined to comment on the performance of their claims. King Street, Davidson Kempner and Paulson didn’t return calls for comment. — Bloomberg