Sept. 10 (Bloomberg) -- Yu Lia Chun, a retired hospital orderly in Hong Kong, never heard of Lehman Brothers Holdings Inc. before she got a call last September from her banker.
“He said, ‘Did you hear the news? Something has happened to Lehman,’” Yu, 66, recalled in an interview in June. “I didn’t get it.”
Yu, who has a sixth-grade education, said she thought her money was in a savings account. She didn’t know she had lent it to a bankrupt American securities firm. Eventually, she found out that her HK$1.2 million ($155,000) nest egg was gone. Her children lost another HK$3.8 million because Yu had persuaded them to make similar investments.
“There is no way a person like me could understand any of this,” Yu said, dabbing her eyes with a tissue in a coffee shop in Hong Kong’s financial district. “Sometimes I feel like jumping off a building.”
What hit Yu and her family was a tidal wave triggered halfway around the world by the biggest bankruptcy in U.S. history. The Sept. 15, 2008, collapse of Lehman, with $613 billion in liabilities, had unforeseen and far-flung consequences that devastated those, like Yu, who didn’t know their fates were tied to the New York-based investment bank.
The chief operating officer of a private-equity firm in London jumped in front of a commuter train because he blamed himself for leaving the company’s money in a Lehman account, according to a coroner’s report. The Israeli managers of a hotel construction project on the island of West Caicos, northeast of Cuba, were taken hostage by Chinese workers when an anticipated Lehman loan didn’t materialize and wages weren’t paid. In Hong Kong, Yu and thousands of others who had invested in Lehman products camped out in the rain, thumping drums and chanting, “Give us our money back.”
The realization that a U.S. securities firm so woven into the financial system couldn’t pay its debts radiated out from New York, panicking investors around the world. It was a doomsday scenario that former International Monetary Fund chief economist Simon H. Johnson likened to Kurt Vonnegut Jr.’s 1963 novel “Cat’s Cradle,” in which a single crystal of the fictitious substance ice-nine hardens all of the planet’s water.
What differentiated Lehman from previous financial crises was how fast the panic spread, said Richard Sylla, an economic and financial historian at New York University’s Leonard N. Stern School of Business in New York.
“Communications made things happen faster,” Sylla said, describing how it took six months for the 1931 failure of Austria’s Creditanstalt bank to put stress on the British financial system. “The news of everything got spread around much quicker this time.”
Goldman Sachs Debt
The freezing of global credit markets following Lehman’s demise began with professionals who traded commercial paper in New York. They were the first to feel the chill when the Reserve Primary Fund, the oldest money market fund, was inundated with requests for redemptions and seized up hours after the bankruptcy filing. The $785 million that Reserve had lent to Lehman was deemed worthless by 4 p.m. the next day.
Fear that more banks and financial firms might fail meant most investors stopped lending to anyone other than the government. Even New York-based Goldman Sachs Group Inc., which earned $11.6 billion in 2007, more than any U.S. securities firm in history, wasn’t immune. The average annual cost of insuring $10 million of Goldman Sachs debt for five years soared to a record $545,000 from $182,557 in the three days after Lehman failed, according to data compiled by Bloomberg.
Plummeting Prices
Lehman’s demise triggered a panic. Money fund managers were forced to raise cash to pay off investors. They tried selling what securities they held and couldn’t. The market was flooded, and prices were plummeting -- if prices could be obtained at all. The Standard & Poor’s 500 Index suffered its worst decline in six years. Mistrust leaked into the corporate bond market.
The most widely traded 30-year bond of General Electric Capital Corp., the world’s biggest issuer of commercial paper, dropped by as much as 30 cents on the dollar to 62 cents by Sept. 18 because of doubts that GE would be able to persuade money funds to renew its short-term notes.
At that price, the three-day loss for owners of the issue was more than $1.9 billion, according to prices provided by Trace, the bond-trade reporting system of the Financial Industry Regulatory Authority.
The U.S. responded within a week to guarantee money markets and bank-to-bank lending. Within a month, Congress agreed to spend $700 billion to prop up banks under the Troubled Asset Relief Program, the Federal Deposit Insurance Corp. guaranteed new bank debt, and Federal Reserve lending to financial institutions ballooned by $1 trillion.
Lehman Minibonds
Those programs, which succeeded in stemming the panic, remain in place today. What they didn’t do was save Yu and thousands of other investors in Hong Kong, Singapore, Taiwan and elsewhere who had bought equity-linked notes or so-called minibonds connected to Lehman.
Equity-linked notes combine attributes of both bonds and stock by investing part of the proceeds in share options and the remainder in fixed income. Minibonds are custom-made securities linked to the creditworthiness of companies, backed by collateralized-debt obligations and sold in denominations of $5,000. They functioned like credit-default swaps in reverse, where the investor stands to lose his principal when the firm named in the note can’t pay its debts.
‘Information Asymmetry’
Yu, a mother of six who emigrated from mainland China in 1962, didn’t have a chance, according to Joseph Stiglitz, a Columbia University economics professor who won a Nobel Prize for his work on the effect of unequal access to information on buyers and sellers in financial markets.
“As securities got more complex, the opportunities for gaming, to the disadvantage of ordinary people, increased,” Stiglitz said. “Complexity opened up new venues for information asymmetry, which banks exploited.”
Asia became Lehman’s highest growth region in 2007, taking in more than $3.1 billion in revenue, or 16 percent of the firm’s business. Revenue was up more than 41 percent from 2005 in Asia, while it climbed 3 percent in the U.S. in the same period, according to Bloomberg data.
Yu said she went to an export trade show in Hong Kong two years ago and met Chow Chi Chung, a salesman for Amsterdam-based ABN Amro Holding NV. He offered her a better return on her savings if she switched banks, she said. So she did.
Two-thirds of Yu’s money, about $100,000, came from a settlement with her employer after an elevator fell half a floor, injuring her pelvis, according to Yu, who still drags her right leg when she walks.
Didn’t Read Prospectus
A month after their meeting, Yu said Chow called her to say he had a new product that could return as much as 20 percent a year because it was linked to the stock performance of three large Chinese companies -- China Communications Construction Co.,China Merchants Bank Co. and Ping An Insurance Co.
Yu said she didn’t read the fine print, trusting Chow when he told her she couldn’t lose her principal. Had she looked at the prospectus and understood it she would have discovered that she had essentially bought three call options -- contracts that would capture gains if the shares of the three companies rose by a certain amount -- coupled with the equivalent of a Lehman corporate bond. If Lehman defaulted, her money would be gone.
Cash Bonus
ABN Amro, now part of Edinburgh-based Royal Bank of Scotland Group Plc, also recruited Yu to sell the same product to her family, giving her a cash bonus of about $155 for each person who signed up, she said.
Yuk Min Hui, a Hong Kong-based spokeswoman for RBS, declined to comment about Yu’s case. She said in an e-mail that if the bank determined that “sales processes and guidelines were not properly followed,” it would offer “appropriate remedies.” Only a small number of investors fall in this category, she said.
Chow couldn’t be located.
There are 873 issues of such Lehman equity-linked structured notes outstanding with a combined face value of about $8.7 billion, all now in default, according to data compiled by Bloomberg. Bonds were denominated in pounds, Swiss francs and Hungarian forint, as well as Australian and Hong Kong dollars.
Banks also sold $1.8 billion of Lehman minibonds to an estimated 43,000 investors in Hong Kong, where the notes were first marketed in 2003, according to the Hong Kong Monetary Authority. The biggest seller was BOC Hong Kong (Holdings) Ltd., a unit of Beijing-based Bank of China Ltd.
Financial Dumplings
The minibonds were all issued by a Cayman Islands-based entity called Pacific International Finance Ltd., set up by Lehman with trustees from London-based HSBC Holdings Plc. The notes were financial dumplings -- derivatives contracts tied to the creditworthiness of major companies wrapped inside Lehman corporate bonds. Series 19 notes, for instance, were linked to securities dealers including Citigroup Inc. and Goldman Sachs. If any of those businesses or Lehman defaulted, the investor wouldn’t get paid.
In effect, investors in Series 19 notes bought the losing end of credit-default swaps, or insurance policies pegged to the survival of financial institutions. If any of those companies failed, the noteholders were the ones responsible for paying off the principal on the derivative.
Lehman took payments from investors in exchange for a guaranteed yield, then placed the cash in a Lehman-managed money market fund and issued commercial paper to borrow more money. Those funds were in turn used to invest in CDOs sold by Lehman off-balance-sheet entities in places such as Ireland and the Cayman Islands.
‘Blood and Sweat’
Sun Kwan, a 58-year-old retired parks worker, was among those who bought Lehman minibonds. He stood outside the I.M. Pei-designed Hong Kong headquarters of the Bank of China on June 15, along with Yu and 51 other protesters, banging a chipped red drum with a stick every two seconds. Raindrops beaded on the brim of his blue cap. A sign around his neck, hand-lettered in Chinese characters, read: “The Bank of China is a hooker. Give me back my money earned with blood and sweat.”
Sun, who has a high school education, invested about $285,000 in Lehman Minibond Series 12 notes, sold to him by BOC Hong Kong, which paid about 4 percent interest a year.
He said he thought he was putting his money into a certificate of deposit. Instead, as the prospectus explained, the notes were a bet against the default of the Chinese government and five companies, including Hutchison Whampoa Ltd., which operates ports and telecommunications services, Chinese state-owned oil producer CNOOC Ltd. and Lehman.
As an incentive, he was given $26 in supermarket coupons.
Rhinos, Whales
Sun also purchased $40,000 worth of Octave Series 10 notes, a similarly structured product created by Morgan Stanley, in which the investor would lose all of his money if Lehman or any of six other companies defaulted. He said he never heard of Lehman and thought the notes were backed by the People’s Republic of China because most of the businesses were state- owned.
Nick Footitt, a spokesman for Morgan Stanley in Hong Kong, declined to comment.
Each minibond series was custom-made, so their characteristics differed. Packagers skipped using some numbers, including 4, which is considered unlucky in Chinese culture and would make the bond difficult to market. Investors got prizes, including video cameras and flat-screen televisions, according to newspaper advertisements and fliers handed out at banks. The ads, in both Chinese and English, featured rhinoceroses, whales and other symbols of potency, luck or profit.
‘Rotten Deal’
“It’s all gone,” Sun said in an interview conducted through a Chinese translator at the demonstration. “I almost wanted to kill myself. I’ve been crying for months, even though I am a man.”
He said he hadn’t yet told his 25-year-old son, Sun Chi Yan, what had happened to his nest egg, most of which came from a settlement when the government bought his family’s land.
Sun and Yu were among investors who staged protests almost every business day for nine months, sparking a Hong Kong legislative investigation and calls for more protection for retail customers. The raucous demonstrations in the city’s financial district, including a tent encampment and bullhorns connected to an iPod that blared the looped chant “Rotten Deal -- Money Back,” became an embarrassment to the banks.
In a city of 7 million, where only 30 percent of workers had pensions before 2001, the Lehman protesters struck a chord, according to Audrey Eu, one of 60 members of Hong Kong’s Legislative Council.
Bank Offer
“A lot of them lost their life savings,” Eu said in an interview in June. “They’re all crying. They work as cleaners, and $50,000 is a lot of money to them.”
Angel Yip, a spokeswoman for BOC Hong Kong, said in an e- mail that “we understand and sympathize with customers” who lost money as a result of the Lehman collapse. She said advertisements and prospectuses distributed by the bank “contained a detailed description of the structure and risks” of the investments.
In July, 16 retail banks, including BOC Hong Kong, offered to repay minibond investors at least 60 cents on the dollar, a deal brokered by the city’s securities regulator that would amount to $813 million. About two-thirds of eligible noteholders accepted the offer, the Hong Kong Monetary Authority said in a statement on Sept. 4. Sun said he hadn’t yet made up his mind.
“The compensation offer is totally unfair and based on groundless calculations,” Sun said. “If we have to accept it eventually, it’ll be because we’ve exhausted all other means.”
‘Grotesquely Wrong’
While investors in Hong Kong have the right to sue banks, there are no class-action laws or contingency fees, making it difficult to find lawyers willing to take cases.
Patrick Daniels, a lawyer with Coughlin Stoia Geller Rudman & Robbins LLP in San Diego, has filed a class-action suit against Lehman in federal court in New York on behalf of minibond holders like Sun in Hong Kong, Taiwan and Singapore seeking $1.6 billion from Bank of New York Mellon Corp. The money, mostly shares in Lehman’s Institutional Money Market Fund, is being held by the bank as collateral to secure the minibonds, Daniels said. Other Lehman creditors are trying to get the same funds from the Bank of New York Mellon, which isn’t accused of wrongdoing. The case is pending.
“Something is grotesquely wrong here,” Daniels said in an interview in July. “These people were just flat-out lied to and stolen from.”
Neither the lawsuit nor the settlement applies to Yu or other holders of equity-linked notes from Houston to Singapore.
London Suicide
Hong Kong retirees weren’t the only victims. Even professional investors were stuck with Lehman losses.
The stocks and bonds of Lehman’s London brokerage customers, used as collateral to borrow more money, were frozen on Sept. 15. About 3,500 clients, including 700 hedge funds, couldn’t get access to an estimated $65 billion of assets. PricewaterhouseCoopers, Lehman’s U.K. bankruptcy administrator, is still sorting out who should get paid and how much. Some firms have closed, and others may have to wait as long as a decade to get their assets back, Tony Lomas, the PwC partner in charge of the U.K. administration, said in August.
It took only 10 days for the ice-nine to get to Kirk Stephenson, chief operating officer of Olivant Ltd., a London private-equity firm run by former UBS AG Chairman Luqman Arnold. On Sept. 25, Stephenson, 47, jumped in front of a train going 125 mph at a station in Taplow, 28 miles (45 kilometers) west of London.
The coroner’s office for the county of Buckinghamshire ruled the death a suicide. Stephenson, a native of New Zealand, was despondent about the financial crisis and talked about killing himself one week after Lehman’s demise, according to a statement from his wife read at the coroner’s inquest.
U.K. Lock-Up
Lehman Brothers International (Europe) was Olivant’s prime broker. It held the firm’s 2.78 percent stake in UBS, Switzerland’s largest bank by assets, according to a statement from Olivant on Oct. 1. The shares were worth 1.6 billion francs ($1.44 billion) at the time.
The hedge fund lock-up led the U.K. to reconsider its procedures when firms fail. While Lehman’s broker-dealer in the U.S. stayed out of bankruptcy long enough to process many of its trades, the business seized up in the U.K.
“In the U.S., everything was wrapped in cotton wool for four days,” said PwC’s Lomas. In the U.K., “everything failed come 7:56 a.m. that Monday morning.”
‘Black Hole’
The U.K. had an advantage in attracting hedge fund assets before the Lehman bankruptcy. While U.S. prime brokers face limits on how much they can loan hedge funds, those rules could be circumvented with overseas units like Lehman’s in London. Some U.S. clients didn’t know they were customers of Lehman Brothers International (Europe).
“If you didn’t pay attention to what you were signing, you would have missed it,” said Michael Romanek, principal at Rise Partners Ltd., which arranges financing for funds from London. “It was called enhanced prime brokerage, where they could be more accommodating with more leverage or loans. It just took signing some extra papers in New York. Most people didn’t realize it.”
Some fund managers with frozen assets say they’ve gone from extreme anger to resignation that they’ll have to wait a long time to see any return.
“I still don’t know if I’ll ever get any money back,” said Edward Chin, whose Hong Kong-based Pride Revelation Fund used Lehman as its sole prime broker. “We’re in a black hole.”
$30 Billion Gap
The ice-nine also halted construction projects from Wall Street to the Turks and Caicos Islands.
Lehman borrowed against property investments that couldn’t easily be sold, such as construction loans. So when the property market turned sour and creditors demanded more collateral for the loans or their money back, the investment bank was stuck.
The property portfolio doomed Lehman when a rescue still seemed possible. On Saturday, Sept. 13, 2008, Timothy Geithner, then president of the Federal Reserve Bank of New York and now U.S. Treasury secretary, asked a team of the world’s top bankers to evaluate Lehman’s real estate holdings as part of an effort to facilitate a sale of the investment bank to London-based Barclays Plc.
The team, including representatives from Goldman Sachs and Credit Suisse Group AG, determined that Lehman had overvalued its real estate investments by $20 billion to $30 billion, according to people who attended meetings at the New York Fed last September.
Watergate Hotel
When Barclays pulled out of an agreement to buy the firm, Lehman was forced to file for bankruptcy. Only then did Barclays buy Lehman’s U.S. securities business, including its headquarters in Manhattan’s Times Square.
The bankruptcy deprived the international real estate market of a major source of financing. The bank was known for doing deals nobody else would touch, according to a former Lehman executive.
The Watergate Hotel, made famous by the 1972 break-in that led to the resignation of President Richard Nixon, was sold at auction in August for $25 million after its owner, Washington- based Monument Realty LLC, defaulted on its mortgage. Monument was financed by Lehman.
A condo conversion at 25 Broad St. in Manhattan, two blocks from Goldman Sachs’s headquarters, was suspended by developers. It too was financed by Lehman.
SunCal, Depfa
Irvine, California-based SunCal Cos., a closely held developer, said it had $1.6 billion in financing from Lehman. Since the bank’s failure, 19 projects, all in California, have filed for bankruptcy, SunCal said. Work has stopped on all of them, including the 248-acre Marblehead Coastal community in San Clemente, which was supposed to feature 69 single-family homes, 244 other residences, a movie theater, parks and hiking trails.
Munich-based Hypo Real Estate Holding AG received 102 billion euros ($143 billion) in debt guarantees and credit lines from the German government after its Depfa unit was stuck without short-term funding following Lehman’s bankruptcy. Like Lehman, Hypo funded long-term real estate assets with short-term loans such as commercial paper.
German Finance Minister Peer Steinbrueck defended the bailout of the lender because the global financial system was just “millimeters from the abyss.”
Molasses Reef
On West Caicos, an otherwise uninhabited island 250 miles northeast of Cuba, work stopped on the Molasses Reef Ritz- Carlton Hotel and Residences, slated to include a cluster of $6.5 million cottages. About 400 Chinese employees of Tel Aviv- based construction firm Ashtrom Properties Ltd. didn’t get paid when Lehman funding dried up, according to Jonathan Siegel, New York-based managing director of Logwood Hotel Development Co.
About 60 electrical workers rebelled, taking a dozen managers hostage and refusing to let them leave the island.
“We had 400 to 500 unhappy men, and we were concerned violence would erupt,” Siegel said. “The Turks and Caicos government was very unhappy with the situation. There was a limited supply of food and water.”
Ashtrom ended the standoff after a week by paying what it considered “a ransom,” Siegel said. The project, about 70 percent completed, is still on hold, said Verona Carter, Ritz- Carlton Hotel Co.’s director of public relations for the Caribbean area.
Financial Leadership
The vulnerability of the global financial system revealed by Lehman’s bankruptcy -- from ordinary investors like Sun and Yu to London hedge funds and German lenders -- makes it all the harder to regulate.
“The difficulty you have in getting control is that you need a global alliance,” said former World Bank President James D. Wolfensohn in an e-mail. “You need all the finance ministers to come together, because if a transaction can’t be done here, it can be done in Lichtenstein or France or the Far East.”
Lehman’s bankruptcy also poses a challenge to America’s financial leadership.
Wall Street profited by arranging financing that allowed other countries to tap global capital markets to build offices, factories, resorts and housing. What’s broken now is the trust the rest of the world had in U.S. banks, said Phillip Yin, a native of Seattle who is managing director of Asia Investors Partners Ltd., a Hong Kong-based research firm.
“All that has happened since -- the job losses, the slump, everything -- is tied to one thing and one event,” Yin said. “And that’s Lehman.”
(Lehman’s Lessons: Next, Too Big to Fail)
To contact the reporters on this story: Mark Pittman in New York at mpittman@bloomberg.net; Bob Ivry in New York at bivry@bloomberg.net.
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