September 15th 2018 marks the 10th anniversary of the Lehman’s default – the biggest market-shaping event of modern times and the climax of the banking crisis. Catalyst Partners Christian Lee and Stephen Loosley played a little-known, but critical role unwinding 66,000 trades across five currencies in a portfolio of $9 trillion. This was “one of the biggest, nastiest and riskiest” parts of the banking crisis and they played a crucial role in containing further market contagion. Below, they talk about how it felt to be at the eye of the storm.
Christian Lee, who was Head of Risk Management for LCH SwapClear at the time, sets the scene. “Before 2008, ‘clearing’ was seen as an arcane, unknown element of financial plumbing. No-one expected it to play a pivotal role in managing market crisis. Stephen and I were responsible for designing and implementing the risk management of LCH’s SwapClear, dealing with the more complex parts of clearing risk. SwapClear was, in fact, the only business to clear OTC (over the counter) IRS (interest rate swap) trades, as opposed to the less complex exchange-traded derivatives. Our job was to prepare for every eventuality, no matter how unlikely or extreme, and to put processes and plans in place to cope with every situation.”
Stephen Loosley adds “By early September 2008, there were indications of issues with several LCH member banks, including Lehman Brothers, and we were in a state of heightened vigilance. And by the week leading up to Friday 12th, we were seeing unusual patterns of trading, flurries of counterparties putting more trades through SwapClear and worried calls from member banks, asking about the consequences of a default. The rumour mill began to run at full tilt. Even so, business carries on – until it doesn’t – and we continued to accept trades and make margin calls right up to the last moment.”
Christian continues “in order to be fully prepared for worst case scenarios, my team and I went into the office on the Saturday, performing our usual checks on positions and risks. We know that our CEO was in discussion with the regulators and other market participant including the Fed in the US. But even then, we all assumed there’d be a bail-out, along the lines of JPM’s rescue of Bear Stearns earlier in the year. By this point Merrill Lynch was also at the centre of the storm along with Lehman’s. As things worsened, it was clear that one bank could probably stand, but not both. And as Sunday dawned, so did the realisation that a major default had moved from theory to reality. When the Bank of America stepped in to save Merrill Lynch, we knew Lehman’s was going down. This was real. We activated our crisis process and started the default protocol.”
Stephen recalls “By Sunday, I was also in the office, fearing but prepared for the worst. Sure enough, in the early evening, the formal instruction to activate came through. The minute Lehman’s defaulted, their books became our responsibility and all hell let loose. Christian and I were certain we had designed a robust default process, we knew our stuff and we had practised time and again. But nothing prepares you for the reality. We had to act, fast.”
Christian continues “Our first move was literal: we decamped from our normal office to London’s Southbank and a third floor ‘safezone’ in Sampson House – the old Lloyds Bank gold vaults. This ringfenced us from the rest of LCH and any other trading and default activity. LCH member banks sent their top traders to join us as part of the Default Management Group. Security and integrity was absolute – the dealers handed in the phones, it was a lock-down. They weren’t happy – these are high adrenalin individuals, whose day job was to manage their own positions, not least when the turbulence of a crisis can be a big profit opportunity. But we had to lay all that aside and get to work hedging and auctioning off Lehman’s swaps portfolio: the biggest, nastiest, riskiest part of the crisis.”
Stephen picks up the story. “There we were, right at the heart of the storm but completely hidden from sight. For the first four days we were fully ‘on’, running on pure coffee and pizza. When 100th of 1% of what you’re dealing with equals $6 – 7 million, you’re pretty focused.
And there was real fear. We knew that if we hadn’t designed a good process or didn’t do a good job executing it, the margin we held would be gone, LCH would be in trouble, contagion would spread like wildfire and banks could topple like dominoes. Several were already wobbling. We had to hold our nerve, not least because there was no guarantee it wasn’t going to get a whole lot worse. We were dealing with unprecedented trades of billions of dollars and, if things did not work out, we were staring into an abyss.
At times we started to question everything, including ourselves. ‘What if we have to handle two simultaneous defaults – or more?’ Some thoughts were quite irrational ‘Are we sure we’re hedging the right way? Rather than reducing risk, could we be exponentially increasing it?’ It was scary. Even when you did sleep for a couple of hours, your mind was racing with what else might be happening by the time you woke up.”
Christian adds “Over the next three weeks, we held five auctions of different currencies. By far the most complex was the final, USD denominated auction. It was only at that point that we really dared to breathe again. There was still a huge amount of turbulence and concern that another bank may fail, particularly when the proposed rescue bill was rejected by the US senate. But over the following weeks, then months, it became clear that we had held a thin red line successfully: the default process that we had designed had done its job.”
Ten years later, how do Christian and Stephen estimate the legacy of those days? “It’s hard to over-state the impact of 2008” says Christian. “The global impact of what happened was unprecedented. And there was a permanent effect on how markets work. By 2009, the G20 meeting at Pittsburgh was laying the foundations for the following decade of financial regulation. Clearing, risk management, deleveraging and market behaviour went straight to the top of global policy making. And the catalyst for that was the SwapClear model, and how we’d handled it.”
Stephen concludes “a career in financial risk means spending your life dealing with things nobody wants to happen. When they do, it tests you to your core. Since 2008 Christian and I have spent our time advising the world’s biggest financial institutions on how to run their businesses in ways that reduce risk and maximise efficiency. Could it all happen again? Possibly – never say never. But it’s much more likely something similar but different will happen. You can mitigate risk but you can’t remove it – and sometimes you just relocate it. It’s entirely possible, for example, that some of the measures put in to manage risk post 2008 have created a new set of entities that are now themselves on the verge of being ‘too big to fail’.”
But that’s another story.
- Listen here to Christian and Stephen on BBC 5 Live’s Wake Up to Money 11/09/2018 podcast
- Hear more of Christian and Stephen’s story on on the BBC World Service: Business Daily podcast
- Listen here to Christian and Stephen’s podcast with DerivSource
- Read more from Christian and Stephen in the Sunday Telegraph coverage of the Lehman’s anniversary
- Learn more about Christian’s views of the ‘too big to fail’ legacy in Financial News
- Stephen was interviewed by Huw Edwards on BBC News at Five