AIG’s particular burden was $80 billion of credit default swaps it had sold that exposed it to subprime mortgages (see “AIG: The Company That Came to Dinner” on
Derivatives certainly did not cause the earthshaking failure of Lehman on Sept. 15 last year. The blame can be laid first on out-of-control leverage and bad investments in commercial real estate, and second on the U.S. government’s decision not to save the company. But the Lehman saga illustrates another toxic aspect of derivatives: They are often a mess to value. That can lead, intentionally or not, to misreported profits and assets. It turns out that the files of this biggest-ever bankruptcy prove the accounting complexity in quite bizarre ways.
Basic facts first: Lehman had a derivatives book of only $730 billion as it neared bankruptcy. Even so, when Lehman’s U.S. entities filed for Chapter 11 in September, this not so-big figure translated into about 900,000 derivatives contracts. The great bulk of them have been “terminated” by derivatives counterparties which under industry protocols had the right to immediately “net” their accounts with Lehman in the event it declared bankruptcy. A handful the last reported number was 18,000—are still open.
Each of these contracts has a “fair value”—an amount that one-side owes the other. Lehman, in fact, has a lot of open contracts that have been going its way. In a droll sign of how derivatives have come to be viewed as indispensable, Lehman has received permission from the court to buy them to hedge some of its open contracts, so that it can lock in the profits it has made since filing for bankruptcy.
Move now to the accounting problem. While sometimes the fair value of a derivative can be precisely determined, at other times it must be derived from murky markets and models that leave considerable room for interpretation. That gives the holders of derivatives a lot of bookkeeping discretion, which is troubling because changes in fair value flow through earnings—every day, every quarter, every year—and alter the carrying amounts of receivables and payables on the balance sheet.