Market estimates of recovery rates on Lehman’s debt are around 10-15% of face value (a loss to investors of 85-90%). Recovery rates will be affected by the nature of assets that many financial institutions now hold - private equity stakes, principal investments, hedge fund equity, complex slices of risk in structured finance transaction and derivatives. The difficulty in valuing these assets, their illiquidity and (currently) the absence of markets for many such assets may exacerbate losses.

If the financial institution files for Chapter 11 or bankruptcy then all derivative contracts entered into with the entity would also normally automatically terminate. This triggers a complex chain of events.

The value of the contracts must be determined by either seeking market quotations or other "commercially reasonable procedures" depending on the documentation. The values of individual contracts may be netted if the contracts specify to arrive at an overall amount that must be settled between the counterparty and the distressed entity. If the counterparty owes that amount then it must be paid immediately to the trustee in bankruptcy. This results in an immediate (possibly large) cash requirement for the non-defaulting party. If the distressed entity owes the amount then the counterparty must lodge proof of debt with the bankruptcy trustee and await payment.

If the counterparty is holding collateral securing the exposure under the contracts then the collateral must be sold to realize cash to cover the amount due.

Where the derivative contract was being used as a hedge, termination of the derivative contracts exposes the counterparty to the underlying risk. The counterparty must then enter into new contracts at current market prices to re-hedge itself to avoid additional risk. Hedging must generally be done on a contract by contract basis with limited scope for netting.

The entire process is complex and time consuming, meaning that the amount of losses sustained may not be known with certainty for some time.

A bankruptcy or Chapter 11 filing may also trigger contracts referencing the financially distressed firm. For example, the bankruptcy filing would have triggered things like credit default swaps ("CDS") contracts on Lehman Brothers, requiring settlement of these contracts as well.

Where CDS contracts were held as hedges, they would alleviate losses that would otherwise have resulted. In all cases, settlement triggers payments creating potential losses and claims on available liquidity and funding. Settlement of credit default swaps on Lehman totaled around $365 billion. If a party is unable to meet its obligations under a CDS on Lehman then the process starts over again involving the new party.

Problems Spread

Financial distress affects other parties through "contagion." Counterparties who had dealings with the distressed entity either suffer losses or suffer cash outflows as they meet termination payments. They may suffer additional losses on sales of collateral or from re-hedging positions. These losses affect their credit quality and solvency setting off falls in the price of their shares and rises in borrowing costs. If credit ratings are affected then this may trigger margin calls or other events that further threaten solvency.

Financial distress of any entity also affects the market. Volatility of asset prices increase reflecting liquidation of positions, re-hedging activity and sales of collateral. Trading liquidity is reduced as the number of counterparties falls. Credit limits become scarce limiting the ability of firms to deal with each other. Uncertainty about the impact of financial distress of one entity on all other market participants causes trading in the inter-bank market to freeze up further increasing volatility and potentially risk of failure of weaker firms. Asset price falls trigger further cash calls and distress for other market players.