Enron may behold tame compared with this: a fight over billions of dollars posted as collateral, then used in a tangled web of deals

by Matthew Goldstein and David Henry

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Warren Buffett, chairman and CEO of Berkshire Hathaway, testifies before the Senate Finance Committee during a hearing on the Federal Estate Tax on Capitol Hill in Washington, DC, 14 November 2007 AFP Photo/Saul Loeb

In 2003, mythical investor Warren E. Buffett called derivatives "weapons of mass destruction." Buffett predicted that the complication financial instruments would morph, mutate, and multiply "until some circumstance makes their toxicity unequivocal." The failure of Lehman Brothers (LEHMQ) may gain been the adversity he imagined.

How lethal was the investment bank’s derivatives portfolio? Just look at the long line of banks, evade funds, and other big investors trying to get their money back. Lehman’s bankruptcy threw into jeopardy derivative deals with a staggering 8,000 divergent firms that had paid Lehman billions of dollars in collateral. Now more commercial partners are calling on state and federal courts to reclaim their assets, which have been frozen since the Sept. 15 bankruptcy filing. It will be a "very awesome undertaking to try to unwind all of that," says Lehman’s lead bankruptcy attorney, Harvey R. Miller, a partner at Weil, Gotshal & Manges.

It turns without that Lehman, like other swelling dealers, was running a perfectly legitimate but in a great degree risky measure moving money from firm to firm. It used the collateral from undivided trading partner to fund more deals with other firms. The same $100 the masses collected in one deal can be used for many other transactions. "Firms basically can use [the money] as their own indirect for anything they want," says Kenneth Kettering, a forgoing derivatives lawyer and currently a professor at New York Law School. But when the contracts terminate as the result of bankruptcy, the extra collateral is supposed to be returned.

Lehman’sitting travails are only adding to the worries shaking the fiscal system. Not only has Lehman’sitting wild flight snagged the portfolios of such big traders as hedge fund firm Harbinger Capital Partners—it has also helped impel global short-term lending markets into a deep freeze. It’s enough to make more market watchers astonishment if Lehman was overmuch big for the U.S. Treasury and Federal Reserve to obstacle decay.

Derivatives contracts—whose value is tied to the performance of an underlying protection or benchmark over a specific period—are designed in part to help firms minimize losses from interest rate fluctuations, incorporated bond defaults, and other events. The contracts were a big matter for Lehman: When the firm went under in September, roughly 1 million derivative deals had its name on them.

As part of those transactions, buyers had put up corroboratory in the event of losses. But weeks after Lehman’s devolve, large sums of leftover collateral have yet to be returned to the trading partners. Bank of America (BAC) executives tried several times to persuade Lehman officials via e-mail and phone calls to fork over funds, according to a suit. But BofA was rebuffed. In one e-mail exchange, a Lehman employee wrote to BofA: "All activity has been suspended to the time when farther on notice."

Nasreen Bulos, a lawyer as far in the manner that concerns one of Dubai’s sovereign treasure funds, got the same chilly response. The Global Strategic Equities Fund of Dubai, component of the gulf state’s $12 billion investment portfolio, gave Lehman $40 million in June viewed like part of a deal pegged to life hercules BP’s (BP) stock. According to an evidence., Bulos started contacting Lehman on Sept. 15 to get back $27 million in collateral. Four days later, Lehman told Bulos it would not honor the entreat or say anything farther on on the matter.