The alchemy of modern finance is coming back to haunt what were thought to be pretty mundane deals. As every follower of Mortgage REITs knows by now, borrowing short and lending long can be a risky proposition. Those REITs that have any shot at surviving the market carnage were those that matched the average life of their liabilities to the average life of their assets. Managing interest rate risk is accomplished in much the same way. Most don't think it's wise to borrow on a short-term, floating rate basis against long-term assets over a long period of time.

However, floating-rate debt is often cheaper, and sometimes it can be available on more advantageous terms than longer-term, fixed rate debt. And because interest rate swaps allow borrowers to convert floating-rate debt payments into fixed-rate debt payments, it turns out that interest rate risk on a short term, floating rate deal can be completely eliminated. Of course, floating-rate borrowers could go naked and save themselves the expense of the swap, but careful interest rate risk management dictates prudence, so swap they did.

If you were a big bond house like Lehman, this was bread and butter stuff. If you were a big bond house like Lehman that also happened to be big in real estate, your interest rate swap book would be huge (many large real estate development projects were funded with short term, floating rate LIBOR loans). Indeed, the Wall Street Journal reported today (9/15) that Lehman had almost two million individual interest rate swaps on its books as of Friday (9/12).

However, as of the moment Lehman's parent, Lehman Brothers Holdings Inc., filed for bankruptcy protection, all of Lehman's interest rate swap contracts were abrubtly terminated. This would not be of much consequence had the Fed not been slashing interest rates for much of the past year. But because rates are down so dramatically, any swap entered into before rates were cut is now deeply "out of the money". And because the bankruptcy of the parent entity at Lehman is a "Termination Event" under the swap contracts, hundreds of thousands of borrowers must now come up with what basically amounts to a pre-payment penalty under the swaps. The size of the prepayment penalty could range from a few hundred thousand dollars to tens of millions depending on the borrower. One example from the LEH book: the borrower under a $135 million floating to fixed rate swap done JUST ONE MONTH AGO is now on the hook for a $13 million termination payment (the swap tenor is quite long). LEH bankers labored for weeks to convince the borrower that doing a floating to fixed rate swap with Lehman was safe. Multiply this one borrower by two million swaps and you get an idea of the extent of the problems in just one arcane corner of the market.

Shell shocked Lehman employees spent the day Monday drafting these termination notices, among other tasks related to unwinding their books. The borrower in the above example has yet to receive its termination notice, and the borrower did NOT enter into a credit default swap on Lehman risk. Credit default swaps were the province of major financial institutions in New York, London, Hong Kong and Singapore, not borrowers in Gary, Indiana.

As these termination notices go out this week and next, borrowers ranging from the State of New York to real estate entrepreneurs in Phoenix, Arizona will be undergoing crash courses in the Secrets of the Temple. Let's hope there are not too many REITs involved in the Lehman chaos. Where any of these unfortunate borrowers will find the money to make these termination payments in this stressed environment is anyone's guess.