Lehman Structured Product and Lehman Principal Protected Notes (PPNs) - Recovering and Valuing Losses

If you own a Lehman Brothers structured product issued in Europe, the basic components you are ultimately invested in are a bond and an option. The bond is a zero coupon, which means it is issued at a price well below par. The value you have in the bond is whatever price you have bought it at, minus a bit more if the issue is newly launched and minus a bit less if it is nearing maturity. The bond will have been issued by and in the name of Lehman Brothers.

In addition, there is an option that will have been bought from a counterparty. That counterparty may have been the options desk at Lehman, or it may be the same desk at another bank. If that option – based on the performance of an underlying, typically an equity index, such as the FTSE – is in the money, ie it is performing better than anticipated, then the counterparty will owe money to the investor.

Valuing the option that is closed out as a result of the Lehmans bankruptcy is based on the probability of that option being at an expected level at expiry. This is hi-tech mathematics, but the important element for the investor is that these proceeds will have been put to one side by the counterparty, either in cash or liquid securities like US Treasuries. As the money is specifically put to one side it ranks as a secured obligation of the counterparty.

Once the zero coupon bond and the option have been valued, they are then packaged into a total amount that is then multiplied by the market value of Lehman bonds. Taking Lehman bonds at 50 - the level they were quoted at earlier this week - and the zero coupon at 68 and the option at 10: the bond plus option equals 78, multiplied by 50% leaves the investor with a return of 39.

One oddity of the structured product is that the money from the option – if there is any – is secured, and the money from the bond is unsecured. As a result, the option proceeds rank further up the creditor priority chain on bankruptcy.

This is all conditioned by any steps taken by the regulators in Europe. Apparently, the Nordic, German and Swiss regulators, as well as the UK Financial Services Authority are looking into ways to ensure that retail investors may be protected against the worst of the losses. They will try and look after the 'mom and pop' investor as well as they can.

In Asia, the Hong Kong Securities and Futures Commission and the Monetary Authority of Singapore have told investors owning Lehman Minibond paper that they could receive substantially less than their initial investment and that the separately kept collateral and the swap agreements that back the notes are subject to security in favour of the trustee, who is required to act in the best interests of the investors.