The Lehman Examiner’s report gives an unintentionally damning portrayal, both of the the structure of financial regulation in the US and how regulators failed to use the powers they had effectively.
Section III.A.6: Government shows that even with its imperfect grasp of the situation, the authorities recognized Lehman had a large negative net worth. Yet rather than move decisively towards an unwind, they proceeded inertially. They urged Lehman CEO Dick Fuld to find a rescuer (who would invest in that garbage barge, particularly when Andrew Ross Sorkin’s account makes clear that Fuld’s moves were so obviously desperate and clumsy as to be certain to fail) and also promoted the notion of an LTCM-style “share the pain” resolution. Yet with the rest of the industry weak, and the magnitude of hole in Lehman’s balance sheet a mystery, these courses of action had low odds of success from the outset (indeed, the “Lehman weekend” in which the authorities almost bulldozed through a deal, seemed designed to avoid sober analysis of how bad things were at the failing investment bank).
Two unanswered questions stand out. The first is that even with the extensive Jenner & Block report, we still do not have even a rough sense of how big the shortfall in Lehman’s equity was at the time of its collapse. We know it was hiding $50 billion of liabilities at the end of its fiscal second quarter through its Repo 105 program, but that only tells us the size of one of the cover-up mechanisms. The Lehman report indicates that William Dudley at the New York Fed thought Lehman might require a $60 billion bailout entity, with Lehman providing $5 billion of equity, which says the authorities pegged the unreported shortfall at $55 billion.
But the numbers do not add up. The bankruptcy administrator has put the losses at $130 billion (although that number is still in play) and was (remarkably) denying that Lehman had a solvency problem at the time of its collapse, when the tenor of the Government section suggests the reverse. In addition, Lehman’s net worth as of May 31, 2008 was reported at $26 billion. So if we accept the $130 billion estimate, the swing from reported net worth to losses realized was over $150 billion. We still have no satisfactory explanation of how that took place. The bankruptcy administrator, Alvarez & Marsal, blamed some of the losses on the “disorderly collapse”, but assigned “only” a maximum of $75 billion. We do not know the composition of the value shortfalls that led Lehman to play Repo 105 games, which presumably totaled $50 billion (some sus items have been singled out, but that falls short of an explanation). So not only do we lack a decent explanation of that $50 billion, even if we accept the high end of the Alvarez & Marsal estimate, we have an additional $25 billion missing in action.
Frank Partnoy is of the view that the focus has been unduly on the asset side of the balance sheet, and he thinks the explanation for the gap may lie on the liability side (for instance, it isn’t hard to imagine Lehman having commitments that it thought it had hedged, and having those become liabilities as counterparties got downgraded and hedges having to be written down).
The second unanswered question is why were the authorities so poorly prepared for a Lehman collapse. Some of the comments in the report make clear that at least some people in the officialdom knew that Lehman was beyond salvation:
“We were tied to the mast here; the opportunities for re‐engineering were quite limited, and to imply otherwise is wrong.” (p 1492)
And the $60 billion estimate for the size of a bailout vehicle similarly said Lehman was terminal unless there was a miraculous recovery in the residential real estate market. Even though that looked very unlikely, the failure to take more concerted action looks as if the authorities were hoping for a deus ex machina to intervene.
Other issues also emerge from this section of the report. The first is that authority over Lehman was more limited than it appeared to be. The SEC did not have statutory authority over Lehman’s holding company. Its authority was “voluntary”, a sort of regulatory default. The lack of statutory authority creates ambiguity as to its basis for action (for instance, it cannot use statutory violations as a basis for action, nor can it threaten to revoke a license, since it does not have licensing authority. The examiner’s report is definitive upon this point (p. 1484):
The Gramm‐Leach‐Bliley Act of 1999 had created a void in the regulation of systemically important large investment bank holding companies. Neither the SEC nor any other agency was given statutory authority to regulate such entities.
In keeping, to induce the US LIBHCs to participate in an toothless regulatory scheme, the SEC weakened net capital requirements, an action that many experts see as having played a direct role in the crisis (as it is allowed investment banks to attain higher levels of leverage). Moreover, note the implicit limits on the SEC’s authority. From Report 466-A, published September 25, 2008:
The CSE program is a voluntary program that was created in 2004 by the Commission pursuant to rule amendments under the Securities Exchange Act of 1934. This program allows the Commission to supervise these broker-dealer holding companies on a consolidated basis. In this capacity, Commission supervision extends beyond the registered broker-dealer to the unregulated affiliates of the broker-dealer to the holding company itself. The CSE program was designed to allow the·Commission to monitor for financial or operational weakness in a CSE holding company or its unregulated affiliates that might place United States regulated broker-dealers and other regulated entities at risk.
Yves here. Did you catch that? While the SEC can supervise the holding company and unregulated entities, its scope of action is limited to preserving the health of regulated entities only.
The CSE program focused on liquidity, NOT solvency. The SEC recognized its efforts might still prove insufficient (p. 1492):
Cox did not think there was any liquidity number large enough to withstand a run on the bank: “There’s no amount of liquidity that can protect you from an indefinite run.”
Yves here. Recall that Bear’s liquidity vanished in a mere ten days, even as those at the helm of the firm were convinced its liquidity buffers were adequate. With balance sheets financed 50% by repo with any average tenor of a week or less, ANY broker dealer can be brought down by a liquidity crisis, just as even solvent banks can be brought down by a run
Moreover, the SEC has had its wings clipped even where it has had clear authority. Congress has repeatedly limited SEC enforcement capabilities, starting with Arthur Levitt’s tenure as SEC chief. The SEC is the only major financial regulator which does not keep the fees it collects, but instead turns them over to the government and in turn gets an allowance, um, budget, that is considerably lower. But more important, when Levitt wanted to step up enforcement on the retail front (much less controversial and resource intensive than on the institutional investor side) he was not merely blocked by Congress, but actively threatened with budget cuts.
So even where SEC has clear authority, it has been systematically denied the resources to do its job. Its response has been to retreat and focus on activities that have high bang for its limited bucks, primarily insider trading cases.
Moreover, on top of that, despite our initial impression from a reading of the executive summary that Lehman had been open kimono with regulators, a different picture emerges from this section. On the one hand, the SEC staffers described Lehman as “highly cooperative”, even during the post-Bear meltdown period when the SEC was monitoring the firm on a daily basis and the Fed had staff on site, Lehman played games at some critical junctures. One example (p. 1509):
The “primary focus” of the SEC’s liquidity monitoring, as explained by the Liquidity Inspections Scope Memorandum, was to “verify” that CSE liquidity pools were “available to the parent without restriction” and could be monetized “immediately, usually within twenty‐four hours.” A former senior SEC CSE staff member, Matthew Eichner, told the Examiner that the Liquidity Inspections Scope Memorandum was never formally implemented as part of the CSE Program. Nevertheless, Eichner recalled that he communicated the “twenty‐four hours” standard to Lehman.5855 Lehman had a copy of the Liquidity Inspections Scope Memorandum in its possession, implying that the SEC had shared it with Lehman. But Lehman applied a “five days” monetization standard for assets in its liquidity pool. There is no evidence that the SEC directed Lehman to comply with the 24‐hour standard.
Yves here. While it certainly looks like the SEC fell short based on how this incident is depicted in the examiner’s report, it is not at all clear to me how the SEC could have compelled Lehman to adhere, given the limited nature of CSE oversight.
Consider another incident in which Lehman was less than forthcoming (p. 1511):
In late August 2008, the SEC learned that JPMorgan wanted Lehman to pledge $ 5 billion in collateral to continue to fund Lehman trades.5866 SEC personnel spoke to Lehman, and Lehman Treasurer Paolo Tonucci told them that $5 billion would “not affect” Lehman’s liquidity pool.5867 The SEC did not know that JPMorgan had demanded that Lehman post additional capital the week of September 8.5868 The SEC was not aware of any significant issues with Lehman’s liquidity pool5869 until September 12, 2008, when officials learned that a large portion of Lehman’s liquidity pool had been allocated to its clearing banks to induce them to continue providing essential clearing services. 5870 In a September 12, 2008 e‐mail, one SEC analyst wrote:
Key point: Lehman’s liquidity pool is almost totally locked up with clearing banks to cover intraday credit ($15bn with jpm, $10bn with others like citi and bofa). This is a really big problem.
Yves here. Oh, and by the way, the Fed was aware of at least some of these collateral tie-ups (p. 1514), yet didn’t inform the SEC even though the two bodies had a memorandum of understanding in place (the report makes clear both sides were not sharing all information with each other).
But aside from the issue of oversight and compliance, the bigger issue seems to have been denial. Despite the fact that the authorities did appear to see that Lehman had sprung an unpluggable leak and was hopelessly insolvent, the hope seemed to be that if they kept Lehman going, a solution would somehow emerge. This in turn led to contradictory postures (p. 1502):
The challenge for the Government, and for troubled firms like Lehman, was to reduce risk exposure, and the act of reducing risk by selling assets could result in “collateral damage” by demonstrating weakness and exposing “air” in the marks. Geithner said that the FRBNY had “to make sure that the system would be held together and that the strongest institutions would not be imperiled by the weakest.”
Yves here. Note there is NO discussion here of distressed sales artificially depressing the market. The position is “we want Lehman to delever, but if it does, it will expose how phony asset valuations across the industry are. Can’t have that, now can we?”
So Lehman keeps limping along as counterparties demand more and more collateral, worried about their risks in a deteriorating market. The board, if Bryan Marsal’s report is correct, was completely passive and in denial, believing that no one (translation: no one in government) would allow a company with $6 trillion in derivatives exposures to fail. In other words, the board assumed their lapses in performing their duties would be covered by Uncle Sam.
And even with months of presumably intensive monitoring, the Fed and SEC still missed fundamental aspects of Lehman’s exposures:
LBHI filed for bankruptcy protection on Monday, September 15. The FRBNY was surprised by the consequences that Lehman’s filing had in terms of funding LBIE [the UK broker dealer], which was taken into administration by British regulators due to inadequate capitalization. The FRBNY was unaware that LBIE was financed entirely by the parent – that is, that LBHI pulled liquidity into New York, and would then re‐route that funding to LBIE in the U.K. Baxter said he was unaware until that Monday that LBIE was dependent on its LBHI parent, but he learned otherwise when LBHI was forced to file for bankruptcy due to cross defaults from LBIE going into administration in the U.K. Even then, Baxter assumed that the Bank of England had the capacity to fund
LBIE in a manner similar to that by which the FRBNY funded LBI through the Primary
Dealer Credit Facility discount window for broker‐dealers. The FSA told the Examiner that once it became known that LBHI would file for bankruptcy, the FSA asked the FRBNY if financing (via the FRBNY’s discount window for broker‐dealers) would be made available to LBIE and was told that it would not.
Yves here. So get this. The Fed has been on site for months in its role as a “potential lender”. One of a lenders’ big jobs is understanding what the existing claims on an entity are. How in God’s name could the Fed have missed the relationship between the holding company and the UK operation?
And we have a SECOND stunner: the Fed assumed that the Bank of England could/would finance the UK broker dealer because that’s possible in the US. Anyone who has done more than a smidge of cross border work KNOWS never to assume things are the same in another country’s legal/regulatory system. This is provincialism writ large.
As much as the SEC did not cover itself with glory in this exercise, its lapses are somewhat comprehensible. By contrast, the Fed’s are much harder to explain or excuse. And guess who is about to be given more oversight authority?