Lehman: Regulators Chose to Deny, Extend and Pretend

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?

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  1. psychohistorian

    another comment to delete after editing.

    early on your sentence about They ????Dick Fuld get buyer

    Later there is a though that needs to be a thought

    good posting….be well

  2. attempter

    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?”

    That’s been the Gordian knot throughout all of this, hasn’t it. The knot they refuse to untie, which they can only desperately try to keep from catastrophically unravelling, or the rope from breaking.

    Since the moment housing prices started to peak, this whole vast structure of paper has basically become worthless, the whole finance system has become a zombie, and the overriding obsession has been for governments to loot their peoples to prop us the “values” of these worthless “assets”. And the situation today, the problem today, is exactly the same as that described here.

    “We’re all Lehmans now”, and they have been for some time.

    This wretched epic of “regulatory” failure, and our knowledge of the fact that literally nothing has changed in the attitude or actions of these governmental derelicts, is the most graphic proof yet of the absolute, irrecoverable failure of this political system. Of how there will not and cannot be “reform” where we still have this system.

    The banks can’t be reformed because they are insolvent and incorrigible, and this version of government can’t be reformed because it’s irretrievably corrupted and captured by the banks.

    The two intractable knots, the toxic assets and the rogue political system, can be settled only one way. The people must be as a new Alexander and cut them.

    1. Kievite

      The key assumption of the post is that the US government and large
      financial institutions are separate entities.  For example:

      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 initially.

      This rhetoric fall short because the implicit  "independence"
      assumption is a hypothesis that is not supported by the facts on the
      ground. Financization of the economy on the base of of dollar as global
      fiat currency were also financization of the government. and Congress
      now is nothing more then an extended board of those banks. Revolving
      door between large banks and government is well known. Also now we know
      enough about Fed to suggest that the level of influence of large banks
      in Fed was very substantial and influenced key decisions during the
      crisis. The same is true for Treasury and this was true at least since
      Rubin.  Large banks were also the most important instrument of the
      US foreign policy at least since Nixon.  That’s explains why
      Congress was and is so bank friendly.  So calling them "financial
      terrorists" which is a popular stance now might mask the fact that they
      were more like "green berets" of foreign policy.

      Similarly "regulatory failure" should be more properly called
      "regulatory policy" to the extent that large banks  are the
      integral part of the political system.  Suggestions like  "The
      people must be as a new Alexander and cut them." is naive as it
      presuppose existence of a political force supporting this solution.
      Currently I see none as political activity is still channeled via two
      dominant parties co-opted by the financial elite.  That means that
      "extend and pretend" is the only viable political option at the moment
      and that in way Obama is doing "the right thing".

  3. Hubert

    “The bankruptcy administrator, Alvarez & Marsal, blamed some of the losses on the “disorderly collapse”, but assigned “only” a maximum of $75 billion.”

    Disorderly losses are someone else´s “disorderly gains”. Which can be duly hidden in derivative accounting and released over a period of time.

    Since Lehman went down, why do not let it go down with a bang, screw unsecured creditors and make a big killing out of it? Who would find out? Apparently nobody. Only a few bloggers scratch their heads.

    The only problem: Unsecured funding of all US institutions might go away, when the Lehman 10 cents on the dollar made the round. And so it was.

    But that brought another advantage: Hank Paulson had his crisis to “save” AIG (counterparties) and implement “no-more-Lehman” and TARP.

    Very smart, I must say. Criminally smart.

    1. alex

      Conspiracy theories just ain’t what they used to be. Time was you could come up with a crackpot theory without really trying. Now, no matter how paranoid you get, you run the very real risk of being right.

  4. sherparick

    Calculated Risk does an interesting thing today and looks back to December 2007 and what the Fed FOMC outlook at the time was about these matters. http://www.calculatedriskblog.com/2010/03/some-previous-fomc-forecasts.html

    I think the key insight into the thinking of the Fed, the regulators, and the whole political/financial establishment is this:

    “Still, looking further ahead, participants continued to expect that, aided by an easing in the stance of monetary policy, economic growth would gradually recover as weakness in the housing sector abated and financial conditions improved, allowing the economy to expand at about its trend rate in 2009.”

    Well, not quite. But I think this shows how deep in denial the elite was and the groupthink that “U.S. housing prices only go up” especially with a little monetary goosing. They did not think Lehman was in real trouble because they kept expecting a snap back in the housing market. Foolish, stupid, but probably not consciously corrupt. But the tide was going out, houses had become the new tulips, and it took Lehman with it.

  5. Doug Terpstra

    Thanks for another great cortisol stimulant, Yves.

    Of course, that was then. This is now: ‘extend and pretend’ has become the new normal in ‘free market’ mark-to-myth accounting—officially, courtesy of the FASB. And it’s trickling down like yellow rain. Underwater home-‘owners’ have caught on to this game of chicken and have stopped paying mortgages, daring banks to foreclose, some for over a year now.

    From http://timiacono.com/index.php/2010/03/16/scary-housing-statistics-of-the-last-24-hours/

    “More evidence of banks being hopelessly behind or not wanting to take market prices for REOs comes in California foreclosure starts rise nearly 20% in February from the LA Times:

    “The number of properties scheduled for foreclosure … remained near record levels. However, actual sales of foreclosure properties, whether back to the bank or those sold to third parties, dropped 11.9% in February from the month prior.”

    “On average, severely delinquent borrowers have gone more than 9 months without making a mortgage payment—and yet foreclosure has not yet started for them. For those borrowers who are in the foreclosure process, it’s been an AVERAGE of 13.6 months—more than one full year—since they last made any payment on their mortgage.” (EMPHASIS ADDED)

    This is the ultimate, heartbreaking price of rampant rigged-market fraud and total non-accountability: the tricke-down of Darwinian sociopathy and a culture-wide loss of ethics and morality.

    From Alexis de Toqueville:

    “America is great because she is good, and if America ever ceases to be good, America will cease to be great.”

    “The greatness of America lies not in being more enlightened than any other nation, but rather in her ability to repair her faults.”

    Thanks for the hope and change, Barack.

  6. Siggy

    Lehman’s failure was the result of greed and hubris run amok. The wisest thing that the government did was to allow Lehman to fail. Could the government have prevented all of the events that followed Lehman’s bankruptcy? Perhaps some, but not all. Are there further implications as to regulatory abrogation and the arrogation of authority to act beyond the limits of ethical and reasonable conduct? I believe so.

    The financial crisis that occurred during the period running from 2006 thru 2009, and which continues today, albeit it a somewhat muted fashion, has many villains.

    The Lehman Bankruptcy Report is a door that leads to an element of the problem. There is a second door that needs to be opened and that is the one that gives entry into the mess that is AIG.

    1. Kievite

      It’s interesting that Greenspan’s quotes were just before collapse of the Soviet Union: a trillion dollar gift that propelled the economy for almost two decades.

      In a way he was right.

    1. Yves Smith Post author

      I’ve heard numbers more like a trillion, but how you count that is messy. Alvarez & Marsal (of course) says some claims are bogus, plus you have Lehman making counterclaims v. some of its counterparties.

      Lehman UK has a claim of $100 billion against Lehman the parent. How do you include that in a total?

  7. Ginger Yellow

    ” 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”

    This is just staggering. Bear in mind that the PDCF was facility that the Fed created during the crisis – it’s not like it’s something that central banks did as a matter of course. For a man on the street to assume that the BoE had a similar programme would be foolish. That a central bank’s general counsel assumed so is just terrifying.

  8. RHS

    OK Yves, here is where at least 15 billion of that 25 billion went. Its not assets or liabilities its equity. Lehman’s reported equity before the collapse was 23.1 billion on 30 Nov 07. They raised 11.8 billion over the next 7 months. Add in gains from hedges and possible retained earnings from assets you could get to about 40.3 billion. So there is about 10 billion that my numbers do not take into account but it all depends on when you start your analysis. I imagine that the exmaniner started his analysis earlier and there could have been 10 billion in equity that was dully lost in 07. You should not look at the reported net worth before the collapse because its easy to manipulate that number if you wanted to. Hence you should go back to a point where they were most likely telling the truth and follow the money from there. I for one belive the examiner, his numbers pretty much jive with mine. Repo 105 answered the only question I had at the time which was ‘who bought those assets?’ now we know, Lehamn bought them.

    Lehamn also may have been solvent depending on the methodology you use to recognize losses. By my numbers Lehamn was solvent at the time of default, but would be insolvent in the future when you recognized future losses on CMBS.

    1. Yves Smith Post author


      Lehman’s REPORTED equity was $26 billion as of the end of 2Q. Retained earnings? Lehman was trying to mark up kitchen sinks by that point. The fact that they were making Archstone and Suncal at unrealistic levels suggests they were pushing every mark that could be pushed.

      You are suggesting that equity was higher than reported in 2Q 2008. That undermines your argument. The bigger the swing from positive net worth to the $130 billion in losses, the bigger the unexplained number is. If you assume $40 billion in equity, that means you need to explain how $170 billion disappeared.

      1. RHS

        Retained earnings in this case is the money they recieved from performing investments that was not put in a dividend.

        ‘You are suggesting that equity was higher than reported in 2Q 2008.’

        No I am suggesting that the 130 billion number is right (I assume that is the loss for the firm as a whole icluding equity and not just the bond holders) and the 75 billion number for the cost of unwinding is right which gives me losses from res and com mortgages of 55 billion if you realized them at all once. They had 130 billion in exposure to res and com mortgages so a 40% impairment of those assets which is not inconceivable. Now assuming away that 75 billion(that occured because of the default) means they needed 55 billion in equity to be solvent. I am saying between what between what capital they had comming into the crisis added to what they raised added to what they earned from unimpaired assets and hedges gives me 40.3 billion making them short about 15 billion. Total loss to bond holders will be about 90 billion assuming I am right about the 130 billion being charged against the whole firm. That looks about right to me.

        1. Yves Smith Post author

          Your core assumption is wrong. The $130 billion is losses to creditors. And that is after some optimistic discounting by Bryan Marsal. Total creditor claims are over $1 trillion, versus balance sheet liabilities of roughly $635 billion at the end of 2Q.

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