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Lehman Bros. Examiner’s Report Raises Questions

The recent release of the Bankruptcy Examiner’s Report for Lehman Brothers raises some significant questions but one thing is for sure - we need financial regulatory reform. 

On September 15, 2008, Lehman Brothers, one the oldest and biggest financial conglomerates in the U.S., filed for Chapter 11 bankruptcy protection.  This was the largest bankruptcy proceeding ever filed.  As part of the bankruptcy proceedings the Bankruptcy Court appointed an Examiner to investigate certain aspects of the Lehman Brothers’ bankruptcy.  Anton R. Valukas was appointed as examiner and last week filed a 2000+ page report that paints a very disturbing picture of what was happening at Lehman Brothers up to the date it filed for bankruptcy.

The report raises significant questions of fraud, misinformation and accounting manipulation.  Bad stuff that was not much different than what was happening at Enron.  But the report also implicitly raises some bigger questions that may need further investigation and hopefully someone at the Financial Crisis Inquiry Commission is reading this very informative report.

Questions:

1)  Are other similarly structured investment banks also vulnerable to the same problems that plagued Lehman Bros. or new problems? 

From the Examiner’s Report:

Lehman’s business model was not unique; all of the major investment banks that existed at the time followed some variation of a high‐risk, high‐leverage model that required the confidence of counterparties to sustain.

Lehman Bros. was an investment bank and not a commercial bank like Bank of America or JP Morgan Chase.  Lehman Bros. was the same as Bear Stearns (before JP Morgan Chase purchase), Merrill Lynch (before Bank of America purchase), Morgan Stanley, and Goldman Sachs.  Currently, Morgan Stanley and Goldman Sachs are the only two investment banks - despite both financial conglomerates applying for bank holding company status in order to take advantage of cheap lending from the Federal Reserve Bank.

Lehman Bros. did something very similar to a traditional commercial bank.  Its short-term liabilities were matched with long-term assets but the problem and what made it risky was that short-term liabilities were in the from repurchase agreements.  Repurchase agreements by themselves are not particularly risky but the do require a high level of confidence between parties and that is where this funding scheme became risky for Lehman:

Lehman maintained approximately $700 billion of assets, and corresponding liabilities, on capital of approximately $25 billion.  But the assets were predominantly long‐term, while the liabilities were largely short‐term.  Lehman funded itself through the short‐term repo markets and had to borrow tens or hundreds of billions of dollars in those markets each day from counterparties to be able to open for business.  Confidence was critical. The moment that repo counterparties were to lose confidence in Lehman and decline to roll over its daily funding, Lehman would be unable to fund itself and continue to operate.  So too with the other investment banks, had they continued business as usual. It is no coincidence that no major investment bank still exists with that model

That last sentence is key.  So, if “no major investment bank still exists with that model” what are they doing or what did they do to change?  Is it just another risky business model?

2) To what extent did other financial conglomerates use “accounting gimmicks” to hide its financial condition from investors and regulators and are financial conglomerates continuing to use “accounting gimmicks”?

Desperation kicked in at Lehman Bros.  It had gambled heavily in the subprime mortgage market and commercial real estate market and lost big.  But it was still operating in a highly competitive market with the likes of other big players like Goldman Sachs, JP Morgan Chase, Morgan Stanley and other financial conglomerates.  Was it survival at any cost by Lehman Bros. executives?  After all there was a lot at stake for them in the form of huge bonuses. 

Lehman Bros. used what is called “Repo 105” transactions to hide at least $50 billion (yes billion with a “b”) of liabilities from its balance sheet:

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.  Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.  Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.  Thus, Lehman’s Repo 105 practice consisted of a two‐step process: (1) undertaking Repo 105 transactions followed by (2) the use of Repo 105 cash borrowings to pay down liabilities, thereby reducing leverage. A few days after the new quarter began, Lehman would borrow the necessary funds to repay the cash borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet.

Lehman Bros. never publicly disclosed the use of the Repo 105 transactions.  The sole purpose for the use of Repo 105 transactions was to hide $50 billion in liabilities and make it look not as highly leveraged than it actually was.  A major major securities law violation. 

Were other financial conglomerates as desperate to survive?  Millions of dollars in bonuses and careers were at stake at the height of the financial crisis and continue today.  To what extent are other financial conglomerates continuing to use “accounting gimmicks” to hide huge liabilities and leverage?  Stress tests performed by the Fed and other regulators in the closing months of Lehman Bros. existence failed to uncover the Repo 105 transactions. 

3)  What impact was 2004 SEC decision to exempt certain broker/dealers from ‘net cap rules’ play in Lehman Bankruptcy and cause problems at other financial conglomerates?

On April 28, 2004, the Securities and Exchange Commission decided to exempt brokerage units from an old regulation that limited the amount of debt brokerage units could take on. 

The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

Guess who were the five investment banks pushing hard for this rule change:  Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley.  Interesting?

But the SEC didn’t stop with allowing these investment banks to bath in debt.  It took an additional step on that day in April:

In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.

That’s right - self policing and what a joke it was.  Check this quote out from a law professor who believed it might work:

“We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing,” said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox).

“Letting the firms police themselves made sense to me because I didn’t think the SEC had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We’ve all learned a terrible lesson,” he added.

But there was one lone voice of dissent at that April 2004 SEC meeting:

A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso, Ind., who said the computer models run by the firms — which the regulators would be relying on — could not anticipate moments of severe market turbulence.
......
He said that similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.

There were several experts that said that the 2004 SEC decision had little impact on leverage but there was certainly a lot of circumstantial evidence that the over all decision had an impact.  Take a look at what has happened to the five investment banks that pushed for the change:

Bear Stearns - In March 2008 near bankruptcy it is “forced” to sell itself to JP Morgan Chase for something close to $2 per share

Lehman Brothers - Bankruptcy

Merrill Lynch - In September 2008, in a very controversial transaction, Bank of America purchased it for $50 billion

Goldman Sachs - In September 2008, applies for Commercial Bank Holding Status and promptly gains access to cheap loans from Federal Reserve Bank and later receives $10 billion from TARP plus another $12.9 billion from AIG bailout and other federal subsidies such as FDIC bond guarantee program.

Morgan Stanley - In September 2008, applies for Commercial Bank Holding Status and promptly gains access to cheap loans from Federal Reserve Bank and later receives $10 billion from TARP plus other federal subsidies such as FDIC bond guarantee program

And what did the Mr. Valukas say about Lehman’s self-policing:

Lehman was required by the SEC to conduct some form of regular stress testing on its portfolio to quantify the catastrophic loss it could suffer over a defined period of time.  Lehman ran a series of stress tests based on 13 or 14 different scenarios.  Some of the scenarios were historical events, such as the 1987 stock market crash or the 1998 Russian financial crisis, while other scenarios were hypothesized by Lehman’s risk managers.  Lehman’s management represented to its external constituents that regular and comprehensive stress tests “were performed to evaluate the potential P&L impact on the Firm’s portfolio of abnormal yet plausible market conditions.”  Stress testing was designed to measure “tail risk” – a one in ten year type event.

When Lehman first adopted stress testing in about 2005, it applied the testing only to its tradable instruments such as stocks, bonds, and other securities; it did not include its un‐traded assets such as its commercial real estate or private equity investments.  Because these assets did not trade freely, they were not considered susceptible to stress testing over a short‐term scenario.  And since Lehman did not then have significant investments in these areas, excluding them from the stress testing did not undermine the usefulness of the results.  The SEC was aware of this
exclusion.

.....

Because Lehman’s stress testing did not include its real estate investments, its private equity investments or, during a crucial time period, its leveraged loan commitments, Lehman’s management pursued its transition from the moving business to the storage business without the benefit of regular stress testing on the primary business lines that were the subject of this strategic change.  For example, as described below, Lehman entered into a series of large and risky commercial real estate transactions in the first half of 2007 without stress testing the particular transactions and without conducting regular stress testing on Lehman’s aggregate commercial real estate book.

These exclusions were significant.  Subsequent stress testing by regulators starting in 2008 showed that there was a significant amount of ‘tail risk’ attributed to those excluded investments.  The self-policing stress testing failed. 

One thing is certain - we need some form of financial regulatory reform.  One that makes these financial conglomerates smaller, discourages complexity and/or one that imposes a higher cost on risk.  One other thing is certain - we cannot afford the status quo.

Good luck.