Absence of individual and institutional accountability for illegal trading activity, along with congenital greed, accounts for the culture of corruption that pervades the financialization industry. Unless you’re a rogue trader or slip on your ego like Bernie Madoff, penalties are part of doing business. Too Big To Fail resents common sense regulation yet down-sizing these banks would be the best medicine for US because they would be forced to be more prudent in their lending and investing practices.
Ever since the current economic crisis began, it has seemed that five words sum up the central principle of United States financial policy: go easy on the bankers.
Ex-Directors of Failed Firms Have Little to Fear
By STEVEN M. DAVIDOFF
Do the former directors of the institutions that collapsed during the financial crisis have anything to worry about? If the experience of Enron is any example, the answer is a resounding no.
Enron collapsed into bankruptcy in 2001 amid accusations of accounting improprieties and outright fraud. The scandal sent shock waves through corporate America, but compared with the global financial crisis, it almost seems small and quaint.
Still, in the case of Enron, unlike in the financial crisis, top corporate executives went to prison. Most prominently, Jeffrey Skilling, a former chief executive of Enron, was sentenced to 24 years in prison.
Yet while some Enron executives paid a price for the scandal, it is a different story with Enron’s former directors — the people charged with overseeing the company. A search of their current whereabouts shows that they have recovered nicely from the scandal.
Four former Enron directors still serve on public boards. Frank Savage, for example, still heads his own investment firm and serves on the boards of Bloomberg L.P. and Lockheed Martin. Norman P. Blake Jr. serves on the board of Owens Corning, where he is the head of that company’s audit committee.
A number have gone back to or entered academia. Wendy Gramm, the wife of the former senator Phil Gramm, vice chairman of UBS investment bank, is still in residence at the Mercatus Center at George Mason University.
Robert K. Jaedicke, who was chairman of Enron’s audit committee, teaches at the Stanford University Graduate School of Business. And Lord John Wakeham has remained chancellor of Brunel University in London.
The private sector Enron directors also continued their careers without much of a hiccup. Ken L. Harrison retired as chief executive of the Portland General Electric Company in 2000. And Ronnie C. Chan has remained chairman of the Hang Lung Group in Hong Kong since Enron’s collapse.
Most of the remaining directors have since retired or now work in small private or family businesses, a euphemism for semiretirement.
John Mendelsohn, for example, is to retire next month as head of the University of Texas MD Anderson Cancer Center.
Then there is Rebecca Mark-Jusbasche. She was named one of the “luckiest persons in Houston” by Fortune magazine. Ms. Mark-Jusbasche left the Enron board in 2000, selling more than $80 million worth of company stock. She now runs family properties in New Mexico and Colorado.
A few of the directors conveniently omit Enron from their biographies, but they do not appear to remain tainted, staying in their chosen professions.
The only court penalty placed upon them was related to a $165 million settlement of shareholder litigation arising from Enron’s demise. The directors personally had to pay a relatively large $13 million. The rest was covered by insurance.
The experiences of the Enron directors over the last decade would appear to offer great hope to the directors of Bear Stearns and Lehman Brothers.
Indeed, many of these directors remain not only as directors of public companies from before the financial crisis, but they have joined new boards. Even Alan Greenberg is still on the Viacom board with a fellow Bear board alumnus, Frederic V. Salerno, who serves on six public company boards. In all, 6 of the 12 Bear directors at the time of the investment bank’s collapse are still directors of public companies.
None of the Bear directors have appeared to have career difficulties. The two academics on the board were the Rev. Donald J. Harrington, who remains the president of St. John’s University, and Henry S. Bienen, who is emeritus president of Northwestern University. Frank T. Nickell is still chief executive, president and chairman of Kelso & Company, while Paul A. Novelly remains C.E.O. of the Apex Oil Company.
In fact, with the exception of James E. Cayne, none are fully retired or appear to be having trouble finding good positions.
It is the same for Lehman Brothers, with Richard S. Fuld Jr., the former chief executive, bearing the brunt of the public approbation. He is at his own firm, Matrix Advisors, and — fairly or unfairly — remains the focus of blame for Lehman’s demise.
As for the other Lehman directors, six of them held directorships as recently as January. Jerry A. Grundhofer was appointed to the Citigroup board after Lehman’s fall. He has since resigned from that board, but he remains on the boards of EcoLab and the Midland Company. Roland A. Hernandez joined the Sony board and still remains on the boards of MGM Mirage, the Ryland Group and Vail Resorts.
The rest of the board members were mostly private investors. Roger S. Berlind was and still is a theatrical producer. Michael L. Ainslie, former chief executive of Sotheby’s, is a private investor. Christopher Gent is a senior adviser to the consulting group Bain & Company as well as nonexecutive chairman of GlaxoSmithKline.
So the Bear and Lehman directors are returning to public company service even quicker than the Enron directors. In part this reflects the old boy network on Wall Street, which keeps people in the same positions because of friendships. It is not a coincidence that two former Bear Stearns directors serve on the Viacom board.
The trend also underscores the decline in the importance of reputation on Wall Street — even since the time of Enron. Prior bad conduct simply is often not viewed as a problem.
But in the case of the Bear and Lehman directors there is another significant factor. The financial crisis was an enormously complex event, and people will be debating its causes for years to come. Blame can be dispersed, and an executive or director can simply say it was the crisis itself — not poor management or inadequate board supervision — that caused their firm’s demise.
I am not arguing that these directors be tarred and feathered or that they should not be able to earn a living, but rather that there should be market penalties for failure — just as Ms. Gramm’s Mercatus Center often argues. At a minimum, one would think that other public companies might be more hesitant to keep these failed directors on their boards.
In the end, the directors of companies that failed in the financial crisis will most likely receive an even freer pass than the Enron directors.
With a pistol, a robber can withdraw $2,000 from the local branch and if apprehended, can spend years locked up. With a pc and a click, a trader, authorized by a manager, can move KKKKKKK and destroy the lives of thousands, without penalties. The economic meltdown that began in 2008 with the collapse of Lehman Brothers resulted from a cascading tsunami of unregulated and unrestrained greed.
Numerous books have been published concerning this predictable and preventable debacle.
Below is a list of recommended books that can provide perspective on the players and the institutions that were/are responsible for our economic mess.
Book Review: All the Devils Are Here
Book review: ‘Age of Greed’ by Jeff Madrick
Fannie Mae’s Johnson Was ‘Pied Piper,’ Drove U.S. Off Housing Cliff
The Road to Ruin
Why did so many prestigious institutions make disastrous bets on American mortgages?
Looting of America*
Is Washington For Sale?
This Is Considered Punishment?
By JOE NOCERA
Published: July 25, 2011
Last Wednesday, nearly lost in the furor over Rupert-gate and the debt ceiling crisis, came the surprising news that the Federal Reserve has issued a cease-and-desist order against a Too-Big-to-Fail bank. The bank was Wells Fargo, which was also fined $85 million and ordered to compensate customers it had unfairly — indeed, illegally — taken advantage of during the subprime bubble.
What made the news surprising, of course, was that the Federal Reserve has rarely, if ever, taken action against a bank for making predatory loans. Alan Greenspan, the former Fed chairman, didn’t believe in regulation and turned a blind eye to subprime abuses. His successor, Ben Bernanke, is not the ideologue that Greenspan is, but, as an institution, the Fed prefers to coddle banks rather than punish them. That the Fed would crack down on Wells Fargo would seem to suggest a long-overdue awakening.
Yet, for anyone still hoping for justice in the wake of the financial crisis, the news was hardly encouraging. First, the Fed did not force Wells Fargo to admit guilt — and even let the company issue a press release blaming its wrongdoing on a “relatively small group.” The $85 million fine was a joke; in just the last quarter, Wells Fargo’s revenues exceeded $20 billion. And compensating borrowers isn’t going to hurt much either. By my calculation, it won’t top $200 million.
Most upsetting of all, the settlement raises the question that just won’t go away: Why can’t the federal government prosecute financial wrongdoers?
I realize that the Federal Reserve can’t bring a criminal case (and, to be fair, there are statutory limits on how big a fine it can levy). But the Justice Department certainly can. Yet ever since it lost an early case against two Bear Stearns fund managers in 2009, it has gone after only the smallest of small fry: individual borrowers, brokers and appraisers who lack the means to do much more than plead guilty.
In March, for instance, I wrote about the sad case of Charlie Engle, the ultra-marathoner, who was convicted of lying on a liar loan — that is, exaggerating his income on a subprime mortgage application — even though the evidence against him was thin. Prosecuted by Neil H. MacBride, the U.S. attorney for the Eastern District of Virginia, Engle was sentenced to 21 months in prison.
Now compare Engle’s alleged crime to the case the Federal Reserve brought against Wells Fargo Financial , which, until it was shut down last summer, was the subprime subsidiary of Wells Fargo, based in Des Moines. There were several allegations, but the one that caught my eye was that Wells employees “falsified income information on mortgage applications.” In other words, they lied on liar loans! The only difference is that the lying was done by a group of Wells Fargo brokers rather than by some poor sap like Charlie Engle.
What’s more, this practice appears to have been quite widespread — “fostered,” as the Fed puts it, “by Wells Fargo Financial’s incentive compensation and sales quota programs.” Matthew R. Lee, the executive director of Inner City Press/Community on the Move and Fair Finance Watch, spent years bringing Wells’ subprime abuses to the attention of the Federal Reserve. “The way the compensation was designed ensured that abuses would take place,” he says. “It was a predatory system.”
These are exactly the kind of loans — built on illegal practices — that gave us the financial crisis. Brokers working for subprime mortgage companies routinely doctored incomes to hand out subprime loans they knew the borrowers could never repay — and then, after taking their fat fees, shoveled the loans to Wall Street, which bundled them into subprime securities. This was the kindling that lit the inferno of September 2008. So again, I ask: Why is there no criminal investigation into what went on at Wells Fargo Financial?
The person I called for answers was the press secretary to Nicholas A. Klinefeldt, the U.S. attorney for the Southern District of Iowa, which includes Des Moines. A glance at Klinefeldt’s 2011 press releases suggests that he takes the MacBride approach to mortgage fraud: only the little guy has anything to fear. Needless to say, his press secretary knew nothing about the Wells Fargo case and even questioned whether the Southern District of Iowa had jurisdiction.
The next day, he referred me to a Justice Department spokeswoman. I wrote her an e-mail laying out my question as plainly as I could: “I am trying to understand why the mortgage brokers who work at a major bank are getting a pass when they have lied on liar loans,” I said.
That was Friday. On Monday, at 8:30 p.m., a half-hour from press time, the Justice Department sent me a statement claiming that in 2010 “the number of defendants in mortgage fraud cases more than doubled” from 2009.
Not one of those defendants ever worked for Wells Fargo Financial.
Posted at 04:22 PM ET, 07/12/2011
SEC settlement with former Morgan Stanley trader is inadequate, commissioner says
One of the SEC’s five commissioners has taken the extraordinary step of publicly dissenting from an enforcement action on the grounds that it was too weak.
Commissioner Luis A. Aguilar said the Securities and Exchange Commission should have charged a former Morgan Stanley trader with fraud in view of what he called “the intentional nature of her conduct.”
Aguilar has long expressed concern that SEC enforcement actions can be too soft to serve as deterrents.
Based on a search of the SEC’s Web site, there have been only two posted dissents to the agency’s administrative enforcement actions since the beginning of 2004.
Aguilar’s action suggests “that it’s a pretty strongly held view,” said David B.H. Martin of the law firm Covington & Burling, a former senior SEC official.
The dissent comes weeks after the SEC took flak for negotiating a $153.6 million fine from J.P. Morgan Chase in another enforcement case but taking no action against any of the firm’s employees or executives.
Under a settlement announced Tuesday, the SEC alleged that former Morgan Stanley trader Jennifer Kim and a colleague who previously settled with the agency had executed at least 32 sham trades to mask the amount of risk they had been incurring and to get around an internal restriction.
Kim and her colleague entered and promptly canceled the fake trades to fool a Morgan Stanley risk management system, the SEC said.
Their trading contributed to millions of dollars of losses at the investment firm, the SEC said.
Without admitting or denying the SEC’s findings, Kim agreed to pay a fine of $25,000.
She was barred from working for a brokerage firm but can apply for relief from that sanction after three years.
The SEC said Kim “willfully violated” a section of the law that prohibits “knowingly circumventing or knowingly failing to implement a system of internal accounting controls or knowingly falsifying any book, record or account.”
Aguilar said the settlement was “inadequate” and “fails to address what is in my view the intentional nature of her conduct.”
“The settlement should have included charging Kim with violations of the antifraud provisions,” Aguilar wrote.
SEC chairman Mary L. Schapiro declined to comment on Aguilar’s dissent.
A Morgan Stanley spokesman declined to comment. A lawyer for Kim did not respond to requests for comment.
SEC accused of dumping records
The SEC has violated federal law by destroying the records of thousands of enforcement cases in which it decided not to file charges against or conduct full-blown investigations of Wall Street firms and others initially suspected of wrongdoing, a former agency official has alleged.
The purged records involve major firms such as Goldman Sachs, Citigroup, Bank of America, Morgan Stanley and hedge-fund manager SAC Capital, the former official claimed. At issue were suspicions of actions such as insider trading, financial fraud and market manipulation.
Abandon All Hope
If you think Wall Street and the big banks are capable of reform, think again. This is the conclusion you are forced to when reading the report of the Examiner responsible for investigating the Lehman Brothers collapse and bankruptcy. Anton Valukas, the chairman of the Chicago law firm of Jenner & Block, was appointed Examiner by the courts, and assembled a staff and a budget of $38 million to produce this week’s blockbuster, 2,200 page report on what happened to Lehman Bros. Here are some of the depressing highlights:
1. CEO Dick Fuld had brought Lehman back from the dead in 1999 after a severe liquidity crisis. He had grabbed market share in out-of-favor market segments, and the firm made a killing afterwards. Because of this experience, once the sub-prime mortgage crisis hit in 2006, he was ready to repeat his success. He ordered the firm to step up its already aggressive mortgage lending and securitizing, plus expand into commercial real estate and leveraged loans. The results were disastrous, leaving the corporation with tens of billions of dollars of very illiquid assets that were useless when Lehman needed to pledge collateral in order to borrow money.
2. The explosion of new business in 2006 and 2007 quickly overrode the firm’s risk management limits. The head of risk management, Dr. Madelyn Antoncic, a respected professional in the industry with 12 years previous experience at Goldman Sachs, protested that the firm needed to cut back on risk. She was overruled by Fuld and the Executive Committee, which increased some limits, and eliminated altogether others like the limit on individual loan amounts. When the firm was in serious liquidity trouble in 2008, Fuld “dismissed” her by transferring her to the office of government relations.
3. When liquidity became a serious concern in 2008, senior management stepped up use of a practice they called Repo 105. Repos are repurchase agreements that brokers use to raise short term capital by pledging some of their assets as collateral, and reversing the transaction later. These are always labeled as a financing or borrowing, and therefore increase the leverage of the firm – the ratio of borrowings to total capital. Under the Repo 105 program, Lehman deliberately over-collateralized the amount they borrowed, and thus called the transaction a sale. This was done at year end for amounts up to $50 billion, and reversed after the New Year, causing the leverage of the firm to be underreported. As one executive explained to the Examiner, the transactions had no purpose other than to misreport the leverage.
4. Ernst & Young, Lehman’s auditors, signed off on the quarterly use of Repo 105 transactions, despite the obvious fact that these were intended to deceive shareholders, regulators, ratings agencies, and even the board of directors. This is also despite all the requirements imposed on Lehman Bros. and Ernst and Young under the Sarbanes-Oxley provisions installed by Congress after the collapse of Enron.
5. As the firm’s liquidity situation worsened in the summer of 2008, Lehman Bros. kept assuring the market it had $40 billion of liquidity on hand, more than enough to meet its obligations. In fact, much of this $40 billion consisted of illiquid loans and investments no one would accept as collateral, and the rest, especially cash, had been pledged to various banks that provided Lehman with clearing and settlement services. By September, 2008, Lehman was in such bad shape that it had only $2 billion of cash on hand, hardly enough to survive.
6. Lehman was pushed over the edge and filed for bankruptcy in September, 2008 when no buyers came forward to invest in and save the firm. By this point, Lehman was pledging large amounts of cash collateral to its two clearing agents: JPM Chase and Citigroup. At any time either of these firms could have pulled the plug and destroyed the firm, and there are some indications that Chase over-collateralized its risk with Lehman because it held the upper hand in any negotiations.
The Examiner has found a number of “colorable claims”, meaning legal claims that, given the facts as now known, would have a good chance of succeeding with a jury. These include:
• A claim against Richard Fuld, CEO, and three successive CFOs (Christopher O’Meara, Erin Callan, and Ian Lowitt) that they are liable for providing “materially misleading periodic reports” regarding the true liquidity situation of Lehman Bros. In particular, these individuals never revealed the true purpose of 105 Repos.
• A claim against Ernst & Young for “professional negligence” in allowing the 105 Repo program to continue without any explanation to the public.
• A claim that JP Morgan Chase did not act with “good faith and fair dealing” when negotiating with Lehman over collateral requests. The bank may have knowingly taken too much collateral.
These colorable claims are an invitation to the receiver for Lehman Bros. to file suits against these individuals or firms and seek damages. Prosecutors may also be interested in filing criminal charges. The Examiner is making all documentation available to the authorities for this or any other purposes.
There were a considerable number of colorable claims looked into that were rejected by the Examiner. He found no culpability with the management for their poor decisions regarding expansion of the business in 2006. This judgment call was deemed to be within the purview of management, having imperfect information at the time, and not having acted in a “reckless” manner.
Similarly, he found no fault with management in overriding the risk management systems or personnel. The Examiner asserted that risk management systems are creations of the management and can be overridden at any time.
The Examiner mentioned that Lehman was, as is typical of a corporation, organized under the favored laws of Delaware, and as such the bar is set very high for anyone wishing to prove criminal or civil charges against the board of directors or management.
What Have We Learned?
1. Do not count on outside auditors or internal risk management professionals to keep a bank or investment firm from doing dangerous and ill-conceived things. While these control functions are not entirely window-dressing (the Examiner found Lehman did not overstate its asset values in the independent mark to market process), it is very easy for senior management to ignore or neuter these professionals.
2. Nothing will be allowed to stand in the way of the revenue and profit goals of the business managers. Prudent risk management and honest legal and accounting practices can suffer when they interfere with profit.
3. The strategic direction of any financial firm can rest almost exclusively on the CEO. The CEO’s experience is often battling with his ego in determining the fate of the firm. Do not rely on their being any true restraint on men like Dick Fuld, Lloyd Blankfein, Jamie Dimon or other leaders who develop a cult presence in the media and among their employees. The more infallible a leader is seen to be, the more likely the firm is going to eventually have a crack-up.
4. Regulators are useless, or even dangerous, if their political masters deprive them of staff, a decent budget, and authority. The SEC is a perfect example of a regulator that was purposely destroyed at the start of the Bush administration in 2000, and never recovered. It had a token, useless leader in Christopher Cox at the time of the Bear Stearns and Lehman collapses, and its staff lost all competence and power to properly regulate Lehman Bros. The firm was therefore able to do whatever it wanted.
5. Similarly, public accounting firms still “do not get it”, after a decade of disasters and the complete loss of Arthur Andersen following the Enron affair. For an accounting firm to do its job properly, it would need to act like Anton Valukas; hire 200 people, charge each bank $40 million annually, have access to all emails and documents, pour over this information daily, and then take a close legal as well as accounting eye on what is going on. The current approach, where a firm may have at most 5 people assigned to Citigroup with an annual budget of $10 million, is not working.
6. The disaster that is Too Big To Fail will keep on delivering failure after failure. Lehman was ultimately dependent on a few big banks for its funding, but that pool has now shrunk during the credit crisis. There are only two banks left in the US that provide clearing and settlement services on a large scale, for example, and everyone will be in their power should a liquidity crisis arise. This means that the power to pull the plug on a competitor is now resting with a few big banks, depending on what the regulators decide to do. The system is more concentrated than ever in terms of risk and power.
There are a number of other salutary lessons to be gleaned from the Examiner’s report. Suffice to say, the overwhelming conclusion is that these large banks are hopelessly out of control except when they get into trouble, and then their lackeys in Washington will protect them.
For those interested in some of the other interesting details to be found among the 2,200 pages of the report, here is the chronology of the decline and fall of Lehman Brothers.
Lehman Bros. was already a significant originator and securitizer of sub-prime and Alt-A mortgage loans (the next safer level of risk) by 2006, when it began to notice a serious deterioration in its business. Defaults were rising unexpectedly and precipitously in the sub-prime portfolio, leading to several consequences. First, the securities that included these mortgages, which had started life with a Aaa risk rating, were being downgraded even to below investment grade. Second, investors were becoming wary of buying more of these securities, and Lehman was being forced to hold more of them in their own portfolio. Third, some of the smaller mortgage originators in the business were going under, lacking sufficient capital to absorb all the securities being returned to them contractually because of higher default risk.
Lehman’s CEO, Dick Fuld, saw this as an opportunity. His experience in the 1999 dot.com crisis taught him two things: Lehman could make enormous profits in such circumstances if it was willing to expand its risk appetite and grab market share, and the company could recover from any liquidity strains which might arise in such a strategy. Fuld, along with his top management, believed Lehman needed to expand its mortgage business, and expand as well into commercial real estate and leveraged loans, all areas that were under pressure in the growing liquidity crisis of 2006. Management set a target for Lehman to grow its balance sheet by 15% each year, and achieve $5 in future business profit for every $1 in loans it extended.
Fuld believed the sub-prime crisis was bottoming out, and that problems in these mortgages would not spread to Alt-A or prime mortgages. If he was wrong, Lehman would be running enormous liquidity risks. It would be filling its balance sheet with illiquid assets, which in a time of market stress could neither be sold or pledged as collateral to raise liquid assets.
The transformational aspect of this strategy related to Lehman’s definition of itself as a broker which “moved” assets rather than “store” them. Some middle managers worried that this new strategy pushed Lehman into a storage mode, much like a bank, and if so, Lehman needed to adjust its sources of funding. The firm had traditionally relied on very short term funding, conducting repos by using its temporary trading assets as collateral for the repurchase agreement. The head of the Fixed Income Department (FID) was especially concerned, because he had to fund these new assets and saw no interest from senior management in finding long term sources of funding. He was joined in his concern by the Chief Risk Officer, who worried about the changing risk profile of the corporation at a time when competitors were reducing risk and leverage.
Risk Controls Relaxed
The market was very receptive to Lehman’s new strategy, since there was a growing need for leveraged loans and real estate financing as some banks and brokers withdrew from these businesses. Throughout 2006 and into 2007 Lehman had its pick of deals, and no problem exceeding the balance sheet and revenue targets. The commercial real estate limit had to be increased from $600 million to $720 million by the end of 2007, and increased again in 2008. The limit for leveraged buyout loans started at $11 billion, and within a year had to be increased to $37.6 billion. The previous limit on individual deal size was completely eliminated. Business risk increased as well because customers were insisting on what were called “covenant light” deals, where the legal documentation left most of the risk with the lender rather than the borrower.
Lehman used standard risk management tools operated by the risk management function, managed by Madelyn Antoncic. This department calculated daily the risk appetite exposure, determined by a formula which weighed credit, market, and event risk against the earnings potential of the corporation. This formula in 2006 calculated a $2.2 billion risk appetite, meaning under very adverse circumstances in the market the corporation could lose this much money. Within a year this exposure had jumped to $3.3 billion, beyond the limit set by management for the corporation. Antoncic and other executives argued that this exposure was too high, and risk needed to be reined in. They were overruled by Fuld and the rest of the Executive Committee, and the limit was raised to incorporate the new risk.
Risk Management also conducted stress tests monthly, using more extreme hypothetical market circumstances. Through 2006 and most of 2007, stress testing excluded leveraged loans, real estate, and private investments of the corporation, and was limited to trading positions only (which were much easier to model for stress testing purposes). Risk Management was criticized by internal auditors at Lehman for excluding so much of the new risk being created, and by the end of 2007 they managed to add these exposures. The result leapt from $2.6 billion in potential extreme losses to $13.4 billion, but these results were never sent to senior management.
By 2007 Lehman Bros. was running regular overages to its risk appetite exposure, and periodically the Executive Committee would raised the limit retroactively. The Office of Thrift Supervision criticized this practice in its annual review, and also questioned why the corporation did away with the limit on deal size for leveraged loans. The SEC, in its separate review, looked at both of these situations and found no problem with Lehman’s actions.
By August 2006 the problems in the sub-prime mortgage portfolio were serious enough that Lehman management dropped most of its activity in this area. For example, the corporation would no longer accept 80/20, no doc loans. These were mortgages for 80% of the property value, plus an additional home equity line of credit for the remaining 20% of the value, and the borrower was not required to verify income or assets. Still, the corporation was accepting $700 million in new mortgages each month, many of them unacceptable for securitization in the new market conditions. Furthermore, Lehman expanded its Alt-A program to make up for lost volume, even though these loans were starting to show the same sort of problems as sub-prime.
By 2007, the market was beginning to question the high amounts of leverage carried by US investment banks, which at times could reach 30x capital based on allowances granted these firms by the SEC in 2004. Lehman was getting increasing questions from reporters, regulators, and the ratings agencies about its plans to reduce leverage. CEO Fuld introduced a deleveraging program in 2007 that continued throughout 2008 until the firm’s demise.
To meet management expectations from this program, business managers, especially in the Fixed Income Department, relied more and more on an accounting tool instituted in 2001 and called Repo 105. Repos, short for repurchase agreements, are short term financing tools, usually for a week, and useful for broker/dealers who pledge trading and customer assets to a bank in exchange for liquidity. There is a firm commitment to reverse the transaction at a set date, so these transactions are accounted for as loans.
Under the Repo 105 program, Lehman extended more collateral than would normally be necessary for a typical repo, and called these sales and repurchases of assets, not loans. This allowed the firm to reduce its stated borrowings and therefore its leverage ratios. In 2001 when these were introduced, Lehman sought approval opinions in the US, but was unable to get any law firm or accounting firm to sanction these repos as sales. It did receive accounting approval from the firm of Linklaters in London, authorizing these deals under UK law. Consequently, Lehman conducted all 105 repos through its London subsidiaries, transferring assets to London for this purpose.
Lehman grew to depend on the Repo 105 program at quarter ends, and even deliberately executed some of these transactions during the middle of each quarter to give the impression these were not used solely for window dressing. Even so, managers in the accounting area consistently questioned whether the firm wasn’t running “reputational risk” should the public find out about these repos.
By 2007 and into 2008 the quarter-end use of Repo 105 ballooned to the point that up to $50 billion in assets were “removed” from the balance sheet. The firm was able to accentuate the benefits by using the cash from these repos to temporarily pay down other debt, so each 105 repo had a double benefit. Within a few days after the quarter end, the repos were paid back, and the assets returned to the balance sheet. At no time did the firm explain to the regulators, the ratings agencies or the board of directors that it was reducing leverage temporarily through these accounting fictions. In fact, Lehman management in 2007 and 2008 bragged consistently about its progress in reducing leverage. For example, in 2008 it told the Fitch ratings agency that its leverage had been reduced in one quarter from 15.4x to 12.0x capital, never revealing that this was accomplished in part through 105 repos. The same boasting was done publicly in quarterly calls with analysts and the press, giving a fictitious and misleading view of the firm’s true financial condition.
Running Out of Liquidity
By late summer of 2008, Lehman was widely viewed in the credit and equity markets as the next financial firm to fail. Internal documents supported this possibility, as the firm was unable to raise cash with ease. Several middle level executives assigned to analyzing and improving the firm’s liquidity position created a committee they called ALCO – the Asset and Liability Committee. This sort of committee is common in commercial banks and reflects how completely Lehman Bros. had converted itself from a broker/dealer involved in “moving” assets to a bank involved in “storing” assets. The ALCO meetings generated a monthly projected cash position that was net negative, requiring regular short term borrowings of some sort in order for the firm to survive.
Borrowing was becoming more difficult due to several constraints. Lehman’s assets were concentrated in long term loans to risky, leveraged companies, or to real estate developers. Lenders would insist on steep discounts for these properties as collateral, if they accepted them at all. At the same time, Lehman’s securities portfolio of mortgage-backed instruments was being devalued daily in the market as market prices for similar securities continued to plummet. By mid-2008, Lehman management realized it had a problem with its Repo 105 program, and ordered individual businesses to reduce reliance on this mechanism for liquidity.
To continue in its basic businesses of stock exchange and bond trading, foreign exchange transactions, commodities dealing, and related business, Lehman relied on clearing and settlement services from JP Morgan Chase as its principal provider, and Citigroup as a secondary provider for overseas services. These were long-standing relationships backed by collateral agreements pledging assets to these banks as part of the clearing function. As Lehman began announcing substantial quarterly losses in 2008, these banks asked for renegotiation of the agreements and stricter controls over the collateral.
During the summer of 2008, Lehman was announcing to regulators and the public that it held a pool of about $40 billion of liquid assets available at any time to support the firm. This wasn’t true. Many of these assets were already pledged as collateral and could not be claimed by the firm. Another portion consisted of highly illiquid real estate and leveraged loans. Lehman included in the total $5 billion that was held at JPM Chase as collateral for their clearing services, and $2 billion held at Citigroup for the same purpose. As summer turned into autumn, the amount of truly liquid cash in this pool dwindled to about $2 billion, very insufficient to maintain daily operations at Lehman Bros.
Several regulators noted the illiquidity of most of this pool, and subtracted accordingly when calculating Lehman’s true liquidity. For this reason, regulators at the Federal Reserve and SEC understood Lehman’s situation was more dire than known by the public. JPM Chase and Citigroup eventually realized the same thing, and in September 2008 renegotiated their collateral agreements with Lehman. The negotiations with JPM Chase were particularly involved, and several executives at Lehman afterward complained they signed agreements with Chase under pressure.
The US Treasury and the Federal Reserve attempted to organize an industry rescue of Lehman during the weekend of September 13 and 14, 2008, but offered no capital infusion to help the transaction. Once prospective buyers were able to look seriously at Lehman’s assets, interest in a deal evaporated, and the firm entered bankruptcy on September 19, 2008.