A Few Words on Lehman

I have a trip coming up at the end of this week, and in the meantime I have two articles to write, and a section of a legal thingy, and I’m sick, and my daughter’s sick, so I won’t be able to do justice to the Lehman report issued by the bankruptcy examiner on Thursday. So here are just some moderately quick thoughts.

  • The report is great reading (I’ve read some sections of it). You can get the whole thing here, in nine separate PDF files. If you want to get an overview of the report, Volume I has a comprehensive table of contents. Note that the TOC is thirty-eight pages long. Like many legal documents, some of the section heads are written as sentences, so you can sort of “read” the TOC. In particular, you can see from the TOC which parties might be the subject of legal causes of action. (Note that the “Volume” numbers have nothing to do with the logical organization of the report; they only reflect how it was chopped into nine PDFs.)
  • The topic that has gotten the most press attention (here’s the main Times story, for example) is “Repo 105,” which takes up all 300+ pages of Volume III. A repo agreement is a short-term sale of securities (collateral) with a promise to buy it back later at a slightly higher price — in other words, a collateralized loan. With Repo 105, it seems that Lehman would sell the securities before the end of a quarter and promise to buy them back early the next quarter, and book the transaction as a sale, not a loan. The effect was to reduce the apparent amount of Lehman’s leverage at the end of the quarter — which is when the published balance sheet snapshot is taken. Here’s the Alphaville summary if you want more. In other words, Lehman was cooking the books.
  • If this sounds like Nigerian barges (Enron) to you, you’re not the only one. The examiner’s report itself (section III.A.4(j)(4)(b)) finds that Dick Fuld and his CFOs Chris O’Meara and Erin Callan were “grossly negligent” and that claims for breach of fiduciary duty could be made against all of them. Peter Henning talks about the potential for criminal charges.
  • One theme that has been sounded is that Lehman was an outlier (a “bad apple,” a recent president might have said), and there is an internal email in which a Lehman exec says that the other banks were not engaging in Repo 105-type transactions. Should we believe this? naked capitalism has a tip from a reader saying that other banks (or at least one other bank) were using total return swaps to dress up their balance sheets. I find it plausible that some banks were not cooking the books because, like Goldman, they had shorted the real estate market enough to protect themselves. But Lehman was not the only bank that was in deep trouble in 2007-2008.
  • Frank Partnoy says that alongside the fraud of Volume III, the incompetence of Volume II is perhaps even more troubling.  His post has some good examples. Here’s Partnoy’s conclusion: “The Repo 105 section of the Lehman report shows that Lehman’s balance sheet was fiction. That was bad. The Valuation section shows that Lehman’s approach to valuing assets and liabilities was seriously flawed. That is worse. For a levered trading firm, to not understand your economic position is to sign your own death warrant.”
  • Volume IV (Section III.A.5, “Secured Lenders”) discusses actions by Lehman’s counterparties and whether they are guilty of murdering Lehman. For the most part, the report says that the various banks involved did nothing wrong, or at least nothing wrong that rises to the level of legal action. There is one exception, though. In section III.A.5(f), pages 1220-24, the examiner finds that JPMorgan Chase may have violated an implied covenant of good faith and fair dealing by demanding too much collateral from Lehman shortly before its collapse. There is some evidence (p. 1216) that JPMorgan was overcollateralized and knew it was overcollateralized. (“All we need to talk this morning about the calls Leh has been making about having us return a portion of our excess collateral to their holding co. We have taken the position that their is no excess but they have not yet accepted that. We should make sure our statements are consistent since I am sure you will soon get called as well.”) But there is also evidence (p. 1217) that JPMorgan was behaving reasonably enough.
  • But Yves Smith discusses the most interesting question, which only gets sixty pages in Volume IV (Section III.A.6, “Government”): what was the government doing? The examiner uncovers more evidence that the SEC was not up to the task of monitoring Lehman (similar to the earlier report by the SEC’s own inspector general, finding that the SEC did not effectively oversee Bear Stearns).  Here’s a juicy paragraph that various people have seized on (pp. 1488-89): “After March 2008 when the SEC and FRBNY began on‐site daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress-testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank. The FRBNY developed two new stress scenarios: ‘Bear Stearns’ and ‘Bear Stearns Light.’ Lehman failed both tests. The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed. However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed. It does not appear that any agency required any action of Lehman in response to the results of the stress testing.” The general message is that the SEC did not take any real action to address the problems at Lehman; the Fed and the New York  Fed must have been aware of them, but acted primarily as a lender, not as a regulator, deferring to the SEC.
  • There is also a discussion on pages 1500-01 of a plan to create a Maiden Lane-type entity to hold $60 billion of toxic Lehman assets, financed by $5 billion from Lehman and a $55 billion non-recourse loan from the Fed. This seems to contradict the line often stated by Bernanke, Geithner, and Paulson that the Fed could not have rescued Lehman in a manner similar to Bear (backstopping enough of the toxic assets to make Lehman a palatable acquisition for someone else). It is possible, however, that the Fed decided that Lehman’s assets were too toxic for such a maneuver; the report doesn’t say why the Fed decided not to go ahead with the plan.

Overall, I’m surprised by how little interest the report has gotten in the media, given its depth and the surprising nature of some of its findings. Of the blogs I read, naked capitalism is giving it the most coverage and discussion.

Update: Andrew Ross Sorkin, the prince of the mainstream media when it comes to Wall Street, is getting on the case. In Dealbook, he points out that regulators saw everything that was going on at Lehman during the crucial months:

“There’s a lot riding on the government’s oversight of these accounting shenanigans. If Lehman Brothers executives are sued civilly or prosecuted criminally, they may actually have a powerful defense: a raft of government officials from the S.E.C. and Fed vetted virtually everything they did. . . .

“The problems at Lehman raise even larger questions about the vigilance of the S.E.C. and Fed in overseeing the other Wall Street banks as well.”

To Sorkin’s credit, he also cites Yves Smith for asking the question before he did.

28 thoughts on “A Few Words on Lehman

  1. I’m not surprised that this isn’t getting any traction in the MSM – it points actual fingers at actual people and actual agencies for screwing actual taxpayers, investors, etc. The ONLY thing Conservatives are 100% right about these days is that we, as a nation and culture, no longer value personal responsibility, so when people get named, we tend to duck and run – lest our sins are next.

  2. Isn’t it interesting how hard the Republicans like Dick Shelby and Bob Corker have worked to get the regulatory power inside the Federal Reserve?? And yet when the NYFRB knew the lies and corruption occurring at Lehman Brothers, the NYFRB chose to “defer” regulatory responsibility to the SEC, which everyone in NYC and Washington DC knew had become a TOTAL JOKE. Instead the NYFRB saw their only duty was to dole out taxpayer dollars to Lehman Brothers, a bank they FULL WELL KNEW was corrupt and had lied multiple times on their balance sheets.

    I guess we can see very clearly now why Republicans Dick Shelby and Bob Corker want the regulatory powers inside the Federal Reserve. All those quite meetings in the dark corridors pay off very well with those two Senators.

  3. excuse me, I should have said “quiet meetings” in the above post, not “quite meetings”. Anyway, the main point I want you to come away with is Senators Dick Shelby and Bob Corker are filth, dirt, and scum.

  4. To echo Ted K, it becomes very clear from reading Too Big to Fail that SEC chairman Cox was, to put it generously, woefully ineffective and out of his depth. In Sorkin’s descriptions of some meetings among the prinicpal actors, it is almost possible to hear Geithner’s and Bernanke’s eyes rolling when Cox is mentioned. So the news that “the SEC was not up to the task” is not really surprising.

  5. Somebody decided that Lehman wasn’t worth saving but AIG was (and AIG counterparties had to get 100% payouts to boot). It seems just a little bit suspicious that the biggest beneficiary to an AIG bailout was Goldman Sachs and Chairman of the NYFed was a Goldman Director (and former Goldman CEO).

    Others have raise this question on various blogs, but now we know that the NYFed knew of Lehman’s precarious state for months and did nothing.

    Was the Fed incompetent? or worse? It seems that it the answer to one or both of these questions is YES.

  6. There is a very comprehensive article about the policy views of the principal decider with power on the spot, Tim Geithner, in the current Atlantic . It is called ” Inside Man” by Joshua Green.

    Geither, it seems, is a doer. He picked up the pieces from his deciding perspective within the bureaucracy when the others were dithering about theory. Or so the article would have you believe.

    Obama gave Geithner Treasury on the basis of one 65 minute interview. Obama barely knew Geithner. Other big time doers too had similar views about Geithner. Geithner may or may not be a political enemy needing defeat. But always know the adversary better than he knows himself. That means respecting what is.

    The doer picks up the action and others live with the results. Life and death crises force such actions.

    Valukas report is a highly adversarial document. If it is not, then Valukas wasted $38 million of Lehman Estate funds. As a creditor of Lehman, I would want that $38 million parlayed into $38 billion so that my loss is recovered.

  7. Overall, I’m surprised by how little interest the report has gotten in the media, given its depth and the surprising nature of some of its findings. Of the blogs I read, naked capitalism is giving it the most coverage and discussion.

    Yeah, Nakcap’s been excellent on it.

    As for the MSM, why would they want to give it much coverage? It’s one giant, ugly, smelly manure pile of news which makes everyone involved – their bankster masters, their fellow government lackeys, and of course themselves, look terrible.

    And what a distration it could be from the tower of fraudulent hype for the “recovery” they’ve been so desperately building.

  8. Why doesn’t the MSM media cover this? Because MSReaders have little interest in the story. And why is that? Because the direct, immediate, and infuriating impact of what the Fed has done is on (1) savers and (2) taxpayers. That’s the problem. Beyond the readers of this blog, Naked Cap, and Calculated Risk, there are approximately 75 MSReaders who (1) save and/or (2) pay significant income taxes. But, let me tell you, all 75 of us are really ticked.

  9. Given the MOU between the SEC and the FRBNY to collaborate and share information, for the FRBNY to say it was wholly the SEC’s responsibility is disingenuous.

    How about this quote from v. 4: “How Lehman reports its liquidity is between [sic] Lehman, the SEC, and the world.” So the FRBNY knew that Lehman was cooking books on liquidity but said nothing. Is that OK with you?

    More here: http://www.contrarianpundit.com/?p=374

  10. Timmy-Gate. His possible involvement raises further questions about Obama’s judgement regarding appointing Geithner, etc to top econ jobs knowing their past associations, statements and actions. How could he not have known Tim’s hands were dirty?

  11. Re: Repo 105

    Trying to treat a repo as a sale is not a new trade. It has been around for several decades, generally for the same reasons…to at least reduce the apparent size of a balance sheet, sometimes for regulatory purposes and obviously sometimes to bury credit issues. The real issue is that the other side of the trade has to take the deal, and clear heightened risk, that the “seller” may not show up to repurchase the collateral. The point is that there must be a complicit counter-party (or I suppose a dumb one) to book the other side.

  12. True, but maybe I was a bit too gentle above. If the Fed (both NY and Washington) knew the SEC was incompetent, and they had access to lots and lots of data about Lehman, should they have taken some action, maybe in their role as Lehman’s banker of last resort? Or was it right to watch the SEC screw it up?

  13. Sorry, the only insight I have is Sorkin’s — for example, (p.346):
    “…Paulson ordered Cox, who was the onl;y regulator in the room with legal authority over Lehman Brothers, to call McCarthy. Cox, Paulson thought to himself with a sense of annoyance, was supposed to have prewired these very regulatory issues. ‘I don’t want to be left here holding Herman’….”

  14. I think at the very least the FRBNY should have notified the SEC that Lehman was cooking the books. There was a memo of understanding that they were to collaborate and share information. How can the FRBNY onsite monitor say Lehman was engaged in “three card monte” (his exact words) accounting and just leave it be?

  15. I agree, CP. But the Fed may very well have informed the SEC of its suspicions, and the SEC just rolled over and went back to sleep. After all, Markopolis repeatedly informed the SEC that Madoff was up to no good, and was ignored.

    Cox was obviously another political appointee given his job as a reward and told to keep the seat warm, no different from Michael “Heckuva Job” Brown or Michael “Heckuva Dad” Powell.

  16. Hey guys. Let’s not forget that it was Paulson and Co. that were sitting by letting Lehman tank. We must not totally scapegoat them. Yes, they did wrong. But, by blaming them for messing up (which they did, I do deny), we cannot turn our heads from all the other firms that were still standing after the crash because they had better political connections than Lehman.
    From reading Sorkin’s too big to fail, I drew heavily the conclusion that Paulson and Co. let Lehman fail and played Fuld and Co. like a rigged game of poker. So by continuing to read these reports and then reign down more hatred and blame on Lehman, we are forgetting the other actors in this play. Which could have been Paulson and Co.’s plan all along. Lehman the fall guy.

  17. ” some banks were not cooking the books because, like Goldman, they had shorted the real estate market enough to protect themselves.”

    But it’s not “better” to be fraudlently selling known garbage with one hand while betting against it with the other, deliberately killing the “investment” you’re fraudulently selling.

    It’s just a different kind of fraud.

  18. So, FBRNY: “We didn’t tell the SEC because we don’t like them.” Bravo.
    They might have said, “We could have told the SEC, but they are so clueless they wouldn’t have known what to do with the information anyway.”

    Either way, great reporting, CP. Wish I had time to read the whole Valukas report myself (OK, not the whole report).

  19. It still isn’t clear how much of a haircut Lehman Bros creditors are going to take even now that a first proposed Plan has been released. While the bankruptcy is very bad for Lehman equity holders and Lehman subordinated debt, I still haven’t seen anyone make a strong case for a scenario where Lehman and Lehman affiliate general creditors get less than 90-95% of their principal back, and where all creditors with any kind of priority are paid in full. Any loss in a bond investment is bad news for the investor, but it is still a lot better than stockholders in many solvent companies did in that time period.

    It is also interesting that the main complication in the bankruptcy plan is not what we usually think of as systemic risk — links to other unrelated entities that are dragged down with it. Instead, the main complication is how to sort out intercompany guarantees when all of the companies file for bankruptcy together. There is little evidence that Lehman Brothers has dragged anyone down with them.

  20. As has been noted by others, the Financial Times is the only print newspaper to really take this seriously (page one news twice in one week).

    American daily newspapers are the walking dead. There is no reason for anyone to read them.

  21. Maybe Michael Lewis can make simple sense of all of this in his new book which just came out.

  22. Late to this discussion, which is a shame because this James brings up an interesting point.

    James, I think you were too gentle and unfortunately, also missed the separation between the politics of Washington and the reality in New York. During my tenure in DC, I’ve learned that the way to demonstrate your value is not by out performing your peers, but by supplying them with enough rope to hang themselves. I’m certain this was the case with the FED and the SEC.

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