Wednesday, March 31, 2010

Reforming a broken mortgage system

Original posted on Politico by George Soros:

Treasury Secretary Timothy Geithner testified Tuesday on a plan to reform Fannie Mae and Freddie Mac, the government-sponsored enterprises now in limbo. But we don’t have to wait years to reform the mortgage system; a better approach could be introduced right away.

The business model of Fannie Mae and Freddie Mac is fundamentally unsound. These public-private partnerships were supposed to serve the public interest and the interest of shareholders. But this was never properly defined and reconciled.

Management’s interests were more closely allied with those of shareholders. They had an incentive to lobby Congress — both to expand homeownership and to protect and use their government-sponsored duopoly status.

The GSEs extended their activities from insuring and securitizing mortgages to building highly leveraged portfolios of securities by taking advantage of their implicit government backstop. They profited from the growth without bearing the risk of collapse: Heads they win, tails you lose.

The GSEs already had a checkered history, riddled with accounting irregularities. Eventually, they blew up — at a huge loss to taxpayers that may exceed $400 billion.

Early in the century, private enterprise had started eating into the government-guaranteed mortgage market. Borrowers once served by the Federal Housing Administration turned to subprime and Alt-A mortgages.

These “non-agency” mortgage securities gained increasing market share. They were sliced and diced, repackaged into CDOs and CDOs squared. Geographic diversification was supposed to reduce risk. But the originate-to-distribute model of securitization actually increased risk by creating a severe agency problem: Agents were more concerned with earning fees than protecting the quality of the mortgages. The housing bubble ended with a crash — and the government was forced to take over GSEs.

With the private sector largely incapacitated, the GSEs and FHA became virtually the only source of mortgage financing. This is a paradoxical situation in which a fundamentally unsound business model holds a quasimonopolistic position. This cannot last.

What needs to be done is clear: The GSEs’ mortgage insurance function must be separated from mortgage financing.

The former, mortgage insurance, is the legitimate function of a government agency, especially when the private sector has collapsed. A mortgage insurance entity should be run as a government agency.

But mortgage financing should revert to the private sector. This would get rid of a business model that has failed.

There is a proven mortgage financing system already up and running. The Danish model has been in use, continuously, since the aftermath of the Great Fire of Copenhagen in 1795. It has not prevented housing bubbles, but it has never broken down. And it proved its worth again in 2008.

In the Danish system, homeowners do not borrow from either a mortgage originator or a GSE. They borrow from the bond market, through a mortgage credit intermediary. Every mortgage is balanced by an equivalent amount of an identical, and openly traded, bond. This is called the Principle of Balance.

In the United States, mortgage securities are separated at birth from the borrower. Thereafter, they lead separate lives. But in the POB system, the link is never broken.

Mortgage Credit Intermediaries operate the POB system. They help homeowners understand and navigate the process. Most important, MCIs bear the credit risk of the mortgages — they remain “on the hook” in the event of delinquency or default.

In Denmark, these mortgages are not insured by a government agency. This would have to be modified in America. Given the current demoralized state of the market, a government agency would have to guarantee mortgages, but the MCIs would be required to keep “skin in the game” with a stake of, say, the top 10 percent.

A key benefit of the POB system is that it offers performing homeowners the opportunity to buy back their loans when interest rates rise. If the price of the associated mortgage bond drops, the homeowner can buy the equivalent face value of bonds at a discount, to redeem the existing home loan.

The homeowner’s ability to lower his mortgage liability reduces the chance that he will be under water when home prices fall because of a rise in interest rates.

This helps forestall foreclosure crises. And it would have a counter­cyclical effect: Homeowners repurchasing mortgages help moderate upward pressure on interest rates. By contrast, the current system tends to exacerbate upward pressure by lengthening duration, a likely near-term prospect.

This system would have many other advantages over one that has collapsed.

It would eliminate the agency problem that was the primary cause of failure. It would separate the credit risk from the interest rate risk. It would be transparent. And it would be open: The duopolistic position of the GSEs would disappear.

What would remain is a government agency offering mortgage insurance to all qualified MCIs without competing with them.

How to get there from here? Do it in steps.

The first is to introduce mortgage securities based on the Principle of Balance. GSEs could, and should, do this, with the government regulator setting clear and conservative standards. No legislation is required.

The second step is to open the process so all qualified MCIs can issue POB bonds. To make this market work, this means new law requiring that MCIs maintain skin in the game for any federally guaranteed mortgage.

After that, the GSEs could be phased out from their role as MCIs, and the guarantee function hived off to a government agency. Eventually, the GSEs would be liquidated, as their portfolios run off.

Legislation would also be required to extend the POB system to areas that government insurance does not cover.

In fact, legislation authorizing “covered bonds” is making its way through Congress.

But it should better take into account the lessons of the last crisis — and begin the introduction of the Danish model. This should be part of the financial reform package.

We could start rebuilding a stronger mortgage finance system along these lines now.

Tuesday, March 30, 2010

Fear of fire sales and the credit freeze

BIS Working Paper by Douglas Diamond:

Abstract: Is there any need to “clean” up a banking system in the midst of a crisis, by closing or recapitalizing weak banks and taking bad assets off bank balance sheets, or can one wait till the crisis is over? We argue that an “overhang” of impaired banks that may be forced to sell assets soon can reduce the current price of illiquid assets sufficiently that weak banks have no interest in selling them. Anticipating a potential future fire sale, cash rich buyers have high expected returns to holding cash, which also reduces their incentive to lock up money in term loans. The potential for a worse fire sale than necessary, as well as the associated decline in credit origination, could make the crisis worse, which is one reason it may make sense to clean up the system even in the midst of the crisis. We discuss alternative ways of cleaning up the system, and the associated costs and benefits.

Download paper here:

Illiquidity and all its friends

BIS Working Paper by Jean Tirole:

Abstract: The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don't know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment.

Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macro-prudential policies.

Download the paper here:

The failure mechanics of dealer banks

BIS working paper by Daryl Duffie:

Abstract: I explain the key failure mechanics of large dealer banks, and some policy implications. This is not a review of the financial crisis of 2007–2009. Systemic risk is considered only in passing. Both the financial crisis and the systemic importance of large dealer banks are nevertheless obvious and important motivations.

Download the paper here:

Monday, March 29, 2010

How Did a Domestic Housing Slump Turn into a Global Financial Crisis?

By Steven B. Kamin and Laurie Pounder DeMarco:

Abstract: The global financial crisis clearly started with problems in the U.S. subprime sector
and spread across the world from there. But was the direct exposure of foreigners to the U.S.
financial system a key driver of the crisis, or did other factors account for its rapid contagion
across the world? To answer this question, we assessed whether countries that held large
amounts of U.S. mortgage-backed securities (MBS) and were highly dependent on dollar funding experienced a greater degree of financial distress during the crisis. We found little evidence of such “direct contagion” from the United States to abroad. Although CDS spreads generally rose higher and bank stocks generally fell lower in countries with more exposure to U.S. MBS and greater dollar funding needs, these correlations were not robust, and they fail to explain the lion’s share of the deterioration in asset prices that took place during the crisis.

Accordingly, channel of “indirect contagion” may have played a more important role in the global spread of the crisis:
  • a generalized run on global financial institutions, given the opacity of their balance sheets;
  • excessive dependence on short-term funding;
  • vicious cycles of mark-to-market losses driving fire sales of MBS;
  • the realization that financial firms around the world were pursuing similar (flawed) business models; and
  • global swings in risk aversion.
The U.S. subprime crisis, rather than being a fundamental driver of the global crisis, may have been merely a trigger for a global bank run.

Download the paper here:

Friday, March 26, 2010

Debunking subprime contagion

Original posted on FT Alphaville by Tracy Alloway:

Flashback alert!

And so on.

But here’s an interesting idea, contained in a just-published Federal Reserve discussion paper, by Steven B. Kamin and Laurie Pounder DeMarco, and asking: “How Did a Domestic Housing Slump Turn into a Global Financial Crisis?”

In it, the authors assert that the global financial crisis was not caused by direct exposure to the US subprime market. In other words, banks’ CDS spreads and stock prices during the crisis were not correlated with their holdings of US mortgage-backed securities (MBS) or dependence on dollar funding.

Instead, the contagion was caused by something else; namely a general “disillusionment” with bank models around the world, or, a sort of global bank run.

Perhaps that’s not a huge shock, but the theory is interesting:

To summarize our key findings, we found scant evidence of a direct channel of contagion spreading the U.S. subprime crisis abroad . . . Moreover, even if holdings of U.S. toxic assets and exposure to dollar funding were more important than we were able to document, we still believe that a number of indirect channels stressed in the growing stock of commentary on this crisis were relevant as well:

(1) a generalized run on global financial institutions, given lack of information as to who actually held toxic assets and how much;

(2) the dependence of many financial systems on short-term funding (both in dollars and in other currencies);

(3) a vicious cycle of mark-to-market losses driving fire sales of ABS, which in turn triggered further losses;

(4) the realization that financial firms around the world were pursuing similar (flawed) business models and were subject to similar risks; and

(5) global swings in risk aversion supported by instantaneous worldwide communications and a shared business culture. At an extreme, the U.S. subprime crisis, rather than being a fundamental driver of the global crisis, may have been more of trigger for a global bank run and for disillusionment with a risky business model that already had spread around the world.

The authors say there’s some uncertainty in the MBS data but, overall, it’s certainly food for thought.

And the standout bit from the paper: according to the authors international losses on US portfolio holdings didn’t even stem from assets related to American mortgages, but from other things:

In fact, it is ironic that, although the global financial crisis appeared to originate in the U.S. sub-prime sector, losses on U.S. ABS accounted for only a small part of the total losses taken by foreigners on their holdings of U.S. assets. As indicated in Table 4, foreigners experienced some $1.3 trillion in losses on their portfolio holdings in the United States, but only $160 billion of those losses were linked to ABS. By far the greatest losses were on their holdings of U.S. common stock.

And the table:

So, not the subprime crisis but your-run-of-the-mill stock crash?

It doesn’t have quite the same ring to it.

Thursday, March 25, 2010

Libor-gazing, counterparty-casing

Original posted on FT Alphaville by Tracy Alloway:

Does anyone remember Libor?

The London Interbank Offered Rate, the reported cost of borrowing between banks, has fallen by the wayside a bit since it shot to infamy — and a record high — in October 2008, in the wake of Lehman’s collapse. But with recent negativity in swap spreads, Libor is being thrust back into the spotlight.

The key measure for Libor is the Libor-OIS spread, or the difference between the interbank rate and the market’s expectation of central bank rates — i.e., pure counterparty risk.

Here’s a chart of what the (3-month dollar) spread’s been doing recently (click to enlarge):

The lows of the spread are important since they indicate the ’success’ of government actions. In September 2009, for instance, Libor-OIS reached 11bps, about the average rate pre-credit crisis — but that was with the huge supporting factor of government bank guarantees and liquidity programmes.

But you can see from the above chart (or alternatively from this one) that there’s been some volatility in the spread, with a recent uptick trend. Libor-OIS though is currently at about 8.3bps — well below its pre-crisis levels.

Where does this all fit with negative swap spreads?

Swap spreads are basically the difference between Treasuries and interest rate swaps. Swap rates are usually based on Libor, which means that under normal circumstances the spread is positive since lending to the US government is perceived as less risky than lending to a money market or bank counterparty.

But, the 10-year spread swap went negative on Tuesday. The 30-year spread went negative back in 2008, post the Lehman collapse, and has been confined to zero or sub-zero ever since.

Jck over at Alea puts it eloquently:

By construction swaps rates represent double AA credits , while government bonds represent the credit of the sovereign state. It has long been assumed that negative spreads are mathematically impossible, but this is true *only* if the sovereign is a real triple AAA, otherwise the spread can go negative. Since the swap rate is a hardwired double A, the message of negative swap spreads is that sovereigns aren’t or won’t be real triple A going forward. C’est tout.

While counterparty risk measured by Libor-OIS has reduced rapidly, it looks like the USA’s counterparty rating may be deteriorating in the eyes of some investors viz those negative swaps. Perhaps that’s to be expected with the central bank essentially taking on much of the market mantle.

(Others of course, think differently).

Friday, March 19, 2010

Greenspan says, je regrette quelque chose

The Crisis, by Alan Greenspan.

It sounds like an airport novel. But the 66-page paper is the closest we’ve ever gotten to a mea culpa from the former Fed chief, who chaired the US central bank in the midst of a growing housing bubble.

As the New York Times reports, Greenspan is due to present the paper at the Brookings Institution on Friday. And this is the bit, according to the NYT, where the sort-of-contrition comes into play:

For years the Federal Reserve had been concerned about the ever larger size of our financial institutions. Federal Reserve research had been unable to find economies of scale in banking beyond a modest-sized institution. A decade ago, citing such evidence, I noted that “megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail.” Regrettably, we did little to address the problem.

Fun fact; the word “regrettably” actually appears a total of four times in the paper.


The most pressing reform that needs fixing in the aftermath of the crisis, in my judgment, is the level of regulatory risk adjusted capital. Regrettably, the evident potential for gaming of this system calls for an additional constraint in the form of a minimal tangible capital requirement.

And here:

Bank regulators are perforce being pressed to depend increasingly on greater and more sophisticated private market discipline, the still most effective form of regulation. Indeed, these developments reinforce the truth of a key lesson from our banking history–that private counterparty supervision remains the first line of regulatory defense.” Regrettably, that first line of defense failed.

And this is our favourite:

We at the Federal Reserve were aware as early as 2000 of incidents of some highly irregular subprime mortgage underwriting practices. But regrettably we viewed it as a localized problem subject to standard prudential oversight, not the precursor of the securitized subprime mortgage bubble that was to arise several years later.

So, Alan Greenspan — no longer fighting back?

Not quite. In the paper, the erstwhile central banker also says he still thinks the Fed’s policy of low (overnight) interest rates was not to blame for the housing bubble, and associated excess risk-taking.

Academia — and rational thought — would suggest otherwise.

BTW, Is there a reason this chart — from Alan Greenspan’s Brookings paper — stops in September 2009?

The former Federal Reserve chairman is offering his explanation of the financial meltdown to the Institute, in a paper aptly called “The Crisis.” In it the erstwhile central banker makes this comment:

Our broadest measure of credit risk, the spread of yields on CCC, or lower, bonds (against 10- year U.S. Treasury bonds) fell to a probable record low in the spring of 2007, though only marginally so (exhibit 6). Almost all market participants of my acquaintance were aware of the growing risks, but also cognizant that risk had often remained underpriced for years.

And here’s the accompanying exhibit:

If the chart extended to today (March 2010) what one might see is something similar to the below.

From Bloomberg, the spread between Bank of America Merrill Lynch’s high-yield index and 10-year US Treasuries, between 2002 and March 2010. Click to enlarge:

The difference between the two — essentially the premium investors demand for holding `risky’ assets over US government bonds — is currently about 5.08. Which means it’s beginning to veer very close to the ultra “mispriced” days of spring 2007. It’s obscured on the chart, but it was circa 2.88.

The median figure for the whole eight-year period, is about 4.9.

Some analysts are calling for the spread to narrow to 4.0 by the end of 2010.

And that’s despite the whole financial crisis thing.

Wednesday, March 17, 2010

Lehman and U.S. Regulatory Gaps

Original posted on Naked Capitalism:

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....

The first [issue] 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?

Tuesday, March 16, 2010

Time for Truth: Three Card Monte is for Suckers

Posted on New Deal 2.0 by Elliott Spitzer and William Black:

In December, we argued the urgent need to make public A.I.G.’s emails and “key internal accounting documents and financial models.” A.I.G.’s schemes were at the center of the economic meltdown. Three months later, a year-long report by court-appointed bank examiner Anton Valukas makes it abundantly clear why such investigations are critical to the recovery of our financial system. Every time someone takes a serious look, a new scandal emerges.

The damning 2,200-page report, released last Friday, examines the reasons behind Lehman’s failure in September 2008. It reveals on and off balance-sheet accounting practices the firm’s managers used to deceive the public about Lehman’s true financial condition. Our investigations have shown for years that accounting is the “weapon of choice” for financial deception. Valukas’s findings reveal how Lehman used $50 billion in “repo” loans to fool investors into thinking that it was on sound financial footing. As our December co-author Frank Partnoy recently explained as part of a major report of the Roosevelt Institute, “Make Markets Be Markets“, such abusive off-balance accounting was and is endemic. It was a major cause of the financial crisis, and it will lead to future crises.

According to emails described in the report, CEO Richard Fuld and other senior Lehman executives were aware of the games being played and yet signed off on quarterly and annual reports. Lehman’s auditor Ernst & Young knew and kept quiet.

The Valukas report also exposes the dysfunctional relationship between the country’s main regulatory bodies and the systemically dangerous institutions (SDIs) they are supposed to be policing. The NY Fed, the regulatory agency led by then FRBNY President Geithner, has a clear statutory mission to promote the safety and soundness of the banking system and compliance with the law. Yet it stood by while Lehman deceived the public through a scheme that FRBNY officials likened to a “three card monte routine” (p. 1470). The report states:

“The FRBNY discounted the value of Lehman’s pool to account for these collateral transfers. However, the FRBNY did not request that Lehman exclude this collateral from its reported liquidity pool. In the words of one of the FRBNY’s on-site monitors: ‘how Lehman reports its liquidity is between Lehman, the SEC, and the world’” (p. 1472).

Translation: The FRBNY knew that Lehman was engaged in smoke and mirrors designed to overstate its liquidity and, therefore, was unwilling to lend as much money to Lehman. The FRBNY did not, however, inform the SEC, the public, or the OTS (which regulated an S&L that Lehman owned) of what should have been viewed by all as ongoing misrepresentations.

The Fed’s behavior made it clear that officials didn’t believe they needed to do more with this information. The FRBNY remained willing to lend to an institution with misleading accounting and neither remedied the accounting nor notified other regulators who may have had the opportunity to do so.

The Fed wanted to maintain a fiction that toxic mortgage products were simply misunderstood assets, so it allowed Lehman to maintain the false pretense of its accounting. We now know from Valukas and from former Treasury Secretary Paulson that the Treasury and the Fed knew that Lehman was massively overstating its on-book asset values: “According to Paulson, Lehman had liquidity problems and no hard assets against which to lend” (p. 1530). We know from Valukas’ interview of Geithner (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.

Or, in plain English, the Fed didn’t want Lehman and other SDIs to sell their toxic assets because the sales prices would reveal that the values Lehman (and all the other SDIs) placed on their toxic assets (the “marks”) were inflated with worthless hot air. Lehman claimed its toxic assets were worth “par” (no losses) (p. 1159), but Citicorp called them “bottom of the barrel” and “junk” (p. 1218). JPMorgan concluded: “the emperor had no clothes” (p. 1140). The FRBNY acted shamefully in covering up Lehman’s inflated asset values and liquidity. It constructed three, progressively weaker, stress tests — Lehman failed even the weakest test. The FRBNY then allowed Lehman to administer its own stress test. Need we tell you the results?

We believe that the Valukas report cries out for an immediate Congressional investigation. As we did with A.I.G., we demand the release of the e-mails and internal documents from the New York Fed and Lehman executives that pertain to analyses of Lehman’s financial soundness. What downside can there possibly be in making these records available for public analysis and scrutiny?

Three years since the collapse of the secondary market in toxic mortgage product, we have yet to see significant prosecutions of the kind of fraud exposed in the Valukas report. The SDIs, with Bernanke’s open support, exorted the accounting standards board (FASB) to change the rules so that banks no longer need to recognize their losses. This has made the SDIs appear profitable and allows them to pay their executives massive, unearned bonuses based on fictional profits.

If we are to prevent another, potentially more devastating financial crisis, we must understand what happened and who knew what. Many SDIs are hiding debt and losses and presenting deceptive portraits of their soundness. We must stop the three card monte accounting practices that create the potential and reality of fundamental misrepresentation.

A.I.G.’s CEO, its board of directors, and the trustees that are supposed to represent the interests of the American people have failed to respond to our December letter calling on them to release to the public the AIG documents that would be the treasure trove (along with other SDI documents) that would allow our nation to uncover and end the gamesmanship that caused this financial crisis and will bring us recurrent crises. We call on them to act.

Why Excessive Risk-Takers Make Horrible Traders

Original posted on the Business Insider by Courtney Comstock:

A new study from Vanderbilt University shows that people with psychopathic tendencies (like aggression, lack of empathy, lack of fear) are more prone to take excessive risk without considering the consequences.

During the study, researchers tested people with psychopathic qualities to see how they react to reward.

Very well, it turns out.

Both people with psychopathic qualities and normal people were told they would receive a cash reward for a simple task. Those brains with psychopathic tendencies showed heightened levels of activity in the dopamine reward area of the brain, the nucleus accumbens, as they anticipated receiving the award.

The nucleus accumbens is the part of the brain that is always referred to as the part that blinds traders to excessive risk-taking. Here's why:

A researcher says, "It's not just that they don't appreciate the potential threat, but that the anticipation or motivation for reward overwhelms those concerns."

So if a trader is taking a lot of risk, it's probably because they are so hopped up on dopamine they can't see any negative consequences. Oh, and they're kind of a psychopath.

Visit to Fed Shows Where Any Reform Should Start

Original posted on the Wall Street Journal by Dennis Berman:

He has a Ph.D. And a beard. It is hard not to think of Ben Bernanke as the embodiment of the Federal Reserve, wisely and nobly protecting the nation's financial security.

Then there are the people who really do the work: An anonymous corps of bank examiners who hump across the country like traveling salesmen, inspecting bank records in lonely conference rooms.

Some of these examiners are among the people who would get new power under the plan proposed by Sen. Christopher Dodd as he embarks on a great reshuffling of U.S. financial regulation. The bill he introduced Monday would give the Fed supervision over the country's largest financial institutions, while cutting its oversight of smaller banks.

With 198 bank failures since 2007, some in Congress are still skeptical about whether the Fed is up to the task. Why didn't the Fed's regional examiners, who were literally working inside the nation's rotting banking system, sound a stronger warning about bad real-estate lending? Citigroup, National City, Wachovia, and dozens of smaller banks all got into serious trouble—on the Fed's watch.

Last Friday, I visited bank examiners at the Federal Reserve Bank of Philadelphia, hoping to better understand the people securing the front lines of our broken financial system. These examiners are responsible for overseeing 130 banks in asset size from $50 million to $150 billion. Their salaries range from about $40,000 to $140,000.

They were people like 43-year-old James Corkery, who has served as an examiner for 20 years off and on, plying the Philly Fed's territory from Delaware to central Pennsylvania.

The day-to-day of bank examinations—poring over bank loan portfolios, assembling spreadsheets of bank asset quality—seemed to be in Mr. Corkery's blood. He said he spent 60 nights on the road last year, conducting on-site visits at community banks. "It's my nature to take apart things," he said from a conference room amid a warren of putty-colored metal walls and cubicles.

There was H. Robert Tillman, whose thick, gray hair suggests Bernanke-ian wisdom. Mr. Tillman spent 14 years as an in-house attorney at New Jersey banks, and said he loved his work, especially investigating money laundering. It has "an impact on the economy and the strength of society," he said.

And yet for all their dedication, the examiners appeared to be working with a very narrow mandate.

As Mr. Corkery pointed out, examiners are "not auditors." Instead they serve more as government-paid consultants, helping banks identify portfolio risks and correct them. Even after the greatest banking crisis in generations, Mr. Corkery said he is "not sure there have been any radical changes" in how he does his job.

Michael E. Collins, the Philadelphia Fed official in charge of supervision, acknowledged that the Fed system has to change, taking into account the health of the broader banking system, rather than a bank-by bank analysis. "The supervision of tomorrow has to be vastly different than the supervision of today," he said.

But how will the Fed change? Only two of the 12 regional Fed presidents have direct experience as a field examiner: New York's William Dudley and Kansas City's Thomas Hoenig.

Examiners long had been viewed as second-class citizens to the Brahmins shaping monetary policy at the Fed, said Mark Williams a former Fed examiner from 1991 and 1993 and now a professor at Boston University.

"At the end of day, examiners are taking cues from the people above them," said Kevin Fitzsimmons, who worked as an examiner in the mid 1990s and is now a banking analyst at Sandler O'Neill & Partners.

Nor are they given the technological tools to keep pace with the banks they are regulating, Mr. Williams said. "They're not proactive. The Fed has a peashooter to the AK-47s of Wall Street."

With all the Fed's brainpower and reputation, it is easy to see why Sen. Dodd views the central bank as the best place for improving safety of our banks.

But from a brief visit inside, it is clear that reform must begin at the Fed itself.

Monday, March 15, 2010

Banks Face a Mark-to-Market Challenge

Original posted in the Wall Street Journal by David Reilly:

The war over mark-to-market accounting is about to get hot, again. In coming weeks, the Financial Accounting Standards Board is likely to propose that banks expand their use of market values for financial assets such as loans, according to people familiar with the matter. That departs from current practices in which banks hold loans at their original cost and create a reserve based on their own view of potential losses.

The result, if the proposal flies, would be big changes to bank balance sheets, the shape of income statements and some of the metrics investors use to evaluate financial institutions.

At the four biggest banks—J.P. Morgan Chase, Bank of America, Citigroup and Wells Fargo—$2.8 trillion of loans could be affected, or about 40% of their total assets. Smaller banks would see a bigger impact because more of their assets are loans that aren't marked to market prices.

Don't expect changes without a fight from banks. Yet the battle could provide a headwind for recently high-flying bank stocks. After all, markets cheered last spring when Congress browbeat FASB into watering down mark-to-market rules.

Banks generally loathe mark-to-market rules, which rely on what they feel are too-often irrational market prices. The market value of some loans did fall excessively in the depths of the crisis. And many bankers, and bank regulators, believe the rules worsened the financial crisis.

But that argument ignores the fact that banks clearly didn't pay enough heed of market values in the run-up to the crisis, and their own estimates of potential losses were woefully inadequate.

This left bank balance sheets, and investors, unprepared for the credit crunch. If banks had focused on market values as well as internal models, many may have acted sooner to raise equity.

If anything, FASB's proposals may not go far enough. Many swings in the market value of loans, for example, still likely won't hit net profit. Even so, the potential changes are far-reaching.

First, under the proposals, banks would show loans on their balance sheets at historical cost, and then adjust them for both loan-loss reserves and market values. That would allow investors to see the difference between what management has provisioned against losses and what investors think the loans are actually worth.

Second, banks' financial holdings would be divided between those they trade and those they hold. Changes in the value of tradable assets would hit profit as today. Non-trading assets would be also be marked to market, but those changes would go to a portion of shareholders' equity called other comprehensive income.

Third, income statements would show more than just net profit. After that line would be added an "other-comprehensive-income" category reflecting changes in the market value of loans and securities. That would be added to net income to create a new bottom-line figure called comprehensive income. Earnings per share would still be based on net profit.

While the FASB will likely come under fire for these approaches, it may have found an ally last week in House Financial Services Chairman Barney Frank. In a letter to the big four banks, Mr. Frank said banks were refusing to accept reality when it came to the value of second-lien mortgages such as home-equity loans.

"Because accounting rules allow holders of these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loans," Mr. Frank wrote.

Marking such loans to market values, and making the impact more prominent in accounts, would be a step toward forcing banks to take the more-realistic view—as Mr. Frank and many investors want.

Goldman Sachs Demands Derivatives Collateral It Won’t Dish Out

Original posted on Bloomberg by Michael J. Moore and Christine Harper:

Goldman Sachs Group Inc. and JPMorgan Chase & Co., two of the biggest traders of over-the- counter derivatives, are exploiting their growing clout in that market to secure cheap funding in addition to billions in revenue from the business.

Both New York-based banks are demanding unequal arrangements with hedge-fund firms, forcing them to post more cash collateral to offset risks on trades while putting up less on their own wagers. At the end of December this imbalance furnished Goldman Sachs with $110 billion, according to a filing. That’s money it can reinvest in higher-yielding assets.

“If you’re seen as a major player and you have a product that people can’t get elsewhere, you have the negotiating power,” said Richard Lindsey, a former director of market regulation at the U.S. Securities and Exchange Commission who ran the prime brokerage unit at Bear Stearns Cos. from 1999 to 2006. “Goldman and a handful of other banks are the places where people can get over-the-counter products today.”

The collapse of American International Group Inc. in 2008 was hastened by the insurer’s inability to meet $20 billion in collateral demands after its credit-default swaps lost value and its credit rating was lowered, Treasury Secretary Timothy F. Geithner, president of the Federal Reserve Bank of New York at the time of the bailout, testified on Jan. 27. Goldman Sachs was among AIG’s biggest counterparties.

Goldman Sachs Chief Financial Officer David Viniar has said that his firm’s stringent collateral agreements would have helped protect the firm against a default by AIG. Instead, a $182.3 billion taxpayer bailout of AIG ensured that Goldman Sachs and others were repaid in full.

Extracting Collateral

Over the last three years, Goldman Sachs has extracted more collateral from counterparties in the $605 trillion over-the- counter derivatives markets, according to filings with the SEC.

The firm led by Chief Executive Officer Lloyd C. Blankfein collected cash collateral that represented 57 percent of outstanding over-the-counter derivatives assets as of December 2009, while it posted just 16 percent on liabilities, the firm said in a filing this month. That gap has widened from rates of 45 percent versus 18 percent in 2008 and 32 percent versus 19 percent in 2007, company filings show.

“That’s classic collateral arbitrage,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York who previously worked as treasurer at Morgan Stanley and chief financial officer at Lehman Brothers Holdings Inc. “You always want to enter into something where you’re getting more collateral in than what you’re putting out.”

Using the Cash

The banks get to use the cash collateral, said Robert Claassen, a Palo Alto, California-based partner in the corporate and capital markets practice at law firm Paul, Hastings, Janofsky & Walker LLP.

“They do have to pay interest on it, usually at the Fed funds rate, but that’s a low rate,” Claassen said.

Goldman Sachs’s $110 billion net collateral balance in December was almost three times the amount it had attracted from depositors at its regulated bank subsidiaries. The collateral could earn the bank an annual return of $439 million, assuming it’s financed at the current Fed funds effective rate of 0.15 percent and that half is reinvested at the same rate and half in two-year Treasury notes yielding 0.948 percent.

“We manage our collateral arrangements as part of our overall risk-management discipline and not as a driver of profits,” said Michael DuVally, a spokesman for Goldman Sachs. He said that Bloomberg’s estimates of the firm’s potential returns on collateral were “flawed” and declined to provide further explanation.

JPMorgan, Citigroup

JPMorgan received cash collateral equal to 57 percent of the fair value of its derivatives receivables after accounting for offsetting positions, according to data contained in the firm’s most recent annual filing. It posted collateral equal to 45 percent of the comparable payables, leaving it with a $37 billion net cash collateral balance, the filing shows.

In 2008 the cash collateral received by JPMorgan made up 47 percent of derivative assets, while the amount posted was 37 percent of liabilities. The percentages were 47 percent and 26 percent in 2007, according to data in company filings.

By contrast, New York-based Citigroup Inc., a bank that’s 27 percent owned by the U.S. government, paid out $11 billion more in collateral on over-the-counter derivatives than it collected at the end of 2009, a company filing shows.

Brian Marchiony, a spokesman for JPMorgan, and Alexander Samuelson, a spokesman for Citigroup, both declined to comment.

Derivatives Market

The five biggest U.S. commercial banks in the derivatives market -- Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley and Wells Fargo & Co. -- account for 97 percent of the notional value of derivatives held in the banking industry, according to the Office of the Comptroller of the Currency.

In credit-default swaps, the world’s five biggest dealers are JPMorgan, Goldman Sachs, Morgan Stanley, Frankfurt-based Deutsche Bank AG and London-based Barclays Plc, according to a report by Deutsche Bank Research that cited the European Central Bank and filings with the SEC.

Goldman Sachs and JPMorgan had combined revenue of $29.1 billion from trading derivatives and cash securities in the first nine months of 2009, according to Federal Reserve reports.

The U.S. Congress is considering bills that would require more derivatives deals be processed through clearinghouses, privately owned third parties that guarantee transactions and keep track of collateral and margin. A clearinghouse that includes both banks and hedge funds would erode the banks’ collateral balances, said Kevin McPartland, a senior analyst at research firm Tabb Group in New York.

‘Level Playing Field’

When contracts are negotiated between two parties, collateral arrangements are determined by the relative credit ratings of the two companies and other factors in the relationship, such as how much trading a fund does with a bank, McPartland said. When trades are cleared, the requirements have “nothing to do with credit so much as the mark-to-market value of your current net position.”

“Once you’re able to use a clearinghouse, presumably everyone’s on a level playing field,” he said.

Still, banks may maintain their advantage in parts of the market that aren’t standardized or liquid enough for clearing, McPartland said. JPMorgan CEO Jamie Dimon and Goldman Sachs’s Blankfein both told the Financial Crisis Inquiry Commission in January that they support central clearing for all standardized over-the-counter derivatives.

“The percentage of products that are suitable for central clearing is relatively small in comparison to the entire OTC derivatives market,” McPartland said.

Bilateral Agreements

A report this month by the New York-based International Swaps & Derivatives Association found that 84 percent of collateral agreements are bilateral, meaning collateral is exchanged in two directions.

Banks have an advantage in dealing with asset managers because they can require collateral when initiating a trade, sometimes amounting to as much as 20 percent of the notional value, said Craig Stein, a partner at law firm Schulte Roth & Zabel LLP in New York who represents hedge-fund clients.

JPMorgan’s filing shows that these initiation amounts provided the firm with about $11 billion of its $37.4 billion net collateral balance at the end of December, down from about $22 billion a year earlier and $17 billion at the end of 2007. Goldman Sachs doesn’t break out that category.

A bank’s net collateral balance doesn’t get included in its capital calculations and has to be held in liquid products because it can change quickly, according to an executive at one of the biggest U.S. banks who declined to be identified because he wasn’t authorized to speak publicly.

Counterparty Demands

Counterparties demanding collateral helped speed the collapse of Bear Stearns and Lehman Brothers, according to a New York Fed report published in January. Those that had posted collateral with Lehman were often in the same position as unsecured creditors when they tried to recover funds from the bankrupt firm, the report said.

“When the collateral is posted to a derivatives dealer like Goldman or any of the others, those funds are not segregated, which means that the dealer bank gets to use them to finance itself,” said Darrell Duffie, a professor of finance at Stanford University in Palo Alto. “That’s all fine until a crisis comes along and counterparties pull back and the money that dealer banks thought they had disappears.”

‘Greater Push Back’

While some hedge-fund firms have pushed for banks to put up more cash after the collapse of Lehman Brothers, Goldman Sachs and other survivors of the credit crisis have benefited from the drop in competition.

“When the crisis started developing, I definitely thought it was going to be an opportunity for our fund clients to make some headway in negotiating, and actually the exact opposite has happened,” said Schulte Roth’s Stein. “Post-financial crisis, I’ve definitely seen a greater push back on their side.”

Hedge-fund firms that don’t have the negotiating power to strike two-way collateral agreements with banks have more to gain from a clearinghouse than those that do, said Stein.

Regulators should encourage banks to post more collateral to their counterparties to lower the impact of a single bank’s failure, according to the January New York Fed report. Pressure from regulators and a move to greater use of clearinghouses may mean the banks’ advantage has peaked.

“Before the financial crisis, collateral was very unevenly demanded and somewhat insufficiently demanded,” Stanford’s Duffie said. A clearinghouse “should reduce the asymmetry and raise the total amount of collateral.”

Cap * 105

Original posted on FT Alphaville by Tracy Alloway:

What is it with Lehman Brothers and 105-titled operations? Buried in Volume II of the 2,200-page Court Examiner’s report is the story of Cap * 105 — a commercial property valuation system used by Lehman’s Principal Transactions Group (PTG) and its real estate servicer, TriMont. While no where near as controversial as the machinations of Repo 105, it’s worth a look since it provides some insight into the failed bank’s valuation practices.

Here’s how it worked:

Lehman’s primary method for valuing the collateral underlying its PTG positions was the Cap * 105 method. Cap * 105 calculated the current capitalization of the underlying property (i.e., outstanding debt plus equity invested to date), and then multiplied this number by 105% to estimate the value of the collateral as of the specific valuation date. The additional 5% represented the presumed appreciation of the collateral.

The technique was meant to rein-in valuations in the midst of rising real estate prices, in other words keep the presumed appreciation or property, or value inflation, under control. It basically had a tendency to limit or undervalue Lehman’s collateral, and appears to have had zero market-based inputs.

In early 2007, and to its credit, Lehman Bros decided Cap *105 was no longer a suitable valuation tool given real estate prices were falling — rapidly. Cap * 105 was no longer tending to undervalue collateral, instead it was doing the exact opposite; overvaluing it sans-market signals.

So Lehman began switching to an Internal Rate of Return, or IRR, model.

Unlike the Cap * 105 models, the IRR models were meant to use some market-based inputs, in the form of market-based yields. Here’s how that worked:

Under the discounted cash flow method, an IRR model calculated the current value of collateral by determining the Net Present Value (“NPV”) of all monthly discounted Net Cash Flows (“NCF”). As a first step, the IRR model calculated the NCF produced by the asset by taking monthly expected revenue and subtracting monthly expected expenses. To this result, the IRR model applied a discount rate to produce the NPV of the NCF. In order to reflect fair value, the discount rate should reflect, for both equity and debt investments, the yield an investor would require to purchase the property.

The problem was though, that the switch from Cap * 105 to IRR was slow to happen. According to the Examiner’s report, at least 228 PTG positions still relied on the Cap * 105 method, or a variant of it, in May 2008. That’s about a third of the total PTG portfolio in the second quarter of 2008.

The Examiner also found evidence that (only) 153 positions migrated from Cap to IRR between May and July 2008. When they did switch, collateral values for the positions dropped by 20 per cent.

Furthermore, even when IRR models were used, the discount rate employed was generally based on Lehman’s expected rate of return, or on the interest rate associated with the underlying loans at origination — not, crucially, necessarily reflecting yield investors would want to buy the property.

Par example, from the report:

That’s the discount rate used by TriMont on three PTG properties, versus a discount rate used by a third-party valuation co., Cushman & Wakefield (C&W), for a property called Heritage Fields. You can see that the varying rates result in a difference in collateral valuations of about 20 per cent.

And so, to the Examiner’s conclusion:

The Examiner finds sufficient evidence to support a determination that Lehman did not appropriately consider market-based yield when valuing PTG assets in the second and third quarters of 2008. While the Examiner recognizes that the valuation of illiquid assets requires judgment and that there is a wide range of reasonable valuations for any particular asset, Lehman’s systemic failure to incorporate a market‐based yield generally resulted in an overvaluation of PTG assets. Accordingly, the Examiner finds that there is sufficient evidence to support a finding, for purposes of a solvency analysis, that the values Lehman determined for certain of these assets were unreasonable.

Note, however, that perhaps unlike Repo 105, the Examiner’s report found no evidence that Lehman workers charged with valuing PTG positions breached their fiduciary duties.

Related links:
Lack of consistency in Lehman’s asset valuations – FT

Sunday, March 14, 2010

You Thought Wall Street Wasn't Regulated?

This chart from the Consumer Federation of America (via the Huffington Post) shows just how much Wall Street is in fact regulated:


What they want -- and what might make a lot more sense -- is a system like this.


Friday, March 12, 2010

Chart of the Day: What If Everybody in Canada Flushed At Once?

Posted on Pat's Papers:
The water utility in Edmonton, EP

What’s in Repo 105

While Repo 105 was created in 2001, it proved very useful for Lehman Brothers in terms of publicly reducing leverage as the financial crisis intensified in 2007 and 2008.

Lehman had lots of assets — CMBS, subprime mortgages, and the like — which were falling in value in a very illiquid market. Merely selling off those assets to decrease leverage would have resulted in significant losses for the beleaguered bank. Repo 105, explained here, provided an alternative.

But what exactly was Lehman Bros stuffing into the Repo 105 sausage?

Perhaps counter-intuitively it was not using the stuff on its balance sheet that was hardest to sell into markets.

Rather, it was the most liquid — things like A- to AAA-rated securities, Treasuries and Agency debt, which you can see in the below table, from the Examiner’s Report (Appendix 17):

Lehman’s own accounting policy required assets used for Repo 105 “be readily obtainable” — i.e. liquid — according to the report. Lehman’s lawyers also recommended they be liquid so that “the Buyer could easily dispose of the Purchased Securities and acquire equivalent securities if it wished.”

But that doesn’t mean Lehman didn’t try to shift other things into the thing as the crisis worsened.

From the footnotes:

Certain documents, however, suggest that Lehman perhaps attempted to use less liquid collateral in Repo 105 transactions. See e‐mail from Michael McGarvey, Lehman, to Gerard Reilly, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 3213312] (“There was call this morning with John Feraca on getting Mortgages out on 105. London is going to show some examples of fixed AAA non‐agency mortgages to Mizuho (who we have a good relationship with) to see if they would be open to taking them. Based on Mizuho’s reaction we are going to meet again Monday to determine [how] much we can do.”); e‐mail from Kentaro Umezaki, Lehman, to Christopher M. O’Meara, Lehman, et al. (Aug. 17, 2007) [LBEXDOCID 1533678]

Even whole deals — specifically the $2bn Windermere securitisation — were attempted:

. . . (discussing whether, if Lehman can transfer all Windermere securities using Repo 105, Lehman “can…eliminate the gross up in addition to netting down the bonds?”); e‐mail from Marie Stewart, Lehman, to Mark Cosaitis, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 3223801] (indicating that Stewart planned to have a meeting that day with Grieb to discuss possibility of placing Windermere bonds into Repo 105 program);

And it looks like Lehman was semi-successful in moving some of its less-valuable assets through Repo 105. The below table, also from the report, shows Repo 105 usage by rating.

You can see that by May 2008, the bank had managed to shift some $47m of CCC-rated assets through Repo 105. The vast majority of Repo 105 usage, however, was still for A-range assets.

Without the knowledge of Repo 105, anyone watching the bank would probably have thought Lehman was tring to reduce its leverage by getting rid of its most illiquid (and probably least valuable) assets.

Unfortunately, the exact opposite would have been true based on this report.

The genesis of Repo 105

In 2001 Lehman Brothers held a meeting with its lawyers and auditors.

A new US accounting standard — SFAS 140 — had just come into effect, and the banking heads were keen to find a way to use it to their advantage. They settled upon something called Repo 105 and 108, which would allow it to essentially book repurchase agreements as sales rather than temporary transactions — thus massaging its balance sheet and net leverage figures.

That year, the firm sent around an internal accounting memo for what became known as Repo 105, which you can view here. A normal Lehman repo transaction can be seen here:

Under SFAS 140, repurchase agreements could be accounted as true sales but only if certain conditions proving that the transferer had given up control of the asset were met.

Lehman argued that its Repo 105s should be classified as sales based on the overcollateralisation, or higher than normal haircut (5 or 8 per cent as opposed to a `normal’ 2 per cent) in the transactions. That was meant to show Lehman had ceded `control’ of the assets and it was a true sale; the asset could then go off-balance sheet and Lehman’s leverage ratio went down.

There was just a small problem, however.

Even with the higher haircut, most of Lehman’s Repos did not meet SFAS 140 criteria for true sales; no US lawyer would sign off on their treatment as a true sale. Without true sale status, the things were pretty much pointless.

But there was a clever way to get around the US GAAP problem.

Lehman went abroad — to London and to `magic circle‘ law firm Linklaters specifically. They could do so by dint of their non-US operations, in particular, Lehman Brothers International Europe (LBIE), which ended up taking the lead on Repo 105 transactions.

From the Examiner’s Report (Section III):

“Repo 105 and Repo 108 contracts typically are executed by Lehman Brothers International (Europe) (‘LBIE’) because true sale opinions can be obtained under English law. We generally cannot obtain a true sale opinion under U.S. law.

Did other banks have the same SFAS 140 idea back in 2001?

Possibly, but the report suggests not.

Here’s an illustrative July 2008 e-mail exchange from two Lehman staff:

Vallecillo: “So what’s up with repo 105? Why are we doing less next quarter end?”

McGarvey: “It’s basically window‐dressing. We are calling repos true sales based on legal technicalities. The exec committee wanted the number cut in half.”

Vallecillo: “I see . . . so it’s legally do‐able but doesn’t look good when we actually do it? Does the rest of the street do it? Also is that why we have so much BS [balance sheet] to Rates Europe?

McGarvey: “Yes, No and yes. :)

Thursday, March 11, 2010

Repo 105

Original posted on FT Alphaville by Tracy Alloway:

Think window-dressing on a massive, and possibly misleading, scale.

Much of the 2,200-page Examiner’s report into the Lehman Brothers bankruptcy, centres around an “accounting gimmick” used by the bank, and signed off by auditors Ernst & Young, to reduce leverage.

That would be Repo 105 and Repo 108 — or Repo 105 for short.

And it/they worked like this, according to Volume III of the report:

Lehman employed off‐balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008.

Repo 105 transactions were nearly identical to standard repurchase and resale (“repo”) transactions that Lehman (and other investment banks) used to secure short‐term financing, with a critical difference: Lehman accounted for Repo 105 transactions as “sales” as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction. By recharacterizing the Repo 105 transaction as a “sale,” Lehman removed the inventory 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.2851 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 never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions . . .

You can see why Repo 105 would be a tempting thing in the midst of a brewing financial crisis.

Leverage had become a focus of the ratings agencies and was widely thought to be an indicator of bank risk, which meant Lehman would have been hellbent on reducing its leverage — at least publicly.

At the same time prices for things like CMBS and subprime loans were falling and/or illiquid — Lehman could not have reduced its balance sheet simply by selling things off without incurring large losses.

Hence the Repo, which the bank increasingly used between 2007 and 2008 — even breaching its own internal cap on the Repo’s use (about $22bn as of summer 2006).

And the effect is pretty clear. From the report:

Hence the Examiner’s conclusion:

The Examiner concludes that there is sufficient evidence to support a colorable claim that: (1) certain of Lehman’s officers breached their fiduciary duties by exposing Lehman to potential liability for filing materially misleading periodic reports and (2) Ernst & Young, the firm’s outside auditor, was professionally negligent in allowing those reports to go unchallenged. The Examiner concludes that colorable claims of breach of fiduciary duty exist against [former CEO/CFOs] Richard Fuld, Chris O’Meara, Erin Callan, and Ian Lowitt, and that a colorable claim of professional malpractice exists against Ernst & Young.

And the response, as reported by the FT:

In a statement, Mr Fuld’s lawyer wrote: “Mr Fuld did not know what those transactions were – he didn’t structure or negotiate them, nor was he aware of their accounting treatment,” his attorney wrote in a statement.

“Furthermore, the evidence available to the examiner shows that the Repo 105 transactions were done in accordance with an internal accounting policy, supported the legal opinions and approved by Ernst & Young, Lehman’s independent outside auditor.”

E&Y said in a statement: “Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view.”

Mr Lowitt’s attorney said in a statement: “In the three months during which he held the job, Mr Lowitt worked diligently and faithfully to discharge all of his duties as Lehman’s CFO, Any suggestion that Mr Lowitt breached his fiduciary duties is baseless.”

Mr O’Meara could not be reached for comment. A lawyer representing Ms Callan declined comment . . .

Why Did Lehman Fail?: The Official Answers

Original posted on the WSJ MarketBeat by Matt Phillips:

Why did Lehman fail? There’s now a 2,200 page official answer available, after court-appointed bankruptcy examiner Anton Valukas’ report was released this afternoon. (Here are the first 200 pages.) Plus a snip from DJ:

“The business decisions that brought Lehman to its crisis of confidence may have been in error but the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements–Lehman’s CEO Richard S. Fuld, Jr., and its CFOs Christopher O’Meara, Erin M. Callan and Ian T. Lowitt,” examiner Anton Valukas said.

His report, released Thursday, also said there are “colorable claims” against Lehman’s external auditor Ernst & Young for “its failure to question and challenge improper or inadequate disclosures in those financial statements” as well as secured lenders J.P. Morgan Chase & Co. (JPM) and Citigroup Inc.’s (C) Citibank.

In the report, Valukas says a colorable claim is one for which he has found that “there is sufficient credible evidence to support a finding by a trier of fact.” He notes, however, he’s not the ultimate decision maker. Whether the claims are valid will be for others to decide.

The examiner also found that Lehman management’s decisions and valuation procedures can be questioned in retrospect, but none fall outside the business judgment rule, thus he found no colorable claims.

For all the non-lawyers in the house, “colorable” is legalese for “valid” or “genuine.” And we’ll be picking through this bad boy for interesting tidbits, so stay tuned.

From the Huffington Post:

The examiner in charge of investigating the bankruptcy of venerable Wall Street investment house Lehman Brothers, the most expensive bankruptcy in U.S. history, said in a report publicly released Thursday that senior officials failed to disclose key practices, opening them up to legal claims, and that JPMorgan Chase and Citigroup contributed to the firm's collapse. In addition, the report concludes that the firm's auditor, Ernst & Young, failed to meet "professional standards."

The exhaustive report was unsealed today by Judge James M. Peck, who said the report reads "like a best-seller."

The examiner, Anton Valukas, also found that parties have claims to pursue against JPMorgan Chase and Citibank in connection with their behavior regarding the modification of agreements with Lehman and their increasing collateral demands in Lehman's final days. These demands had a "direct impact" on Lehman's diminishing liquidity -- its cash on hand -- which was a prime reason behind the firm's demise.

The examiner's report notes:

The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule.The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule.

But the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements -- Lehman's CEO Richard S. Fuld, Jr., and its CFOs Christopher O'Meara, Erin M. Callan and Ian T. Lowitt.

There are colorable claims against Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements.

The examiner defines a "colorable claim" as those for which the examiner "found that there is sufficient credible evidence to support a finding by a trier of fact." In other words, plaintiffs can start lining up.

The examiner notes that the issue giving rise to these potential claims was Lehman's creative use of repurchase agreements, otherwise known as repo. These are agreements between financial firms that essentially act as loans for cash -- one firm pledges collateral to another in exchange for cash with a promise that they'll buy back that collateral.

The examiner said the sole function of Lehman's use of repo was "balance sheet manipulation," according to the report:

Although Repo 105 transactions may not have been inherently improper, there is a colorable claim that their sole function as employed by Lehman was balance sheet manipulation. Lehman's own accounting personnel described Repo 105 transactions as an "accounting gimmick" and a "lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end." Lehman used Repo 105 "to reduce balance sheet at the quarter‐end."

The reason for that, the report notes, was to lower Lehman's leverage -- a critical component of the firm's credit rating.

In 2007‐08, Lehman knew that net leverage numbers were critical to the rating agencies and to counterparty confidence. Its ability to deleverage by selling assets was severely limited by the illiquidity and depressed prices of the assets it had accumulated.

Against this backdrop, Lehman turned to Repo 105 transactions to temporarily remove $50 billion of assets from its balance sheet at first and second quarter ends in 2008 so that it could report significantly lower net leverage numbers than reality.

Lehman did so despite its understanding that none of its peers used similar accounting at that time to arrive at their leverage numbers, to which Lehman would be compared...

Lehman's failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those "low" leverage numbers to investors as positive news, created a misleading portrayal of Lehman's true financial health.

Colorable claims exist against the senior officers who were responsible for balance sheet management and financial disclosure, who signed and certified Lehman's financial statements and who failed to disclose Lehman's use and extent of Repo 105 transactions to manage its balance sheet.

But Lehman wasn't alone in its gimmickry. The firm's auditor, Ernst & Young, one of the four biggest auditing firms in the world, failed in its oversight role:

In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties; in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet and quarter end.

The next day ‐- on June 13, 2008 ‐- Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee's assertions, despite an express direction from the Committee to advise on all allegations raised by Lee.

Ernst & Young took virtually no action to investigate the Repo 105 allegations. Ernst & Young
took no steps to question or challenge the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions.

Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee's allegations and in connection with its audit and review of Lehman's financial statements.

In total, the examiner collected in excess of five million documents, estimated to
comprise more than 40,000,000 pages

Although a handful of subpoenas were threatened and in a few cases served, ultimately Valukas received nearly all requested documents voluntarily.

In all, more than 250 individuals were interviewed:

There was only one individual the Examiner sought to interview but could not. The Examiner requested an interview with Hector Sants, chief executive of the UK's Financial Services Authority ("FSA"), to discuss the FSA's involvement in the events of Lehman Weekend and the Barclays transaction. The FSA considered the request, but did not make Mr. Sants available for an interview. However, the FSA did provide detailed, written answers to specific questions that would have been posed to Mr. Sants.