Subscribe to Dollars & Sense magazine. Recent articles related to the financial crisis. Lehman: The Art of the 'Sale'Friday saw the release of a mammoth official report on the demise of the late, lamented Lehman Brothers. Written by Anton Valukas, a court-appointed Chicago securities lawyer, the over 2,000 page report, which was based on a staggering 350 billion pages of documentation [hard to believe the "billions," but that's what's been reported], claims that practices designed by the megabank whose travails nearly took down the global financial system in September, 2008, "ranged from serious but non-culpable errors of business judgment to actionable balance sheet manipulation." Specifically, the report documents the use of a maneuver known as "repo 105" to disguise the fact that Lehman was supporting its own balance sheet, recently loaded up with subprime mortgages that were rapidly falling in value, with, well, almost nothing.The way this deception worked involved a part of the finance industry that has become increasingly important over the years, but remains opaque to most people. The "repo," or "repurchase" market involves the transfer of bank assets, like bonds, to other financial firms, like broker-dealers, for extremely short periods of time (often just a few days), in return for cash. The securities, then, function as a sort of collateral. The banks, after the short period of time has elapsed, are required to take the collateral back, and pay a usually nominal amount by way of interest. In this way, the banks get ready cash, and the firms that take the securities are free to use the securities for potentially profitable short sales or to just to collect the interest. In this case, however, Lehman tried to disguise what looked like repo transactions--to the tune of up to $50 billion a quarter--as a sale of securities. Funny kind of sale: they were "selling" something they were obligated to take back within days. And they were paying far above the rate of interest customary in such transactions. For "repo 105", for instance, Lehman was paying 5%; on "repo 108", 8%. And why would Lehman do this? Well, repos remain on the bank's balance sheet. Lehman, as mentioned before, had, in the months running up to the crisis, piled into subprime loans. So this massive expansion of assets on the balance sheet was supposed to be offset by a similar build-up of equity, or of funds which might cover potential losses on the assets. Knowing that raising so much equity was impossible, Lehman asserted that the repo transactions were in fact sales, which, of course, constituted a permanent transfer of assets, and, therefore did not require booking on the balance sheet. But Lehman was not only taking these assets back in a few days, it was paying exorbitant amounts of money to offload the assets right at the time when they were supposed to be booked for quarterly results. It was as if a drug dealer sublet an apartment in which s/he had stowed away a a boatload far below the market rate, right when the landlord was supposed to come calling. Of course, this leads to the questions as to why so many of Lehman's counterparties were willing to go along with such unusual offers. But it was worse than this. Ernst & Young, the accounting firm, signed off on Lehman's books, and, moreover, a venerable City of London law firm, Linklaters, was asked for advice on the legality of these little transactions. Funny that Lehman didn't even bother to ask for legal advice from any other law firm, especially in the Wall Street firm's own country, the USA, and that it let its European office do the dirty work. Then again, it was AIG's London office that was responsible for that firm's fate. Regulatory arbitrage, and the financial liberalization that enables it, is and remains a powerful force in financial markets, indeed. Lehman did this three quarters in a row: in 4Q 2007 to the tune of $38.6 billion, in 1Q 2008 for $49.1 billion, and for $50.4 billion in 2Q. Saturday's NYTimes had two articles on the Lehman revelations: one recounted many of the details above; the other added another wrinkle—the role of the New York Fed. The articles says that the Valukas report "raises fresh questions about the role of the New York Fed in supporting Lehman during the frantic months leading up to its collapse." It seems that the Fed was the main institution The paragraphs explaining the Fed's involvement bears quoting in full: ...it was that month [March 2008] that the Fed started a spwecial lending program open to Wall Street banks like Lehman that could not [otherwise] borrow directly from it [the Fed]. The Fed also lowered its standards for the kinds of collateral that it would accept against such short-term loans. Read the full article. CLO means "collateralized loan obligation", and is the corporate cousin of the collateralized debt obligations that served to repackage mortgages during the subprime debacle. CLOs are--or were, during the boom-times, an important source of finance for mergers and acquisitions. What happened here was that Lehman was swapping nose-diving corporate loans (the M&A had all but dried up) with the Fed for hard Federally-backed cash in repo. It was trading cash for trash. And you were paying the potential difference. This has been a rapid and brief overview, but the main lesson from this is that, only a few short years after Enron, similar devices, far from being discouraged by the convictions in that case, were being employed on a far-larger scale, and using a government vehicle designed explicitly to save the offending firm from its own abuses. Financial reform, nonexistent in the last administration, and always half-hearted under the present one, had seemingly come to a kind of dormancy akin to that applying to healthcare reform in the weeks up to the publication of this report. If this doesn't force us to demand a complete and utter makeover of financial regulation, it is difficult to say what could. Is our broken economy so dependent on the distorted exaggerations of fictitious finance that we will sit back and allow the very same abuses that slapped us in the face a few years ago to knock us unconscious again and again? Perhaps the final word today should be that of a veteran Wall Streeter, who said: "I almost threw up when I read the report. It makes me sick of this industry." If they can't endure it anymore, can we? Labels: anton valukas, Ernst and Young, Federal Reserve, federal reserve bank of new york, financial crisis bailout, financial reform, Lehman Brothers, linklaters, repurchase agreements Please consider donating to Dollars & Sense and/or subscribing to the magazine (both print and e-subscriptions now available!). |
