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Asleep in the kennel

15 March 2010 By Antony Currie

Those hoping that giving more power to regulators will help avoid the next financial crisis need to read the bankruptcy court examiner s report on Lehman Brothers demise. The Securities and Exchange Commission, the Federal Reserve and Treasury were crawling all over Lehman — and even had examiners embedded in the Wall Street firm during its final six months. But all that power and access achieved little, if anything — hardly a promising sign for future oversight.

Arguably the teams from the SEC and the New York Fed should have spotted the so-called Repo 105 trades, which were accounting tricks employed by Lehman to temporarily and artificially reduce its balance sheet. After all, both took up residence at the firm after Bear Stearns collapse in March 2008 to monitor Lehman, especially its liquidity. It doesn t say much for their investigative powers that they failed to spot large, short-term changes in Lehman s assets near the end of each quarter.

That s not to say they were completely blind. The trouble was, when they did spot anomalies, they often seemed unclear on their role, passed the buck, failed to cooperate with each other or didn t push back against Lehman s management.

The SEC, for example, told the report s author, Anton Valukas, that it didn t have the authority to regulate investment banks liquidity practices — even though the agency itself issued a memo in February laying out its mandate to do so in broad terms. Meanwhile, the New York Federal Reserve Bank s team wanted to make clear it was at Lehman purely in the guise of lenders checking on a client — as Lehman had since March 2008 been allowed to borrow at the Fed s discount window — rather than as regulators, and certainly not with any intent to usurp the bank s chief watchdog, the SEC.

The Fed and SEC teams also didn t coordinate with each other: information was shared, but not always, and was often not shared on the grounds that the other side hadn t been forthcoming, either. One glaring example is the matter of how Lehman was still counting assets in its liquidity pool that counterparties like JPMorgan, Citi, Bank of America and HSBC had taken as collateral — another balance sheet sleight of hand, like the so-called Repo 105, that was designed to make Lehman s balance sheet look healthier than it was.

The Fed knew about it in mid-August. The SEC only found out just how much collateral had been taken a couple of days before the firm filed for bankruptcy in September.

Not that the Fed did anything with the information. Its team subtracted the assets taken as collateral by others from Lehman s liquidity pool for its own purposes as a lender, but never told Lehman to do so — or let the SEC in on the shenanigans. Betraying his own dislike for his SEC counterparts, the report shows Fed investigator Jan Voigts said how Lehman reports its liquidity is between Lehman, the SEC and the world.

The SEC s mindset was no more expansive, with staffer Matthew Eichner declaring to Valukas that the agency was very comfortable living with a world where numbers in the public were the ones the firms worked out with their accountants, as opposed to the narrower numbers worked out by the SEC.

In fact, the SEC had a longer history of not pushing management on its findings. It determined in early 2008, before Bear s collapse, that Lehman could have more problems trying to put fair values on its illiquid assets than its rivals, as the team responsible for doing so was understaffed and overly process driven. But the agency never formally told anyone, including Lehman executives.

What s more, the SEC was also aware that Lehman had been breaching risk limits in its determination to be a bigger player in leveraged loans and commercial real estate — the illiquid assets that ultimately led to its demise (and which the SEC incredibly ignored in its own stress tests of Lehman). The agency s response, according to Valukas, beggars belief: It did not second-guess Lehman s business decisions so long as the limit excesses were properly escalated within Lehman s management. In other words, the SEC had relegated itself to making sure firms dotted the i s and crossed the t s on their forms.

One regulator, at least, did spot the excesses and said something: the lowly, and almost certainly soon to be extinct, Office of Thrift Supervision, which seemed during the crisis to be so willing to accommodate its charges, which it called customers, that it appeared captured by them. Yet it was the only regulator to haul Lehman over the coals for excessive risk taking, first in its 2007 annual review of the firm and then in a subsequent report in mid-2008 on its commercial realty business. Lehman was, it wrote, materially overexposed and guilty of major failings in risk management.

June 2008, of course, was too late: Lehman s attempts to find a buyer for its commercial property portfolio, or the entire firm, were already faltering. Its executives decisions ran the firm into the ground. Perhaps its regulators would have been powerless to do anything to prevent Lehman s demise, even without all their faults. But they must show that they are capable of doing much more than, as Valukas puts it, limiting their activities to collecting data and monitoring to be effective regulators in the future.


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