Getty Images A man carries a box after leaving the Lehman Brothers European Headquarters building in Canary Wharf in east London on September 15, 2008.
Reforms made in response to the bankruptcy of Lehman Brothers in 2008 won’t prevent a repeat, experts told MarketWatch.
As the 10th anniversary of the Sept. 15, 2008 bankruptcy of investment bank Lehman Brothers approaches, MarketWatch looked at whether the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 and other reforms will prevent another financial crisis if there’s a messy failure of a non-bank financial institution like Lehman.
According to the law’s preamble, Dodd-Frank’s purpose is,“To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end too big to fail, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices and for other purposes.”
MarketWatch looked at two areas of reform resulting from Lehman’s bankruptcy and the effect the failure had on the financial crisis: the new Dodd-Frank orderly resolution authority that replaced bankruptcy for “too big to fail” banks, and the elimination by accounting standard setters of the loophole that enabled the use of Repo 105, an accounting technique Lehman that also allowed balance sheet “window dressing.”
Anton Valukas, the Lehman bankruptcy examiner, wrote in 2010 that determining whether the bankruptcy filing made the financial crisis worse was beyond the scope of his investigation. However, what happened next suggests the Lehman bankruptcy filing had a significant impact on the depth of the crisis.
• The Dow Jones Industrial Average DJIA, -0.31% plunged 504 points on September 15, 2008.
• American International Group AIG, -0.43% was on the verge of collapse on Sept. 16 and the government intervened with a financial bailout package that ultimately cost more $182 billion.
• Also on Sept. 16, the Primary Fund, a $62 billion money market fund, announced that – because of the loss it suffered on its exposure to Lehman – it had “broken the buck,” that is its share price had fallen to less than $1 per share.
• On Oct. 3, 2008, President Bush signed the $700 billion Troubled Asset Relief Program, or TARP, rescue package, into law.
An orderly resolution
In 2008, the Fed did have broad authority to lend to banks in trouble “in unusual and exigent circumstances” as long as the loan was “secured to the satisfaction of the Federal Reserve Bank,” according to the Federal Reserve Act. At the time of Lehman’s troubles, however, there were significant disagreements about the “true value” of Lehman’s assets and whether it was insolvent or not.
Laurence Ball, an economics professor at Johns Hopkins University, told MarketWatch in July that the official version of why Lehman received no government bailout and had to file bankruptcy is incorrect.
“At this point it is possible to go back and put together the numbers, there is enough data on what Lehman’s assets were, what its liquidity needs were, and if one actually does that exercise, it is clear that Lehman did have ample collateral for the loan it needed to survive. So, if the Fed had asked is there enough collateral, the answer would clearly have been yes. They could have made a loan, it would have been legal, it would not have been very risky, and probably the whole financial crisis and Great Recession would have been less severe,” said Ball.
The Dodd-Frank Act of 2010 still allows the Fed to set up emergency loan facilities but prohibits it to bail out an insolvent firm. The Bankruptcy Code defines “insolvent” as a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation.”
At least five firms have to be eligible to borrow from the Fed’s emergency loan program, so the loans can’t be created to suit just one bank. One bank cannot borrow to lend to another that is insolvent.
Dodd-Frank gave the new Financial Stability Oversight Council, made up of top regulators led by the treasury secretary, the authority to designate as Strategically Important Financial Institutions, or SIFIs, any financial firm that “could pose a threat to the financial stability of the United States” if they failed or engaged in risky activities. That designation subjects the firm to stricter oversight from the Federal Reserve, including stricter capital requirements, participation in stress tests, the requirement to create living wills or bankruptcy contingency plans.
Before Dodd-Frank, the FDIC’s resolution authority was restricted to commercial banks. According to the Brookings Institution, when investment banks Lehman Brothers and Bear Stearns and insurer American International Group ran into trouble, they were not eligible for FDIC receivership since they were not commercial banks.
They had a choice of either declaring bankruptcy, as Lehman did, or asking for emergency aid from the Federal Reserve, as Bear Stearns and AIG did. Citigroup and Merrill Lynch, for example, came close to failing and received temporary taxpayer support.
Systemically important financial institutions can include a holding company and potentially several more pieces such as an investment bank, broker-dealer, hedge funds and private equity firms, and maybe even an insurance company. Each piece, including the holding company, may be subject to a different regulatory authority or maybe no regulation at all and is subject to a different test for insolvency.
Title II of the Dodd-Frank Act now gives the FDIC extended authority to include the entire bank holding company. Its Orderly Liquidation Authority can finance the wind-up of a troubled firm through the Orderly Liquidation Fund.
Non-banks, however, have to be designated SIFIs to be subject to the enhanced regulatory oversight that would inform regulators help is needed and make the firms eligible for FDIC resolution.
The FDIC released a report in 2011 entitled, “The Orderly Liquidation of Lehman Brothers Holdings Inc. Under the Dodd-Frank Act,” that examines how it could have structured an orderly resolution of Lehman Brothers Holdings Inc. had the law been in effect in advance of Lehman’s failure. The FDIC concluded that it could have acted “decisively to preserve asset value and structure a transaction to sell Lehman’s valuable operations to interested buyers.” Those actions could have “promoted systemic stability and made the shareholders and creditors, not taxpayers, bear the losses.”
“The very availability of a comprehensive resolution system that sets forth in advance the rules under which the government will act following the appointment of a receiver could have helped to prevent a ‘run on the bank’ and the resulting financial instability,” according to the FDIC report.
Access to the OLF could be considered a competitive advantage and a good reason to want to be a SIFI. But, instead, complex non-bank financial institutions have fought the label.
MetLife MET, -0.24% rejected it and fought the SIFI designation. General Electric GE, -0.88% restructured itself to become smaller and therefore ineligible.
“The process looks at all kinds of systemic risk from any kind of institution. The problem is institutions can fight it as MetLife has done and as Prudential Financial PRU, -0.45% likely will,” says Mayra Rodríguez Valladares, managing principal of MRV Associates a consulting firm focused on financial regulatory and risk based supervisory issues.
“Surely Lehman would have fought a SIFI designation, just like BlackRock has fought it and other non-bank institutions resist the additional regulatory oversight and the extra cost that comes with it,” said Rodríguez.
BlackRock BLK, -0.11% is the world’s largest money manager with $6.3 trillion in assets.
Mike Konczal, a fellow with the Roosevelt Institute where he works on financial reform, told MarketWatch in an interview, “triggering OLA for any institution requires a lot of people to turn the key. It’s not that easy,” said Konczal.
“If the Trump administration doesn’t use the SIFI tool, the economy is still at risk,” according to Konczal.
Because OLA has never been triggered for a non-bank, it’s not certain it will work.
“The FDIC is great at resolving banks,” says Rodríguez, “but I am not so sure that it would be so easy peazy to resolve a complex institution that includes a hedge fund, broker dealer, and investment bank.”
Lehman’s balance sheet “window-dressing” with Repo 105
Lehman bankruptcy examiner Valukas wrote that the investment bank had removed approximately $49 billion in debt from its 2008 balance sheet via the use of Repo 105 transactions. In a Repo 105 transaction, Lehman pledged assets, usually Treasury securities, with a value of 105% or more of the cash received.
Accounting rules permitted the transactions to be treated as sales which allowed Lehman to reduce its asset balance, since the cash received was less than the value of the assets it had pledged. However, the cash it received was not recorded as a loan, and the obligation to repay the loan and repurchase the Treasury security was not recognized as an increase in liabilities. Instead, the right to repurchase the collateral was recorded as a new asset, a derivative right to purchase securities in the future.
Valukas concluded that the transactions had no business purpose, according to the examiner’s report. Lehman’s “primary motive for undertaking tens of billions of dollars in Repo 105 transactions at or near each quarter-end in late 2007 and 2008 was to temporarily remove the securities inventory from its balance sheet in order to report lower leverage ratios than Lehman actually had,” Valukas wrote.
Lehman also, “did not disclose its use – or the significant magnitude of its use – of Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board of Directors. Lehman’s auditors, Ernst & Young, were aware of but did not question Lehman’s use and nondisclosure of the Repo 105 accounting transactions,” the bankruptcy examiner’s report said.
In 2010, the SEC proposed a rule in response to Lehman’s lack of disclosure of the Repo 105 liabilities. The proposal, called “Short term borrowings disclosure,” said that “a critical component of a company’s liquidity and capital resources is often its access to short-term borrowings for working capital and to fund its operations…Recent events have shown that these types of arrangements can be impacted, sometimes severely and rapidly, by illiquidity in the markets as a whole.”
In a comment letter to the SEC on its proposal, then Sen. Carl Levin wrote, “Inaccurate accounting treatment of repurchase agreements was not confined to Lehman Brothers. Other investment banks, such as Bank of America BAC, +0.03% and Citigroup C, -0.67% , have, in response to SEC inquiries, acknowledged that they erroneously recorded repurchase agreements as sales rather than as financing transactions.”
In April 2011, the FInancial Accounting Standards Board changed the rule that allowed Lehman to treat the repos as sales. FASB tweaked repo accounting rules again in June 2014 when MF Global, a global broker-dealer led by former N.J. Governor Jon Corzine, collapsed. MF Global could not meet margin calls when the value of European sovereign debt it used as collateral in repo transaction collapsed.
MF Global had recorded profit upfront from investing in the sovereign bonds and then using them as collateral in so-called “repo-to-maturity” contracts without fully disclosing its repo loan liabilities.
The SEC’s 2010 proposal for better disclosure was never finalized. A spokeswoman for James Kroeker, who is now the vice chairman at the FASB but who was the SEC’s chief accountant at the time of the proposal, declined to respond to a request for comment on the never-finalized proposal.
A spokeswoman for the SEC confirmed the proposal for enhanced disclosures was never finalized but declined further comment.
J. Edward Ketz, an accounting professor at Pennsylvania State University, told MarketWatch that despite the reactive fixes, “Managers will keep looking for loopholes that allow off-balance sheet treatment for repos. Auditors have to make sure they ‘know what they don’t know’ and that all off-balance sheet arrangements are disclosed in the footnotes,” Ketz said.
In July the Treasury’s Department’s Office of Financial Research proposed to collect more data on the U.S. repo market, to “enhance the ability of the Financial Stability Oversight Council to identify and monitor potential risks to U.S. financial stability by closing the data gap on centrally cleared repo transactions.”
A Fed report said in early 2017 the Fixed Income Clearing Corporation processed about $400 billion each day in same-day settling overnight centrally cleared repo transactions collateralized with U.S. Treasury securities.
Source: The Federal Reserve Bank, February 27, 2017
Even if this proposal is approved, the U.S. bilateral repo market would still be in the shadows according to Gregg Gelzinis, a research associate at the Center for American Progress, an independent nonpartisan policy institute.
In triparty repos, a clearing bank provides collateral valuation, margining, and management services to ensure the terms of the repo contract are met. In a bilateral repo, the lender drives the valuation and margin requirements on collateral pledged by the borrower.
“There’s a gap here in a market that was systemically important during the financial crisis and still is. It is disappointing that the SEC never finalized the disclosure rules since it would have aligned non-bank disclosures with bank holding company requirements,” Gelzinis told MarketWatch.
