By Sy Harding | 13 March 2010
Lehman's Contribution To The Financial Meltdown
Sometimes things that seem too disappointing to be true do turn out to be true. Unfortunately over the decades that has happened too often in the financial industry. For instance, just over a year ago a U.S. bankruptcy court in New York appointed former prosecutor Anton Valukas's law firm to investigate the rumors of foul play at Lehman Brothers in 2008, prior to the firm's failure. Lehman's bankruptcy was the largest financial bankruptcy in history.
Valukas released the resulting voluminous 2,200 page report on Thursday. Its revelations are an eye-opener even to those who suspected there was more going on in the financial sector than was made public in 2008. The report alleges that business decisions made by Lehman were not simply errors of judgment, or misunderstanding of the firm's financial condition by its executives, but deliberate and secret manipulations, suggesting that former Lehman executives, its auditors, and several cooperating rival firms could face legal problems.
The damning revelations in the 2,200 page Valukas Investigation report of Lehman Brothers using repo swaps to temporarily remove $50 billion of toxic waste assets from its balance sheet, hiding them from the view of investors and the credit rating agencies, apparently has regulators concerned. Reports are of regulators making nervous calls to other banks trying to ascertain if the manipulations were confined to Lehman, or were common practice in the industry. It's a touchy subject since there never has been any transparency provided regarding the value of questionable assets, including mortgage related derivatives and credit swaps, on the books of the major financial institutions.
The approach has been to let sleeping dogs lie for now, while helping the banks unload those assets onto the Fed's balance sheet and the like. Questions are also being asked about the part several major banks, including CitiGroup, may have played in the Lehman scheme. The concerns are spreading to Europe.
Apparently, Lehman could not find a law firm in the U.S. to sign off on the activities and had to go to a U.K. firm for that service, while counterparties to Lehman's swaps included global banks Barclays, UBS, Mitsubishi, the Royal Bank of Scotland, and others. Being a counterparty in a swap by no means indicates any wrong-doing, but with the report that Lehman's use of swaps in this instance was to mislead investors and rating agencies, investigations into the participations are likely.
The situation will also likely reignite demands for tighter regulations of swaps and other exotic and complex trading that are now such a large part of global finance. It's not a Pandora's box that anyone is going to want re-opened at this point in the recovery, given the panic the contents and quality of bank balance sheets created in 2008. It is an area investors should keep an eye on.
Lehman Brothers was the fourth largest investment bank in the U.S., one of the biggest dealers in large, complex trading schemes, and heavily invested in derivatives linked to sub-prime mortgages. Its tentacles reached far out into global financial activities, and at the time of its failure the extent to which its risks were shared with other major financial firms was unknown. So the firm's failure in September, 2008 created panic in the financial sector, followed by the final spike-down collapse in the stock market to last year's March low.
| It puzzled many at the time that, after having bailed out Bear Stearns, Merrill Lynch, insurance giant AIG, mortgage giants Fannie Mae and Freddie Mac, and others, by either arranging for their purchase by stronger firms, or direct takeover by the government, the Treasury Department and Federal Reserve refused in the end to rescue Lehman. |
The Valukas Investigation report may provide the answer. The Treasury's attempt to rescue Lehman failed when the government balked at providing UK bank Barclays with a guarantee of Lehman's trading obligations as part of the deal to have Barclays acquire Lehman. Although it was similar to guarantees the government had provided in its other rescue deals, it was explained that there was a limit to how much public money should be risked in guarantees of that kind.
But was the Treasury Department already aware of what the Valukas investigation report reveals, that Lehman officials had used "balance sheet manipulation" to hide some $50 billion of its leveraged debt from scrutiny, and so knew it could not guarantee the firm's trading obligations, as Barclays wanted as part of a buyout deal? The report says that by temporarily hiding the $50 billion of toxic assets via misuse of what are known as Repo 105 swaps, Lehman was able to be "materially misleading" by reporting much better risk-leverage numbers, which were a positive to investors, and also a positive to the rating agencies from which Lehman was anxious to maintain a favorable credit rating.
The 2,200 page report will be fodder for debate and conjecture for months to come as analysts plod through it in more detail. For instance, there are allegations that Lehman's outside auditors were aware of how and why the Repo 105 swaps were undertaken but "took no steps to question or challenge the non-disclosure", and that top executives hid the facts from the board of directors. According to court records, Valukas has been sharing his evidence with the SEC, and believes a number of Lehman's executives could face legal charges.
However, that would be quite different from the way government agencies acted in the aftermath of the last severe financial meltdown, after the 1929 crash. At that time, Congress and the courts also undertook extended investigations into the causes of the financial and economic collapse. The findings of excess risk-taking with bank assets, and especially outright fraud, were shocking. For the first time serious regulations were imposed on Wall Street firms, and the Securities & Exchange Commission (SEC) was established to police the financial industry.
In one of his first acts as the SEC's first chairman, Joseph P. Kennedy called in the nervous heads of Wall Street firms, as well as a number of corporate executives whose shady activities had been uncovered in the investigations, and to their great surprise he told them the SEC would not undertake investigation or prosecution for their past operations. No one went to jail. The top executives remained in their positions, only warned to change their ways.
Kennedy said he feared years more of charges and trials rehashing what had gone on before would be a hindrance to the country's ability to move forward into better, more honest times. The decision was providential for Kennedy as well, since his own misdeeds as one of the most notorious of admitted market manipulators of the early 1900's would also fade into the mists of time. I wonder if the times have really changed that much.
It's interesting that here is another example of how secretive complex derivatives transactions and swaps can be used to mislead investors, rating agencies, and regulators, and even contribute significantly to financial meltdowns. And yet whether their use should even be regulated is being debated. Perhaps the Valukas Investigation report will shine a brighter spotlight on the situation.
See also The Valukas Report On The Lehman Brothers Collapse By Gregory P. Bufithis
Valukas Report Finds Few Heroes
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