March 19, 2010

Lehman Brothers - the fall of a Sith Lord?

It took about a year and a half and a 2200 page report by the court-appointed examiner, Anton R. Valukas, to explain what most of us instinctively knew: Lehman Brothers used some rather creative accounting enabling them to "keep on dancing while the music was still playing".  One of the most popular catch phrases this week has been "Repo 105", an inside term for an accounting practice enabling Lehman to have as much as $50bn vanish from its balance sheet and temporarily reduce its debt levels.

The Financial Times has a nice explanation of how this Repo 105 worked:

With these new revelations, finger-pointing has already begun.  Apparently, US regulators (SEC and New York Fed) were warned about potential liquidity problems at Lehman prior to their collapse.  The New York Fed was not able to confirm this and the senior staff at the SEC overseeing Lehman Brothers are no longer working with the SEC - how convenient.

While these revelations are yet another indication of how horribly wrong everything went within the financial services industry, what is much more concerning is the unsettling feeling - correction - the implicit knowledge that this was only the tip of an iceberg and that there is more to come.  As they say, it always takes two to Tango...

Moreover, if Lehman engaged in this practice, others must have done the same.  This seems like a perfect time to quote Jedi Masters from the Movie Star Wars...

Mace Windu: There's no doubt that the mysterious warrior was a Sith.
Master Yoda: Always two there are. No more, no less. A master... and an apprentice.
Mace Windu: But which was destroyed? The master or the apprentice?


Guy said...

Lehman acted in the same way a wild animal would when cornered and fearing for its life; it resorts to whatever it must to survive. However, there is another story embedded in all this. The 2008 crisis invoked several lessons: such as, the dangers of leverage, the lack of balance sheet transparency, and the unintended consequences of government interaction. I would agree that governments needed to intervene to save us all from financial armageddon, but Washington's lack of Capital Markets knowledge is frightening. But this is another topic entirely, so back to my point. While there were many participants who erred to make up the "perfect storm" which was the 2008 crisis, it can actually be summed up as a crisis of confidence. The capital markets shut down and stopped working because banks did not believe the balance sheets (read solvency) of other banks, and so refused to lend (to one another). There were 3 main components which made banks question the financial health of each other: SIV's, CDS, and FASB 157. Clearly SIV's and CDS are off-balance sheet transactions that do not provide any guidance to a banks true liabilities. Furthermore, CDS does not even require any regulatory capital requirements to be set against the contracts. But let' not forget FASB 157 was equally to blame. The 'vague' rule which attempted to provide guidance for marking securities to market, backed away from their original plan and allowed banks to mark illiquid securities basically where ever banks wanted. No bank believed(s) the marks of other banks for level 3 assets. It is very simple why this occurred: because If securities where marked on the bid side, then every bank in the country would have been (would be) insolvent and every bank knew it. If an illiquid security had a 30 bid at 80 offer, FASB 157 backed off and allowed the mark to be 80 not 30. The bottom line: REPO 105 is purposely mis-leading. I would much rather have the banks operate under the rules of FASB 157 and lie legally, I mean mis-mark their positions, so that it seems as if the bank is healthy even though it is not. I certainly would not want to put my savings into a bank that marked correctly and showed their insolvency, especially when the FDIC insurance fund supporting my deposit is broke.

-Guy Haselmann said...

Great Comment, thanks a lot Guy!