Lehman

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Bank Non-Reform

There wasn’t any.

There. That makes it easy to remember. After 2,200 pages of tightly worded legal jargon the law known as Dodd-Frank left our banking system remarkably untouched. Our big banks are still way too big. So big they are beyond the law. By which I mean they are fully aware that they cannot be allowed to fail, and so they can act with impunity. Which they do. Daily. Worse, they are bigger than before. The crisis saw the consolidation of the industry as big names like Merrill Lynch, Lehman, and Wachovia disappeared and their assets fused into the survivors balance sheets. So the percentage of total banks assets concentrated under the control of the lunatics who destroyed the economy in 2008 has increased rather than decreased. Next time the cost of bailing them out will be higher.

And there will be a next time.

Soon.

In fact with the roiling problems in the sovereign debt market, with countries like Greece and Portugal teetering on the brink of default, we can expect more of those “notable rare exceptions” Alan Greenspan so farcically mentioned in his ridiculous Financial Times Op-Ed article. Many more. Why? Think it through. Who holds all that Greek or Portuguese debt? The big banks. So if Greece defaults the big banks take a hit and come under the same kind of pressure they were when the fantasy of the real estate bubble burst.

As taxpayers our decision seems simple: which is cheaper? Bailing out Greece? Or bailing out the banks? Its the same problem. Frankly I would prefer to bail out Greece. At least its a nice place to visit.

What I find remarkable is how much griping emanates from the big banks even though they escaped real punishment. Even today Jamie Dimon is complaining about the negative effects of regulation. He needs to quieten down and clean out the people who pillaged the US economy before he attracts too much more attention. Then again the immunity he apparently feels encourages him to speak out. He is, after all, one of the more likable of the bunch. His roots are slightly more plebeian. Slightly.

Then there is the “threat” from Barclays to leave London and head to New York. Good. Go ahead. I am sure the British taxpayers would love to be rid of having to bail them out. Oh. And by the way perhaps you could take your families and so on with you. No more of this paperwork movement. If you’re going to threaten the taxpayers just remember who votes and who makes the law.

Oh. Damn. That’s right. You make the law.

This is odd. The bankers make the law and yet complain about it. Maybe they left something out of the draft. Maybe they weren’t explicit enough. They didn’t make it clear that the US Treasury and the Federal Reserve Board exist to do the bank’s bidding. Enough of this oversight. It cramps the banker’s style.

On a serious note: the financial system is not stable. The crisis did not engender sufficient fear in politicians that they throw off their paymasters and rise up to reclaim management of the economy. The banks withstood the challenge and now benefit from an even more explicit bail out protection. So much more explicit that the rating agencies – co-conspirators in the financial meltdown – make it clear that their current ratings for the banks depend in large measure on future government support.

That makes it clear.

We fixed nothing.

The big banks depend on our largesse and then insult us every time we beg for a little contrition. These men and women are contemptible. And they are enriching themselves at our expense. With their reputation for being smart, skilled in finance, and adept at managing risk totally exposed as a fraud they have fallen back to the safety of simple childlike disobedience and insult. Their petulance is awe inspiring. Their activities continue unabated. They maybe fools, as their ineptitude demonstrated so clearly.

But we are the clowns that allow them to persist and to corrupt our government with their political donations.

A famous judge in England once opined that income tax is a tax on income. Duh.

By the same logic: donations to politicians are a way to purchase legislation. In the US that’s called free speech. Elsewhere it called bribery and corruption.

The outcome of all that free speech? Zero change in our banking system. And a bigger bill for cleaning up their next party. Reform?

As I said: there wasn’t any. It would have cost the politicians too much at the next election.

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Lehman’s Funny Accounting: Who Knew?

It looks very much as if the report issued today by the investigators examining Lehman’s last days will roil the waters somewhat. There seems to have been some funny accounting going on in a deliberate attempt to mislead investors and counter-parties.

Who knew?

The accounting in question relates to the way on which repurchase agreements – ‘repos’ – are reported on the books. A repo is an exchange where one party hands over assets, such as a wad of government bonds, to another party in return for cash. This is not a sale because there is a second part to the agreement: the first party agrees to buy the assets back at a set future date for a premium. Repos are very common in finance and are an excellent way to raise short term cash. All large banks use them as do many other finance companies. The repo market was one of the first victims of the crisis: it froze up because no one could place a good value on the assets being exchanged and without a reliable price for the underlying collateral the risk of being a counter-party rose to unacceptable limits.

So far so good.

By mid 2008 many of the most aggressive players on Wall Street were extensive repo users. They used the market as a key source of liquidity. So when the market dried up the panic was severe: everyone had to scurry to locate other sources of liquidity. The atmosphere was akin to a gigantic game of musical chairs. When the music stopped Bear Stearns and Lehman were left standing and thus collapsed.

Lehman’s problems apparently go further: they were using repos very heavily, but they were using an aggressive accounting ploy called repo 105 transactions. There is an accounting rule – FAS 140 – that allows sellers of repos to account for the transaction as an outright sale even though there is a contract for repurchase. This is bizarre, but true. The technicality that allows such an oddity is the level of collateral. If the seller hands over assets in excess of the cash value received, in this case 105% or more, then it is allowed to book the transaction not as a pure repo, but as a sale. This has a dramatic effect on the balance sheet. Instead of continuing to despite the fact that it still has an agreement to repurchase the assets in the future.

Why would you do this?

To make your balance sheet look smaller than it actually is. The entire transaction is designed to create the impression that you have sold, rather than repo’d, the assets. Your balance sheet is thus smaller, and in Lehman’s case a smaller balance sheet was one way in which they could present themselves as being less risky as they sought to borrow in the market. Lehman was deliberately misleading its counter-parties, its shareholders, and the regulators about the actual amount of risk on its balance sheet. But it was doing nothing illegal because it was simply applying FAS 140, a legitimate Financial Accounting Standard as promulgated by the accounting profession through its FASB rule setting system.

The fact that no law was broken is why we will be reading bemused statements by accountants that they knew of on wrongdoing. They are correct. But clearly this is an example of an organization abusing an accounting rule. It is common knowledge that accounting rules are being subverted all the time. Corporate reporting is an arms race between internal financial people who want to distort a company’s reports for various reasons, and the accounting profession who are constantly trying to plug holes in reporting methods and establish guidelines so that the public has the ability to extract sensible and consistent information from those reports. FAS 140 must exist for some purpose – I have no idea what that purpose is – but it surely was not to deceive investors, regulators and counter-parties.

What seems to have happened is that as the stress built on Lehman some bright soul came across FAS 140 and realized that it provided a way for the company to appear less risky than it was. Presumably the plan was to survive long enough for real risk reduction efforts to catch up with the funny accounting.

As we know that effort failed, and what we have left is the troubling remains of a concerted deception.

The next step is for the usual suspects to gather around and start the inevitable legal challenges to recoup damages: they have a very strong case that without the deception they would not have entered into business with Lehman and thus would not have lost their investment. Watch the law suits fly. And watch for the ex-executives who signed off on the accounting to lawyer up quickly. This has all the makings of a mess.

Parenthetically: issues such as this are always going to pop up after the implosion of a risk driven organization like Lehman. This is a salutary example of how difficult it is to wind down a complex financial business. Any meaningful financial reform has to concern itself with such complex bankruptcies and the endless repercussions that seem to ripple on for years afterwards. How Lehman’s auditors and regulators allowed it to use FAS 140 in this way is also open to strong criticism. Laxity was endemic. Everyone was to blame for the collapse, but Lehman’s executives hold the ultimate responsibility. No one asked them to cheat, but that’s what they did. I can guarantee you that every Wall Street firm is busy making sure it cleans up its own FAS 140 transactions before the regulators come knocking – already Goldman and JP Morgan Chase have issued statements denying any such behavior.

But that’s today. What were they doing back in 2008?

Who knew?

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Lessons of Lehman

Were there any?

This past week we have been treated throughout the press to a barrage of post-mortem articles about the significance, and otherwise, of the collapse of Lehman Brothers. That collapse produced the largest bankruptcy in American history and will provide a healthy living for attorneys worldwide for years to come.

The major thrust of the media attention follows two avenues: first, was the bankruptcy avoidable; and two, what have we all learned from it.

My take on the first point is that, yes, the collapse could have been avoided. At the moment of its disaster Lehman had a book of business very similar to those of its fellow investment banks – there was nothing uniquely stupid about Lehman. Moreover it had capital in the run up to crisis of around 11% – way above what the regulators consider sufficient even now. So on the surface there was nothing to single out Lehman for its role in the financial implosion last year.

So what did happen?

Lehman was unfortunate. It was unlucky enough to be the center of rumors about liquidity. It’s failure was precipitated by a liquidity crunch more than a fear of insolvency. It was a classic ‘run’ on the bank.

And such runs are the bread and butter of the regulators: so why did the ‘authorities’ not step in and provide support?

The answer appears to be twofold: they felt constrained by what they thought was the limited scope of their legal ability to act; and they, ultimately, wanted to avoid the impression that they could save all the banks. Remember, they had already driven Bear Stearns into a shotgun marriage with JP Morgan Chase earlier in the year, and they had muted pushing Lehman into Bank of America, only to be rebuffed in that effort. Other potential ‘deep pocket’ saviors like Barclays withdrew their interest as the crisis built towards its climax: no one had any idea of the consequences of taking on Lehman’s portfolio, and worried as they were about their own precarious balance sheets, no one wanted to add more risk just at a time when it seemed risk was impossible to measure.

So letting Lehman go became the only option.

My view has changed somewhat over the past year. I have hardened my opinion somewhat. On reflection I think it was correct to allow the bankruptcy. I have been stunned by the response of the banking industry: its sense of entitlement is extraordinary. This is a direct manifestation of the ‘moral hazard’ created through the years by the repeated bail out of failing banks. The impression in the banking industry is that no matter how stupidly they behave the public will always clean up the mess. After all banking is essential to the economy. By occupying this privileged and protected position banks feel safe to pursue practically any strategy they like, no matter how dumb it is. Management skills are not valued in the industry, trading and deal making skills are. Banking is a safe haven for those who want to play with other people’s money and make a personal fortune – or at least a very nice living – along the way.

My own experience in the industry was one of profound dillusionment: no one wanted to make strategic decisions and ‘thinking’ was devalued in favor of a macho ‘ability to do stuff’. that is to say to ignore risk so as to make short term profit. This I found especially odd because my employer had been at the epicenter of the real estate crisis at the end of the 1980’s – an event that cost many of my fellow managers their jobs and reputations. Yet we failed to learn anything at all. It has taken all this time for me to realize that this failure was not just in the bank that employed me, but was endemic to the entire industry.

It is a failed industry.

Yet the people who work there and conform to the ‘shoot first’ philosophy make a great deal of money. They are rewarded for amassing short term profits even if they end up destroying value in the long run.

You and I then are called in to pick up the pieces.

So: letting Lehman go down was supposed, in my mind, to force the bank’s attention on their innate vulnerability.

Did it?

Not at all.

For all the talk about the panic and the freezing up of the ‘credit markets’, nothing truly fundamental seems to have changed. Even most of the players are the same. Most of the Lehman people who drove the ship onto the rocks were quickly absorbed back into the industry where they are now, no doubt, replicating that driving skill they so amply demonstrated. But we should not pick on them too much: every single bank is trying to get back to the same activities. There doesn’t seem to be much of a change at all.

Yes there are surface changes: Goldman and Morgan Stanley are now registered as bank holding companies, which sounds arcane, but is a fairly important shift. Everyone focuses on this shift as as sign the ‘old days’ of rogue trading are over. They are not. I think the shift was driven more by a cynical need by the banks to get more securely under the bail-out wing of the Fed than it was an attempt to change their activities. Sure their leverage is down: but will it stay down? I have no confidence at all that it will. All it takes is for a new, and no doubt ‘innovative’, product to emerge and the pressure to pump up the balance sheet will be unavoidable.

Nothing has changed.

Given the devastation wrought by the ineptitude of the banks you would have thought that legislators and regulators would be clamoring to pile on the chains and lock the industry up as tightly as possible.

Not so.

The ‘reforms’ being touted in Congress are entirely superficial. The basic incentives for anti-social behavior are still in place. Which means we are headed, already, into another bubble of some sort.

So what have we all learned?

Not much apparently.

You and I were exposed, briefly, to a blizzard of jargon and obscure things like CDS’s and LIBOR spreads etc, so we can say that we learned a little about the games being played down on Wall Street. But the people who we need to have learned: those in the industry and those who regulate it, appear to want to return back to ‘normal’ as soon as they can.

I attribute this lack of learning to laziness and self interest. it is simply too much effort to impose restrictions on an industry that provides so much campaign money to politicians. The inherent corruption of the American political system is never more evident than in the legislative approach towards banking – conflicts of interest abound, and money talks, I doubt that the invective will produce a proper limitation on the industry. Let’s hope I am radically wrong.

Nor does there seem to be any recognition of the international scope of the problem. The banks are hoping against hope that there is only limited international cooperation: they especially hope that the US and UK act to water down attacks emanating from mainland Europe. Not that the European banks were innocent – they indulged in pure fantasy too by buying CDS’s to cover risk on their balance sheets rather than carrying the far more expensive basic capital. European banks were more thinly capitalized than many of their ‘gangster’ American cousins.

So here we are a year later. Plenty of words have been spilled about the Lehman debacle. And not much has been learned despite all the effort.

I think a major problem is that our leadership – worldwide – suffers from such a collective ‘group think’ on economic and financial matters that little originality is tolerated. And it is weak. No one wants to disrupt the hallowed market. So the market, embodied on the trading floors of the big banks, continues to corrode the fabric of the economy.

As you contemplate all this let me leave you with the advice I give myself when I try to think about banking: bankers are truly stupid people. They may be extremely bright. They may be clever as all heck. they might have degrees from top universities and they may know how to run wizard like models for risk management. But collectively they are stupid. They destroy shareholder wealth with a monotonous regularity. They rely on us to bail them out with equal regularity. They use our money and pay us nothing for it -our guarantees are offered up free of charge. And they aggrandize themselves through a wickedly perverse reward system that enriches most those who loose the most.

On second thoughts: it isn’t the bankers who are stupid.

We are.

Will that change?

Addendum:

Joe Stiglitz makes a good point: the big banks are now even bigger. They gobbled up failed rivals and now are emerging as ‘even too bigger to fail’ institutions. Yet no one in the administration has made a credible response to this greater concentration of finance. This issue: the size of the big players and their implied ability to tear the economy down, is key to getting the industry back under control. Until we have smaller banks that can be allowed to go into bankruptcy without destroying us all, we will be under their thumb. Don’t hold your breath for a solution however – the Obama administration’s watchword appears to be appeasement.

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What’s Good For Counter Parties Is …

Not good for anyone else.

The winding up of the ill-fated Lehman operations has run afoul of counter-party greed. More to the point it has run afoul of the hopeless inability of the dumb lawyers and bankers who constructed the apparently never ending Russian doll like constructions in which they hid those toxic assets to think clearly. Beyond their bonuses that is.

The problem is this: some of those labyrinthine and senseless structures touch down in foreign countries, where … gasp … they have actual laws and stuff. That might be different from ours. Oh the horror!

You think I’m being funny?

Then think about this.

The dimwits who advised the dimwits at Lehman ended up creating a chain of legal entities that stretches clear around the globe. At every point one of those entities touches planet earth – down from the parallel universe that exists in the attorney’s and investment banker’s minds – there are things called investors. These investors, it turns out, didn’t want to be ripped off so that the aforesaid attorneys and bankers could pay themselves big bonuses, they thought they were going to get a return on their investment.

When the music stopped and Lehman folded a whole host of bankruptcy lawyers went to work all over the world in an attempt to preserve value for their clients, some of whom weren’t aggrieved and bailed out bankers, but were real investors. People with cash at stake.

This has set off an international furore as each set of bankruptcy laws clashes with the next.

What fun.

But it has huge implications.

The latest fight centers around an investment vehicle called ‘Dante’ – presumably an oblique reference to the layers of hell that attorneys and bankers inhabit – whose investors have been ably represented in an English court. The judge concluded, not unnaturally, that they were entitled to compensation from whatever proceeds were available as Dante was wound up. This finding is in complete accord with English law.

It also happens to be completely at odds with what would have happened in a US court.

Here the bank counter-parties would rank ahead of the investors – they have a prior claim under US bankruptcy law. Since paying off the counter-parties would use up all the cash available in the defunct Dante, the investors would get zilch.

Its the American way: protect the bankers and let the investors swim as best they can.

Apparently the English judge knew full well the mess he was walking into -American lawyers like to think that their law applies everywhere and those other people’s laws are simply quaint impediments to be swept aside – so he put a stay on his decision pending appeal.

So now the American lawyers can save the poor counter-parties.

The problem is now this: if this case goes the way the bankers want it too, and American law prevails, the counter-parties will be paid and the investors will be hung out to dry. So who will want to invest in a similar US entity?

This case could spell the end of American bank ability to package and sell all sorts of investment vehicles. Practically any of the exotic securitized assets would fall into the same bucket as Dante. A precedent that protects the banks, rather than the source of the cash, vastly increases the risk associated with investing in a US domiciled investment vehicle.

While this may seem arcane and merely a problem for the future, it actually has huge current implications also: all those existing investment structures sitting on bank balance sheets will get a whole lot riskier too. That makes them worth a lot less to investors. That means their value will drop sharply.

And that, ladies and gentlemen, implies a write-off. Yes: we have discovered a potential new source of bank balance sheet weakness.

The banks are hoist upon their own petard.

By enforcing their rights as counter-parties, they undermine the value of their own balance sheets.

You just can’t make this stuff up. Banks really are that stupid.

The saving grace is that our doughty bankers will most likely have long retired, along with their bonuses, by the time the court challenge is resolved. Which only goes to show the depth of the brotherly love the legal profession has for the bankers. They have such a symbiotic relationship: both make money off the other’s folly.

Sweet.