Valukas Report, Lehman and the need to review Repo 105

In October 1907, the scions of New York’s banking world decided to let Knickerbocker, a bank whose reckless gambles had pushed it to the brink, go to the wall. That failure triggered a bank-run on Wall Street when it emerged that the financier, JP Morgan, had locked the leading bankers in a room until they pledged to lend $25m (£16m), worth $10bn today.

Almost exactly 101 years later Lehman Brothers failed, sparking the global financial meltdown that forced the US government to step in with $250bn of capital. In both cases, the failures led to recession, the loss of millions of jobs and firm pledges that the world must never again be brought so close to Armageddon.

The mammoth 2,200-page report into Lehman by its bankruptcy examiner, Chicago lawyer Anton Valukas, has no shortage of targets for blame. “There are many reasons Lehman failed, and the responsibility is shared,” Valukas wrote. Included are executives, including its past three CFOs, who made poor decisions, a business model that sanctioned excessive leverage ratios and the approval by Ernst & Young of Repo 105, an accounting device that shifted $50bn off the balance sheet when reporting time came around.

No protection
But overarching these concerns is a growing consensus that the lack of a global system for dealing with failures of major institutions contributed to the fallout. Worse, the concurrent failures of Bear Stearns and mortgage lenders Freddie Mac and Fannie Mae convinced the markets that Uncle Sam would always step in.

When it let Lehman go and markets panicked, the US and UK governments saw fit to pledge that no consumer would lose money, inadvertently giving birth to the notion of the “too big to fail” institution and instantly turning it into official policy.

At a recent conference in London, Thomas Huertas, banking sector director at the Financial Services Authority (FSA), said this was “unsustainable over the long haul”. The risk, he added, “is that governments will be forced to step in again when there is a new calamity”. He believes “crisis resolution” is important as the markets “develop a theory of how authorities will respond. The aim is that markets realise that even Citibank can go to resolution”.

William White, former chief economist at the Bank of International Settlements and one of the few regulators to go public on the bubble in the credit markets, says a “credible” resolution regime is an essential element of a new regulatory framework.

The leaders of the G20 countries have made a new cross-border resolution regime a priority for the new Financial Stability Board (FSB), setting a deadline of this October to achieve it. “We should develop tools and frameworks for the effective resolution of financial groups to help mitigate the disruption of financial institution failures,” was their statement after the Pittsburgh Summit.

Randall Kroszner, a governor of the Federal Reserve in 2008, says uncertainties over bankruptcy procedure in the wake of Lehman led investors, customers and counterparties to pull out of the market rather than suffer the jitters.

“The bankruptcy regime is an important international issue so that should be the priority for the G20,” he said recently in a speech at the London campus of the University of Chicago, where he is a professor. “Unfortunately, I don’t think this has been a priority.”

Bridging divides
The FSB reports back to the G20’s Toronto Summit this June with recommendations for a resolution regime. But its most recent progress report would seem to support Kroszner’s criticism. The section on cross-border resolution amounts to 42 words.

According to the FSA’s Huertas, the importance of international co-ordination is one of the key lessons from Lehman. Although it was a global bank, when disaster struck, the US dealt with it “in terms of the US market only”.

It only talked to the UK because of the need for FSA approval – subsequently turned down – for a takeover of Lehman assets by Barclays, he says. And the decision in the US to ban banks there from engaging in proprietary trading – and, in the UK, the 50 percent top rate of tax directed at the bankers – show governments are primarily responding to domestic electoral pressure.

A year after last April’s London G20 meeting, the FSB’s efforts to develop an appropriate regulatory regime for banks is continuing, says Stephen Lewis, chief economist at Monument Securities, “but policymakers are by no means united in believing this is the right way to proceed”.

Achieving a global resolution regime will be no easy task. The difference in bankruptcy regimes in the US and UK meant that when Lehman failed, American administrators could ring-fence customer accounts over there, while in the UK all accounts were frozen.

The FSA wants banks to produce “living wills” to show insolvency practitioners how operations would be resolved in an orderly fashion – though little has been said about this recently. Stateside, the US Senate Banking Committee has backed its Financial Reform Bill requiring firms to draw up “funeral plans” and create a mechanism to organise the “orderly shutdown” of a failed mega-bank.

But commentators say these are examples of national politicians going it alone. Simon Johnson, a former chief economist at the International Monetary Fund, thinks it is wishful thinking for legislators to say the bill hails the death of “too big to fail”.

“How can any approach based on a US resolution authority end the issues around large complex cross-border financial institutions?” he asks. “It cannot.”

None of us will be around in 101 years’ time but so far it seems unlikely politicians have learned the lessons of 1907 and 2008.

Repo 105: case for the defence
by Anthony Harrington
On the face of it, the case against Lehman Brothers’ auditor Ernst & Young (E&Y) and the failed bank’s legal advisers Linklaters, which provided it with the necessary opinion that the “accounting gimmick” Repo 105 was a “true sale”, looks devastating.

In his report into Lehman, Anton Valukas makes it clear he thinks that there are “colourable claims” against E&Y for allowing Lehman to use an accounting device to window-dress its accounts by removing about $50bn in leverage from its balance sheet on three successive quarter-ends. That is not the sort of thing to which auditors are supposed to turn a blind eye, even though they are not required to express an opinion on interim reports.

However, there is often a vast gulf between how things appear where the rubber meets the road. One securities lending source, speaking on condition of anonymity, is fed up with all the blather over Repo 105. “People now pretend they didn’t do it, but it has been a common practice for years,” he says. In addition, all the securities lending firms which offered Repo 105 or variants thereof all worked with legal firms – not just Linklaters – to establish that what they were doing could be construed as a “true sale” and not a standard repo transaction (where one side lends money and the other posts securities as collateral).

The prevailing legal opinion was (and probably still is) that according to the Financial Accounting Standards Board’s FAS 140 – the standard pertaining to accounting for transfers and servicing of financial assets and extinguishments of liabilities – if the provider of collateral could be deemed to have “lost control” of said collateral, then it could be treated as a sale. What constitutes “losing control”? It comes down to our good friend mark-to-market.

Collateral in a repo transaction is marked to the market on a daily basis. If the markets move against the borrower, they must provide more collateral. In a Repo 105, mark-to-market is not allowed unless the movement of the markets is way over a particular percentage: say, 110 percent of provided collateral.

At that point, the collateral provider is deemed to have lost control. Neat? The point for the defence of both E&Y and Linklaters is that, one, this is common and accepted practice; two, it is sanctioned by FAS 140 and three, if the law allows it, where’s the problem? Oh yes, Lehman tanked, taking much of the confidence in the markets with it. But still, where’s the problem?