Lehman's Clear Lesson

NEW YORK ( TheStreet) - If you ask almost anyone in a position to know whether Lehman Brothers was "too big to fail," the overwhelming response is something akin to "obviously."
Lehman

"Lehman was definitely too big to fail," says Lawrence McDonald, a former vice president at the defunct investment bank, when asked whether the collapse of 10 "mini-Lehmans" would have had the same effect. "If smaller banks went down, it wouldn't have anywhere near the impact on the global markets."

Michael Driscoll, a former senior managing director at Bear Stearns' trading desk notes that Lehman's enormous leverage ratio, in effect, made the bank 30 times bigger than itself. "Lehman was in a very tenuous position. It was just a matter of time before, in a bad situation, all that leverage was going to come back to bite you in the rear," says Driscoll, who is now a visiting professor at Adelphi University.

Indeed, at $700 billion, Lehman's balance sheet was big and so was its failure - representing the largest bankruptcy in history. During the S&L crisis of the late-80s and early 90s, thousands of regional banks failed across the country without having nearly as severe an impact on financial markets as Lehman did. Other large investment banks have collapsed throughout the years, too, which pale in comparison to the Lehman debacle.

As Christopher Cox, the Securities and Exchange Commission chairman at the time of Lehman's failure put it: "It has been a fact of life in Wall Street's history that investment banks can and will fail. Wall Street is littered with the names of distinguished institutions -- E.F. Hutton, Drexel Burnham Lambert, Kidder Peabody, Salomon Brothers, Bankers Trust, to name just a few -- which placed big bets and lost, and as a result ended up either in bankruptcy or being sold to save themselves."

McDonald also notes that the scale of crises increased by a factor of 10 between the S&L crisis and the devastating near-collapse of the hedge fund Long Term Capital Management in 1998. But during the decade between LTCM and Lehman, the scale of financial damage increased by a factor of 100.

Yet it might be more accurate to say that Lehman Brothers was actually too opaque to fail, not too big.

Philipp Schnabl, an assistant finance professor at New York University's Stern School of Business, uses the example of the Reserve Primary Fund, a $60 billion money-market fund that "broke the buck" shortly after Lehman's failure because of its exposure to the investment bank's debt securities. While the fund wasn't the largest in the industry, panic quickly spread across all types of money-market funds, forcing the Federal Reserve to put a temporary backstop on the $3 trillion industry.

"If you slice up a Lehman in 10 little Lehmans and one of them fails, investors are worried that the nine others are going to look very much the same and be exposed to the same risks - whether it's true or not - and you could immediately see a run," says Schnabl. "If you just pin it down to size you really miss the bigger picture."

Part of that bigger picture were regulatory deficiencies and accounting standards that helped Lehman obscure its true risk exposure and funding shortfalls.

In April, SEC Chairwoman Mary Schapiro aptly described the conditions leading up to Lehman's failurewhen she pointed to "the proliferation of complex financial products, including derivatives, with illiquidity and other risk characteristics that were not fully transparent or understood."

That's just the problem with Lehman: There are more unanswered questions about the investment bank, two years after its bankruptcy, than there were at the time it failed. And while the Dodd-Frank reform bill has taken steps to address certain items -- such as derivatives clearing, regulatory jurisdiction and the resolution process for large, systemically important financial firms -- it hasn't fully addressed the lack of trust and transparency that plagued the industry from late-2007 through the middle of 2009.

A big contributor to Lehman's demise was a lack of information available to interested parties - whether investors, counterparties, regulators or top executives. No one seemed to know how much capital Lehman needed, how much exposure to toxic real-estate assets it had or how much time was left on the clock to figure it all out.

A key finding by bankruptcy examiner Anton Valukas showed that everyone from managers to regulators to auditors missed an accounting tactic Lehman had been heavily reliant upon to prop up its balance sheet in what he called a "materially misleading" manner.

Valukas uncovered a gimmick called "Repo 105," in which loans are moved into off-balance sheet vehicles for a short period of time and booked as sales. The practice is common in the financial services industry. But while the Fed, Treasury and SEC have been scrutinizing and stress-testing banks' books since the collapse of Bear Stearns in March 2008, none of them seemed to know about Repo 105 until it was brought to their attention by Valukas.

Former CEO Dick Fuld pleaded ignorance on Repo 105, too. But Fuld, Valukas and Robert Hertz, chairman of the Financial Accounting Standards Board, all noted that the practice is considered legit by the FASB's accounting standards to which financial firms are required to adhere.

"The Repo 105 transactions were not inherently improper and that Lehman vetted those transactions with its outside auditor," said Fuld, adding that the bank had "appropriately accounted for those transactions as required by Generally Accepted Accounting Principles."

Think what you will of Fuld, but unfortunately he is correct.

TheStreet examined the off-balance sheet holdings of major financial firms last year, ahead of a rule change by the FASB that required banks to move a heap of those assets back onto the books. Wells Fargo ( WFC), Citigroup, JPMorgan Chase ( JPM), Bank of America ( BAC), Goldman Sachs ( GS) and Morgan Stanley ( MS) held $3.9 trillion worth of notional exposure to off-balance sheet assets as of March 31, 2009. Fannie Mae ( FNMA.OB) and Freddie Mac ( FMCC.OB) had trillions of dollars' worth of off-balance sheet exposure, too .

Somehow, though, the implementation of FAS-167 at the start of this year hasn't had much of an impact and banks still have exposure to losses on complex vehicles held off the books.

Bank of America brought $150 billion worth of assets onto its books at the start of 2010, taking a minor hit from bad credit-card debt. Wells Fargo - whose $1.9 trillion worth of off-balance sheet exposure in early 2009, exceeded its entire balance sheet by a wide margin - brought just $55 billion onto the books this year , which was actually accretive to earnings and capital ratios.

A look at big banks' quarterly filings shows that Wells Fargo held $1.5 trillion in notional exposure to off-balance sheet assets on June 30, with a "maximum loss exposure" of $68 billion. (In other words, in the unlikely case that all related asset values drop to zero, that's how much Wells would lose.)

JPMorgan Chase said it held $333.8 billion in off-balance sheet assets, while Citigroup pegged the maximum loss on $280 billion worth of such items at $32.5 billion. Bank of America had $117 billion in loss exposure to an array of mortgage, municipal bond and structured investment products held off the books. In July, the financial press was littered with reports about "window dressing" tactics akin to Repo 105 after word surfaced that Bank of America had improperly considered up to $10.7 billion worth of items as assets rather than loans.

It's not to say that banks are being fraudulent in their accounting practices - they don't have to. The FASB's rules are apparently so full of holes that banks can drive a big heap of CDOs straight through them. Both Fuld and an FASB representative pointed out in April that Repo 105 is a legit practice under the Generally Accepted Accounting Principles, or GAAP, which banks must adhere to.

McDonald, the former Lehman VP who authored a book on his experience called "A Colossal Failure Of Common Sense," says banks like Lehman and Citigroup, which had huge off-balance sheet exposure to SIVs, were "impossible to analyze" in the years leading up to the crisis.

"It's so much guesswork in analyzing a financial company," says McDonald. "Analysts had a buy on Lehman stock but had no idea, really - they pretend, they just don't know."

Several things will help increase transparency going forward: New requirements for derivatives clearing, long-awaited changes to accounting standards and capital requirements, as well as quarterly reports in the post-crisis era that are rife with detail. But just as banks are required to provide their retail customers with a simple explanation of terms and conditions, perhaps regulators ought to ensure that investors have a clear line of sight into what type of assets financial firms hold and the risk that comes along with them.

After all, in the post-crisis environment, stakeholders and counterparties should be able to focus on whether a firm is worth doing business with -- not how its size will affect its ability to fail.

--Written by Lauren Tara LaCapra in New York.

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