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Repo 105: Creative accounting at Lehman Brothers

by Carrie Tue Mar 16th, 2010 at 08:33:56 PM EST

The latest outrage gripping the financial blogosphere is the recently released report of the Lehman Brothers bankruptcy examiner. In it we learn that Lehman Brothers was cooking its books to make it appear that it was less leveraged than it actually was, given that analysts were paying particular attention to leverage ratios when assessing the health of bank balance sheets.

Let's start with Randall Wray's blog post Timmy-Gate: Did Geithner Help Hide Lehman's Fraud? where we read

Lehman used "Repo 105" to temporarily move liabilities off its balance sheet--essentially pretending to sell them although it promised to immediately buy them back. The abuse was so flagrant that no US law firm would sign off on the practice, fearing that creditors and stockholders would have grounds for lawsuits on the basis that this caused a "material misrepresentation" of Lehman's financial statements. (see here) The court-appointed examiner hired to look into the failure of Lehman found "materially misleading" accounting and "actionable balance sheet manipulation." (here) But just as Arthur Andersen had signed off on Enron's scams, Ernst & Young found no problem with Lehman. (here)

In short, this was an Enron-style, go directly to jail and do not pass go, sort of fraud. Lehman's had been using this trick since 2001. (here) It looked fine to Timmy's Fed, which extended loans allowing Lehman to flip bad assets onto the Fed's balance sheet to keep the fraud going.


It seems to me Wray mixes up two issues, one is extending loans with bad assets as collateral, and the other is the accounting misrepresentations going under the cute name of "Repo 105". I think this is unfortunate. Although there may have been bad assets involved in Lehman's bankruptcy, this is not what "Repo 105" is about, despite what the New York Times reports, quoting unnamed Wall Street sources in the piece Fed Helped Bank Raise Cash Quickly

They were considered the dregs of Lehman Brothers -- "bottom of the barrel," as one banker put it.

But as Lehman executives tried to keep the floundering bank afloat in 2008, they used these troubled investments to raise quick cash that helped mask the extent of the firm's troubles. And they did it with the help of the Federal Reserve Bank of New York.

The newly released report on the collapse of Lehman Brothers -- which lays out what it characterizes as "materially misleading" accounting at the bank -- also sheds surprising new light on Lehman's dealings with the New York Fed.

The only problem with this picture is that "Repo 105" did not involve "the dregs of Lehman Brothers", but prime collateral, according to FT Alphaville's What's in Repo 105
But what exactly was Lehman Bros stuffing into the Repo 105 sausage?

Perhaps counter-intuitively it was not using the stuff on its balance sheet that was hardest to sell into markets.

Rather, it was the most liquid -- things like A- to AAA-rated securities, Treasuries and Agency debt, which you can see in the below table, from the Examiner's Report (Appendix 17):

The same point is made by Tyler Durden of Zero Hedge in The "Repo 105" Scam: How Lehman Fooled Everyone (Including Allegedly Dick Fuld) And How Other Banks Are Likely Doing This Right Now
In August 2008, just before it was over, the firm allowed $55 million, or seven securities, rated CCC to be included in a Repo 105 transaction.
$55 million is about 0.1% of the $50 billion Lehman Brothers was able to move off of its balance sheet in the second quarter of 2008 (link to HuffPo). Tyler Durden continues
The next chart makes it evident it that 105s were used simply to game the firm's assets into quarter end (yellow highlights), by reducing overall asset for leverage ratio calculations.

...

That this scam was going unsupervised (just who the hell were the counterparties?) for many years, and that many banks are likely using it right now to fool investors, regulators, rating agencies, and the idiots at the FRBNY (who certainly also know about this), is beyond criminal. Yet that nobody will go to jail for this is as certain as the market going up another 10% tomorrow. A full investigation has to be conducted immediately into whether existing Wall Street firms, and in particular those who use Ernst & Young as auditors, are currently abusing public confidence via such transactions.

The scam, it is clear by now, didn't involve overvaluing bad collateral to hide losses, but using repos to shunt good assets off the balance sheet in order to reduce leverage ratios. But how is it possible that repos were used this way? A partial answer is brought to us by NY Times blog Deal Book, in In Lehman's Demise, Some Shades of Enron
The examiner's report gives us a new term for hiding problems on a corporate balance sheet that may become common parlance: "Repo 105." Starting in 2001, Lehman Brothers engaged in repurchase agreements, called "repos," which were described by DealBook as "what amounts to a short-term loan, exchanging collateral for cash up front, and then unwinding the trade as soon as overnight." Repos are  a common method for investment banks to finance their operations and are neither illegal nor questionable, at least when clearly accounted for.

Lehman Brothers went a step further by having the collateral exchange under the agreement worth 105 percent of the cash it received -- hence, the "105" in the firm's nomenclature. By doing so, that turned it into a sale for accounting purposes, so that the firm could move the assets it exchanged in the deal off of its balance sheet, at least for a short while.

As explained by DealBook, "That meant that for a few days -- and by the fourth quarter of 2007 that meant end-of-quarter -- Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was." By timing Repo 105 transactions to the end of a quarter, the reports filed with the S.E.C. and reviewed by investors looked much better than what was going to be the case just a short time later. Enron did much the same thing with some of its assets, such as its notorious Nigerian barge deal.

A repo is simply an agreement whereby A borrows an amount X from B in exchange for collateral valued at Y, and they agree that A will repay an amount Z to B (Z being X plus interest) at a later time, at which point B will return the collateral. Are we supposed to understand from this that the accounting treatment of such a transaction depends on the relative values of X, Y, and Z? Can US accounting regulations be really this Byzantine? This is explained by the WSJ's blog Market Beat in Lehman's Repo 105: More Than You Ever Wanted to Know
First off, what's a repo?: Repos, or repurchase agreements, are transactions which banks use to borrow cash short term. The deals involve raising cash to fund operations by lending out high-quality assets (usually Treasury bills) for a short period of time. As part of the deals, the banks agree to repurchase their collateral within days or weeks.

What is the accounting?: In most circumstances, these transactions are accounted for as a loan on the books of the company. Accountants can treat these agreements as sales of assets rather than loans, only if the companies show that the company receiving the loan does not retain control over the securities used as collateral.

How do you know if the company controls the securities or not?: Guidance in the accounting rules suggests that an exchange of securities in excess of 102% of the cash value would show a lack of control. So Lehman exchanged securities worth 105% of the cash it received, which is why they were called Repo 105 deals, according to the Lehman examiner's report. So according to the report, Lehman would get these things off its books, report earnings, showing lower leverage rations, and then buy the assets back.

First off, an obligatory dig at accounting standards: the idea that an overcollateralised loan is a sale is so harebrained it beggars belief. But this is not all that was going on. The hint is again provided by FT Alphaville in What's in Repo 105
Lehman's own accounting policy required assets used for Repo 105 "be readily obtainable" -- i.e. liquid -- according to the report. Lehman's lawyers also recommended they be liquid so that "the Buyer could easily dispose of the Purchased Securities and acquire equivalent securities if it wished."
I suspect in order to make the "loss of control" accounting argument legally watertight, Lehman Brothers must have written a clause into their repo contracts whereby the counterparty had the right to dispose of the collateral at will, and was under the obligation to return not the same security that Lehman posted as collateral but an equivalent security. The only way to make this clause meaningful is for the collateral to be highly liquid, hence Lehman's internal legal recommendation to only use Repo 105 for prime collateral. And so, clearly, Repo 105 was not about hiding losses but about hiding leverage. Now, why did this go undiscovered until Lehman Brothers went bankrupt? And, as Tyler Durden put it, who were the counterparties to this? Well, as it turned out, this was a fraud hidden in plain sight and Lehman Brothers likely had no trouble finding willing counterparties. Think about it: you're a bank and none other than Lehman Brothers approaches you and offers you a 5% overcollateralised Repo for investment-grade assets. The credit risk of the transaction is negligible, not only because the counterparty is the highly-rated Lehman Brothers but also because the loan is overcollateralised with very liquid collateral. Who would say no? The deal is too good to be true. And, of course, when something is too good to be true, it usually is.

Display:
With a hat tip to ARGeezer in the Salon. More discussion and additional links can be found in that thread.

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Tue Mar 16th, 2010 at 08:36:08 PM EST
One of the links in that thread points to Zero Hedge's Senator Kaufman Makes A Stand Against The Criminality Exposed By The Lehman Examiner Report, Questions The Core Principles Of US Democracy
Kaufman calls for a "a thorough investigation, both civil and criminal, to identify every last person who had knowledge that Lehman was misleading the public about its troubled balance sheet - and that means everyone from the Lehman executives, to its board of directors, to its accounting firm, Ernst & Young. Moreover, if the foreign bank counterparties who purchased the now infamous "Repo 105s" were complicit in the scheme, they should be held accountable as well." Zero Hedge sides with Senator Kaufman in this new endeavor (we have yet to see even one other member of Congress or the Senate stand up and voice their opposition to Lehman's criminal conduct).
(emphasis in the original removed, my emphasis added)

Now, were these foreign counterparties complicit? The odds are they were unaware of what Lehman Brothers was doing. According to the WSJ's Repos played a crucial role in Lehman's demise  (via EFinancialNews)

Marie Stewart, the former global head of Lehman's accounting policy group, told the examiner the transactions were "a lazy way of managing the balance sheet as opposed to legitimately meeting balance-sheet targets at quarter end."

Lehman's use of this accounting technique goes back to the start of the decade when Lehman business units from New York and London met to discuss how the firm could manage its balance sheet using accounting rules that had taken effect in September 2000. Lehman soon created the "Repo 105" manoeuvre: Because assets the firm moved amounted to 105% or more of the cash it received in return, Lehman could treat the transactions as sales and remove securities inventory that otherwise would have to be kept on its balance sheet.

Because no US law firm would bless the transaction, Lehman got an opinion letter from London-based law firm Linklaters. That letter essentially blessed using the manoeuvre for Lehman's European broker-dealer under English law. If one of Lehman's US entities needed to engage in a Repo 105 transaction, the firm moved the securities to its European arm to conduct the deal on the US entity's behalf, the report found. That is likely why the counterparties on the repo transactions were largely a group of seven non-US banks. These included Germany's Deutsche Bank, Barclays of the UK and Japan's Mitsubishi UFJ Financial Group. In a statement, a Linklaters spokeswoman said the report "does not criticise" the legal opinions it gave Lehman "or suggest or say they were wrong or improper." The law firm said it was never contacted during the investigation.

(my emphasis) This also answers Tyler Durden's question just who the hell were the counterparties?

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 03:16:32 AM EST
[ Parent ]
So do different  firms report at different times to enable this to work? or are there other firms (the counterparties) that would now be over-levereged as a result of these transactions?

as another question, would you need another firm to be the counterparty? or could this be anglo-shenanigans between UK and US parts of the same bank?                      

Any idiot can face a crisis - it's day to day living that wears you out.

by ceebs (ceebs (at) eurotrib (dot) com) on Tue Mar 16th, 2010 at 11:09:23 PM EST
On the second question, according to this Reuters blog Lehman Brothers may have used transfers between the US [Lehman Brothers Special Financing] and UK [Lehman Brothers International (Europe)] branches as an intermediate step, but an outside party was necessary for this to work at the level of the books of the holding company [Lehman Brothers Holdings].

I don't know about the first question but I suspect that the counterparties would be overleveraged if they chose the same accounting interpretation of the transaction as Lehman Brothers. But since accounting involves an element of interpretation it is possible that they didn't

Accountants can treat these agreements as sales of assets rather than loans, only if the companies show that the company receiving the loan does not retain control over the securities used as collateral
(my emphasis)

See here for another example where it might be possible for the two counterparties to a transaction to disagree on the value of the asset for accounting purposes.

Oh, and this Repo 105 "loss of control" guidance aplies only to US GAAP, not to international accounting regulations. However, in an interesting twist, the reason they used the London arm of the holding company to do this was that they could classify the Repo as a sale under English law, but not under US law. So the holding company used UK law to make the transaction a sale, but they filed their accounts under US accounting regulations. See Marketwatch

Lehman had to overcome one final hurdle before it could book the deals as a sale -- it had to get a legal opinion that the deal was a "true sale."

"The problem was that Lehman was unable to obtain a true sale opinion from a U.S. lawyer," Valukas said in his report.

Instead all the deals were channeled through the firm's London operations, where it was able to get a true sale opinion from law firm Linklaters under U.K. law.

In a statement, Linklaters said Friday that Valukas' report doesn't suggest the legal opinion it gave under English law was wrong or improper.

"We have reviewed the opinions and are not aware of any facts or circumstances which would justify any criticism," the law firm said.



The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 03:09:49 AM EST
[ Parent ]
the counterparties would be overleveraged if they chose the same accounting interpretation of the transaction as Lehman Brothers. But since accounting involves an element of interpretation it is possible that they didn't
Indeed (my emphasis)
The report by examiner Anton Valukas also suggests that some or all of the banks, all based outside the U.S., may have known at the time that Lehman was executing what are known as "Repo 105" repurchase transactions in order to keep assets off its balance sheet, and as a result might "try to squeeze Lehman." The report doesn't allege that any of the banks engaged in any wrongdoing.

Most of the banks are identified in the report only with shorthand versions of their names. The report says Lehman's Repo 105 counterparties in 2007 and 2008 were primarily "Mizuho, Barclays, UBS, Mitsubishi, and KBC"--meaning units of Mizuho Financial Group Inc. (MFG, 8411.TO), Barclays PLC (BCS, BARC.LN), UBS AG (UBS, UBSN.VX), Mitsubishi UFJ Financial Group Inc. (MTU, 8306.TO) and KBC Group NV (KBC.BT). Also identified, more completely, are Deutsche Bank AG (DB, DBK.XE) and ABN Amro Holding NV (ABN.YY).

A KBC spokeswoman said the company "never has an insight in how counterparties book repos in their accounting." She said such transactions are common, with terms varying based on the counterparties or the quality of the collateral that is posted.

(source: UPDATE: Report IDs 7 Counterparties In Lehman Repo 105 Deals, from the WSJ)

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 03:19:15 AM EST
[ Parent ]
this Repo 105 "loss of control" guidance aplies only to US GAAP, not to international accounting regulations
However, according to DealBook's The Origins of Lehman's `Repo 105' there was a different 'gimmick' used called Repo 108 which was "European-only"
First, a quick primer on how Repo 105 (and the similar, European-only Repo 108) worked, based on the report by Anton R. Valukas. Like all repos, short for "repurchase agreements," it involved what amounts to a short-term loan, exchanging collateral for cash up front, and then unwinding the trade as soon as overnight.
Nobody's talking much about how Repos 108 worked.

Anyway, FT Alphaville has a post on The genesis of Repo 105 showing that Lehman Brothers deliberately set out to bend accounting regulations to its advantage, as I am sure any firm does even without ill intentions when a new regulation comes out

In 2001 Lehman Brothers held a meeting with its lawyers and auditors.

A new US accounting standard -- SFAS 140 -- had just come into effect, and the banking heads were keen to find a way to use it to their advantage. They settled upon something called Repo 105 and 108, which would allow it to essentially book repurchase agreements as sales rather than temporary transactions -- thus massaging its balance sheet and net leverage figures.

That year, the firm sent around an internal accounting memo for what became known as Repo 105, which you can view here.

Lehman was interested in shrinking its balance sheet even then because there was internal debate over leverage levels, according to Ex-Lehman C.F.O. Criticizes Repo 105 (NYT's DealBook, again)
"No, it wasn't done at the other firms, so it was clearly an accounting technical approach in order to bring a balance sheet down," he said. "But you're not bringing the balance sheet down. ... If all you're doing is hiding behind a curtain, it's not there."

Mr. Hintz also talked a bit about his time at Lehman, which he said was spent fighting over the firm's debt levels even then. Hurting things was what he called a "primitive" accounting system.

"Although they didn't find any accounting shenanigans, what was very clear to a reader of this was that there was an awful lot of stuff being done by hand," he said. "The battles that I fought inside the company about leverage in the 1990's, they were still fighting 10 years later."

He also seems to deny the implication in one of Tyler Durden's tirades that other investment banks must have been doing the same or are doing it now. It is possible that this was something only Lehman did.

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 03:32:20 AM EST
[ Parent ]
Except for the blog Financial Crookery in Scrabbling Around in a Repo 105 Haze?
Here's your handy extract from the Lehman Accounting Policy Manual in Anton Valukas' monolithic Lehman Examiners Report filing:
Repo 105 and Repo 108 transactions refer to repos with a counterparty in which we sell securities valued at a minimum of 105% (for fixed income securities) or 108% (for equity securities) of the cash received. That is, we sell fixed income securities with a fair value of at least $105 in exchange for $100 of cash for Repo 105, and equity securities with a fair value of at least $108 in exchange for $100 of cash for Repo 108. (Note that we allow Repo 108 to be done at $107 of fair value but we still refer to these transactions as Repo 108.)  Repo 105 and Repo 108 contracts typically are executed by Lehman Brothers International (Europe) ("LBIE") because true sale opinions can be obtained under English law. We generally cannot obtain a true sale opinion under U.S. law.
Financial Crookery translation: "I want to lend you some stuff for a short time and also want you to give me cash collateral.  But I only want $95.24 (per $100 of stuff) cash collateral as this gives me some ancillary benefits.  Don't worry about that though."
That is, Lehman used debt instruments as collateral for Repo 105, and equity instruments for Repo 108.

I am not sure what true sale opinions can be obtained under English law. We generally cannot obtain a true sale opinion under U.S. law means. Is it that US law doesn't allow it or does the more ominous interpretation of Valukas' words "unable to obtain a true sale opinion from a U.S. lawyer", that is, "no lawyer would sign off on the practise" apply?

Financial Crookery also has the language from the accounting standards:

For a repo to be re‐characterized from a secured financing transaction to a sale of inventory, all the following SFAS criteria must be met:
● The transaction is a true sale at law (SFAS 140.9a).
● The transferee has the ability to pledge or exchange the transferred assets
(SFAS 140.9b). and
● The transferor is considered to relinquish control of the securities transferred
(SFAS 140.9c).
FC Translation: "Rightio, here are three hurdles to jump over.  Erm I mean slide under. How do we satisfy all of these conditions to whip a bunch of stuff off our balace sheet temporarily, without actually using a market clearing price for it.


The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 03:44:17 AM EST
[ Parent ]
Thanks for sorting this stuff out. It is more nuanced than I had understood.

Baseline Scenario has a guest post by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts that shows some other interesting aspects of Repo 105. (I haven't copied her links.)

While hiding $50 billion off balance sheet is nothing to sneeze at, `Repo 105' may be an unfortunate distraction. We should focus our attention on a far more mainstream and dangerous use of repurchase agreements backed by securitized bonds to grow balance sheets. This practice, enabled by a 2005 legal change, directly destabilized the financial sector and led to the ultimate credit crisis of 2008. In other words, the approximately $7-10 trillion repo financing market created what Gary Gorton and Andrew Metrick call the "run on repo" or what Gerald Epstein describes as a "run on the banking system by the banking system."

....

Repos have been called the "oil in the industry of Wall Street" largely because, prior to the global financial crisis, investment banks financed up to 50% of their assets in the repo markets. One bank analyst notes that "repo markets are only one channel linking the "shadow banking" sector to the broader economy." Given its size and importance, the repo market is surprisingly obscure.

At its peak in 2007, the repo market in the US was estimated to be between $7 trillion to $10 trillion. Outstanding US repos today are estimated to be in the $3.8 trillion to $4.27 trillion range. Buyers (cash lenders) in the repo market are typically institutional investors like pension funds and mutual funds who need a liquid but relatively safe place to invest cash for the short term, often overnight. Buyers also include broker-dealers and banks that need securities to cover short positions. Sellers (cash borrowers) in the repo market are often broker-dealers and banks who use these arrangements to finance asset purchases and to leverage. With a matched-book repo, a dealer will act as buyer, bringing in collateral, then will with the same collateral act as a seller with a different counterparty, profiting on the spread.

Gorton observes that "The current panic centered on the repo market, which suffered a run when lenders [whom he likens to depositors during Depression-era banking runs] required increasing haircuts, due to concerns about the value and liquidity of the collateral should the counterparty `bank' fail." These repo lenders also refused to rollover existing repos. Both actions created "massive deleveraging . . . resulting in the banking system being insolvent."



"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 17th, 2010 at 12:08:13 PM EST
[ Parent ]
The key to the whole scheme is the fact that prime collateral was used for Repo 105. Everyone is expecting accounting irregularities involving junk assets. FT Alphaville calls it counterintuitive and leaves it at that. Tyler Durden points out that this cements the case that the point of the exercise was entirely to reduce leverage at the time of reporting. And Financial Crookery gets the ability to pledge or exchange the transferred assets backwards, thinking it refers to Lehman's ability to dispose of the cash, not of the counterparty to dispose of the collateral.

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 01:14:43 PM EST
[ Parent ]
What I found of interest in Taub's analysis is this
"run on the banking system by the banking system."
And
"The current panic centered on the repo market, which suffered a run when lenders [whom he likens to depositors during Depression-era banking runs] required increasing haircuts, due to concerns about the value and liquidity of the collateral should the counterparty `bank' fail." These repo lenders also refused to rollover existing repos. Both actions created "massive deleveraging . . . resulting in the banking system being insolvent."

If I recall correctly, the total hole in Lehman's balance sheet was somewhere north of $300 billion, with Repo 105 accounting for ~$50 billion, unless that figure included both Repo 105 and 108. I got the impression that much of the rest was in held by The Fed as longer duration repos of some sort. Also that the Lehman bankruptcy was triggered by Morgan refusing to renew its transactions with Lehman. I do not know the nature of the transaction that Morgan refused to renew.

Unfortunately, I do not have all my sources individually bookmarked and don't have the time just now to look them up again.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 17th, 2010 at 01:55:37 PM EST
[ Parent ]
the total hole in Lehman's balance sheet was somewhere north of $300 billion, with Repo 105 accounting for ~$50 billion

Um, I don't think Repo 105 represents a 'hole' in the balance sheet in the usual sense. I mean it doesn't negatively impact on the solvency of the firm given it is a short-term swap of cash for good quality assets.

Granted, there is a 5% mismatch between the value of the cash and the collateral, which means the $50bn in Repo 105 resulted in an effective loss of $2.5bn - which 1) is recouped when the repo matures and you underpay by 5% when you repurchase the collateral; 2) is just 1% of the "hole" and, I suppose, 3) is a fair price to pay to reduce your leverage ratio.

If the amount of assets in the Repo 105 program had stayed constant (by rolling all the repos) rather than increasing at the time of closing the quarterly books the claim of intentional fraud would be much less plausible, and Lehman would just be taking a $2.5bn loss to permanently (as long as counterparties rolled the repos) shrink its leverage ratio.

The brainless should not be in banking -- Willem Buiter

by Carrie (migeru at eurotrib dot com) on Thu Mar 18th, 2010 at 04:33:16 AM EST
[ Parent ]
You are right if they were only using A rated securities for Repo 105, so I wonder where the hole came from.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Mar 18th, 2010 at 04:36:10 PM EST
[ Parent ]
is exactly what started in the summer of 2007, and lasted until TARP was approved. At the time we were commenting that what was going on was that banks looked at their balance sheets, saw ShitPile™ and wondered if my balance sheet looks like this, what does my neighbour's balance sheet look like?. They stopped lending to each other, which qualifies as a run.

Banks lend long-term assets, and fund themselves short-term (be it deposits or borrowing in the money markets). This is in the nature of things as is unavoidable. Therefore, any bank is vulnerable to a run, which is defined as an inability to secure short-term funding to meet maturing liabilities (in other words, an inability to roll maturing short-term credit). In August 2007 the 3-month interbank market completely dried up for weeks, taking Northern Rock with it. Lehman Brothers, being a broker-dealer, had no deposits and also funded itself exclusively in the short-term money markets (repos, not Repo 105, would be an example of this). The run on the money markets took with it Bear Stearns and eventually Lehman Brothers, which I seem to recall was the smallest and by far the most highly leveraged of the four big US investment banks (Goldman Sachs, Morgan Stanley and Merrill Lynch being the other three).

In the frame of Hyman Minsky's Stabilizing an Unstable Economy banks are by definition speculative, borrowing to pay the interest on their loans (this is what rolling short-term liabilities amounts to). When their leverage exceeds a certain threshold (which is lower if interest rates rise, which is what happened in the run on interbank credit 2 years ago) they become ponzi finance (ponzi finance is not a term of abuse in Minsky, just a name for a situation where you have to borrow to pay down the principal as well as the interest).

The brainless should not be in banking -- Willem Buiter

by Carrie (migeru at eurotrib dot com) on Thu Mar 18th, 2010 at 04:47:15 AM EST
[ Parent ]
So if you look at the bell curve of banks pay out rates, You have a few at the top which are paying out at excessive rates, either because their staff are more skilled, or they are lucky or they are running Madoff style schemes.  There's then pressure to push the peak of the bell-curve up towards those high pay-out rates to attract customers. If you look at the difference between the average on that bell curve and the rate at which GDP is actually growing (I know its a dubious figure at best) then the difference between the two could be called a ponzi gap

Any idiot can face a crisis - it's day to day living that wears you out.
by ceebs (ceebs (at) eurotrib (dot) com) on Thu Mar 18th, 2010 at 06:37:26 PM EST
[ Parent ]
That's actually a good insight.

Of course, as soon as you make it the basis for regulatory action, the thus regulated entities will try to figure out ways to game it. So we'd need to figure out whether it's robust against accounting gimmicks.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu Mar 18th, 2010 at 09:24:53 PM EST
[ Parent ]
The profit motive will ensure that, through "innovation", banks operate on the edge of regulatory compliance.

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Fri Mar 19th, 2010 at 12:36:35 AM EST
[ Parent ]
Which is why it is so crucial to have simple and very clear rules without any complexity.

This is the opposite of the US financial regulation system, and in a large part depends on the political system, where banks can fund individual congressmen and senators to add complexity and exemptions.

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Fri Mar 19th, 2010 at 07:25:02 AM EST
[ Parent ]
Yes, but that just means that they will try to avoid reporting the parameter you're using to regulate them.

Which is why that parameter needs to be reasonably robust against accounting gimmicks.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri Mar 19th, 2010 at 09:42:51 AM EST
[ Parent ]
In fact, you presentation is much more nuanced than any other single coverage or analysis I have read. The FT or someone should be paying you to do this for them! (Not that I want to loose you from ET!)

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 17th, 2010 at 12:18:39 PM EST
Or lose you. :-)

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 17th, 2010 at 12:19:27 PM EST
[ Parent ]
on European Tribune.

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 12:40:34 PM EST
[ Parent ]
I agree with Geezer, though I am not qualified to comment...

You can't be me, I'm taken
by Sven Triloqvist on Wed Mar 17th, 2010 at 12:46:34 PM EST
[ Parent ]
If I am so smart, why am I not rich?

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 12:47:13 PM EST
[ Parent ]
I don't think one necessarily leads, or should lead, to the other. Rich people are rich because they have been fortunate, greedy and selfish: it is very rarely a question of logical skills. Though obfuscation skills can come in handy.

Being not rich is your power in commentary. You really should use it.

You can't be me, I'm taken

by Sven Triloqvist on Wed Mar 17th, 2010 at 12:54:51 PM EST
[ Parent ]
We also rarely describe emotional skills, manipulation skills, and general modeling of other minds as intelligence. "Playing the game" requires these skills and the will to use them to your own ends. Without them you draw a salary at best - which means you are shut out of the big money.

you are the media you consume.

by MillMan (millguy at gmail) on Wed Mar 17th, 2010 at 02:31:19 PM EST
[ Parent ]
If I am so smart, why am I not rich?

I was having this discussion with a fellow engineer back in the late 70s and suggested that, in this society, J. Paul Getty or John D. Rockefeller would have to rank as the some of the smartest people who ever lived. He said: "NO! That can't be true!" Then I responded: "If we are so smart, why aren't we rich?" I suspect that personal and intellectual integrity has something to do with it. Among other problems integrity raises are observations that, in polite society, are considered tactless. If you are going to "Go along to get along" as Carl Albert and Sam Rayburn used to say, it helps not to raise ugly truths that disturb the tranquility obtained by soothing lies.


"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 17th, 2010 at 01:24:56 PM EST
[ Parent ]
Integrity has everything to do with it ;-)


You can't be me, I'm taken
by Sven Triloqvist on Wed Mar 17th, 2010 at 01:54:28 PM EST
[ Parent ]
I believe it was in Al Capp's "Ll'l Abner" cartoon where Li'l Abner says: "We're poor, but honest" Someone else suggests: "No. You're poor because you're honest."

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 17th, 2010 at 02:01:35 PM EST
[ Parent ]
See Chris Cook's diary: The poor are honest.

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 02:13:38 PM EST
[ Parent ]
There is a war going on, why are you not profiteering?

I do not even demand that you profiteer by selling defective guns like J.P. Morgan did.

J. P. Morgan - Wikipedia, the free encyclopedia

During the American Civil War, Morgan was approached to finance the purchase of antiquated rifles being sold by the army for $3.50 each. Morgan's partner re-machined them and sold the rifles back to the army for $33 each. These guns were defective and were known to blow the thumbs off of those who used them. The sale became a scandal and the government refused to pay for their own defective weapons resold to them at an exorbitant markup. Morgan sued the government twice to collect on his contract.[2] Morgan himself, like many wealthy persons, avoided military service by paying $300 for a substitute.[3]

As long as you are ready to treat every scam not explicitly forbidden and effectively prosecuted as a great business opportunity, you should be able to get rich if you are smart. But well, there is the issue of empathy and morals.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Thu Mar 18th, 2010 at 05:24:56 AM EST
[ Parent ]
Fascinating stuff.

It's interesting, I recall some early discussions where we were trying to work out some of the actual mechanisms involved in the bubble and ensuing crisis overall. A key point that came up was the question of measures of money supply and just how much money was in the system. We concluded (to no great purpose at the time) that some of the transactions must have been dedicated to getting around capital adequacy ratio directives... we could see symptoms, but couldn't see the mechanisms...

by Metatone (metatone [a|t] gmail (dot) com) on Wed Mar 17th, 2010 at 12:51:43 PM EST
There's a certain elegance to the scheme, I'm almost impressed :)

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 12:54:02 PM EST
[ Parent ]
I'm pretty sure it's fair to state that "no US lawyer would sign off on it" means what it says... all the US lawyers thought it was not a true sale under US law...

Linklaters role reminds me that many parts of UK Financial law are expressed mostly in archaic formal English, where multiple interpretations abound...

by Metatone (metatone [a|t] gmail (dot) com) on Wed Mar 17th, 2010 at 12:57:34 PM EST
[ Parent ]
I come off with the impression of law firms as mercenaries who will write a legal opinion in support of the higher bidder's claim, as long as it cal be plausibly construed that way. It reminds me of the way the TV series The Tudors which I have been watching recently depicts the evolving legal and theological arguments concocted by various scholars and advisors to Henry VIII to support his goal of divorcing Catherine of Aragón.

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 01:07:10 PM EST
[ Parent ]
Bang on... commercial lawyers basically earn their best money that way... and it appeals to many of them psychologically - you go into commercial law in particular if a certain kind of systems beating/game theory approach appeals to you and you're a humanities student (if you could do math, many other career options exist...)
by Metatone (metatone [a|t] gmail (dot) com) on Wed Mar 17th, 2010 at 01:09:25 PM EST
[ Parent ]
There are lawyers who seek to learn the law so as to promote justice and there are others who learn the law so as know how to stay just inside it. Guess who make more money.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 17th, 2010 at 01:27:42 PM EST
[ Parent ]
ARGeezer:
Guess who make more money.

Making money in more than one sense at that.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Mar 17th, 2010 at 03:58:41 PM EST
[ Parent ]
You're likely referring to The M3 money supply: much ado about nothing? (October 7th, 2007) and your comment
The key issue here is that if you sit down with:

a) M1 and M2
b) Interest rate decisions

you will happily conclude that inflation has been low because inflationary pressures are low. This allows you to ignore the "asset bubble." Incidentally, this kind of round robin of measurements probably plays into the "core inflation" debate too.

It's only when you look at M3 that you get an explanation for the "asset bubble."

Repos show up in Cat's comment
Yes, according to Gary North and Mish. I finally got around to reading these posts, and I think you might find them interesting. You all are about to converge at the same conclusion: the real action has been in M2 and FRB repos, the ultimate buy-back scheme. Basically, the discount window has been and will remain a cover for sucking money out of circulation; supply has been flat, after all. (Graphs of YoY data sets)


The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 01:27:16 PM EST
[ Parent ]
Ethiopian review: Repo 105: "Like, whatever"
Max Abelson has talked to three former Lehman executives about the Valukas report, and you can see why they requested anonymity. Here are some of the gems from Senior Executive #2:
...

The only people who would worry about using an old trick to reduce leverage from 13.9 to 12.1, the second executive said, are "yappers who don't know anything."

The was lots of talk in the early months of the Obama administration about whether Wall Street bankers really Got It or not -- whether they had any comprehension of the amount of justifiable anger in the country and the world that was arrayed against them. Clearly, they don't. ...
... "$50 billion is a drop in the ocean."...

The former managing director in London said that Repo 105 was an open secret there, if it was a secret at all. "Yeah, yeah, yeah. In Europe, people just generically talk about it. It's funny, for nonprofessionals, you can try to make it a smoking gun," the source said, "I'm like, whatever."

But it's important not to lose sight of the fact that what we're seeing here is a corporate failing to an even greater degree than it is an individual one, and that it infects investment banks generally, not just Lehman Brothers. These shops deliberately go out to hire psychopaths, and then they fire the ones who go soft, while promoting the most aggressive assholes, keeping a few smooth-talking client-relationship types on hand to preserve some semblance of a respectable public face.


The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 01:03:41 PM EST
I don't think it's about psychopathology (although that is present) - it's about norms and operating culture. What these Lehman-ites are saying is that manipulating balance sheets this way is common practice across the sector and has been (possibly) for years and years (maybe decades).

Like many aspects of banking - cheating is fine, until you fail - it's only at crisis time that enough firms fail that we can see the cheating. Of course regulators have been failing - usual things... lack of resources, expertise, capture by industry...

It's like houses built in earthquake zones with sub-standard concrete... you can go 80 years with no problems... then the big earthquake comes and you get found out... but there isn't a lot of incentive to worry about that from a market point of view and if regulators fail...

by Metatone (metatone [a|t] gmail (dot) com) on Wed Mar 17th, 2010 at 01:15:38 PM EST
[ Parent ]
I like this from The Epicurean Dealmaker
The answer, of course, is obvious, if politically difficult to put into effect. Staff the SEC, or whatever "Super Regulator" the government decides to deputize to oversee this mess, with a bunch of highly-paid, tough-as-nails, sonofabitch investment bankers. You will have to pay them millions, just like regular bankers. (You can tie their incentive pay to improvements in the value of securities held under TARP and TALF, if you like.) Pay them well, and investment bankers won't be able to treat them like second-class citizens at the negotiating table. Pay them like bankers, and your regulators won't hesitate to read Jamie Dimon or Lloyd Blankfein the riot act, because they won't give a shit about getting a job from them later.
This is, in fact, the profile of the stereotypical FBI field agent in American TV fiction. Hard as nails, ruthless, and with a dark side.
Trust me, these are the kind of people you will need on your team: highly educated, financially sophisticated, psychotically hard-working, experienced professionals who know or can figure out CDOs, SIVs, balance sheet leverage, and credit default derivatives just as easily as the idiots who created and trade this shit. Leading your enforcement and supervision teams you need a bunch of smooth, smart, plausible, grandiosely self-confident senior bankers who will not hesitate to tell Vikram Pandit to go fuck himself, his mother, and the cow she rode in on if he ever tries to fuck with the United States government, the US taxpayer, or the pizza delivery boy again. You know: psychopaths.

This is not a new idea. For yonks, the Brits have known that the best person to hire as gamekeeper on your ancestral estate is a former poacher, someone who knows what they know, how they think, and where to punch them in the genitals to get maximum negotiating effect.



The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 01:19:16 PM EST
[ Parent ]
I agree about the tough as nails.

But I think there is some overestimation of the experience required. You (Migeru) could certainly figure out "CDOs, SIVs, balance sheet leverage, and credit default derivatives just as easily as the idiots who created and trade this shit."

Also, I don't see why you need to create yet another welfare scheme for investment bankers. This is not to say that employee poachers as gamekeepers would not work, but the key is not that they need pay equity, they need political backing... which is the real problem... they need to know that they won't be sacked when Vikram Pandit or whomever calls their congressman to complain.

Certainly they should be paid well... but it doesn't have to be insane money...

by Metatone (metatone [a|t] gmail (dot) com) on Wed Mar 17th, 2010 at 01:32:00 PM EST
[ Parent ]
I am becoming convinced that regulation needs to become both intrusive and heavy-handed. But the screams from the serious people in the salmon-coloured press would be loud indeed.

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 02:16:07 PM EST
[ Parent ]
The serious people are sociopaths, so - of course.
by ThatBritGuy (thatbritguy (at) googlemail.com) on Wed Mar 17th, 2010 at 08:30:21 PM EST
[ Parent ]
You (Migeru) could certainly figure out "CDOs, SIVs, balance sheet leverage, and credit default derivatives just as easily as the idiots who created and trade this shit."

LOL, I guess that's why I work in the Risk Division of a major international bank. (As you know, this means I'm a loser since winners all work as traders and make at least 6 figures)

The brainless should not be in banking -- Willem Buiter

by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 02:31:07 PM EST
[ Parent ]
Those who have a conscience and a desire to maintain their integrity should really qualify for disability in our culture, and that disability should be paid even while you are working.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 17th, 2010 at 03:22:37 PM EST
[ Parent ]
Those who have a conscience and a desire to maintain their integrity should qualify for a job as government regulators.

And you don't need to have them running around in Armani suits to make the industry they regulate treat them as first among equals. You just need to give them a really big stick and permission to make examples of a couple of putatively too big to fail businesses.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Wed Mar 17th, 2010 at 04:56:34 PM EST
[ Parent ]
Metatone:
it's about norms and operating culture.

Which is why social settings like the City of London are important. Setting up the work in another place would be easy but setting up an environment where everyone fawns over your sociopathic norms instead of condemning them, that is the hard part.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Thu Mar 18th, 2010 at 05:36:57 AM EST
[ Parent ]
You mean Dubai or Singapore or Hong Kong don't fit the bill?

The brainless should not be in banking -- Willem Buiter
by Carrie (migeru at eurotrib dot com) on Thu Mar 18th, 2010 at 05:55:55 AM EST
[ Parent ]
Authoritarian places are actually quite complex to deal with... if you do as much damage to Singapore, Dubai or HK as The City has done to the UK there would be some heavy consequences...
by Metatone (metatone [a|t] gmail (dot) com) on Thu Mar 18th, 2010 at 06:00:23 AM EST
[ Parent ]
I mean of course, that if you do that damage while you are based there...
by Metatone (metatone [a|t] gmail (dot) com) on Thu Mar 18th, 2010 at 06:00:53 AM EST
[ Parent ]
Masters of the Universe would not like being caned.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Mar 18th, 2010 at 05:16:34 PM EST
[ Parent ]
Actually, I would assume that they do fit the bill. I am not sure that those currently in London would relocate there though.

But I think the current number of such places is limited and if the City was out-regulated there would be one less. It would also be interesting to see if our political elite would listen so much to advice coming from Dubai.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Thu Mar 18th, 2010 at 02:55:08 PM EST
[ Parent ]
Jon Stewart's explains it all here (no youtube yet). For Lehman see around 4:50.
by gk (gk (gk quattro due due sette @gmail.com)) on Wed Mar 17th, 2010 at 04:48:57 PM EST
We should e-mail him this thread so he can see that Lehman was pawning the good stuff with banks. The Fed probably took the toxic waste.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Mar 18th, 2010 at 12:55:08 AM EST
[ Parent ]


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