SCOTTISH INDEPENDENCE CAMPAIGN

Scotland's First Minister Salmond, leader of his campaign for independence, when talking most confidentlly about future higher per capita income for all, he caveats his statements with the words "according to official figures", or similar phrases, because he, an ex-economist, knows that official estimates are no more than merely crude estimates. Scotland economy data is based on % UK population. It is not empirically calculated, only flexed slightly for a larger regional % of old people and fewer children, thereby giving Scotland a 'regional' per capita GDP above the UK national GDP per capita figure.The idea of Scotland being 'wealthier' or 'richer' than the UK is a mere figment derived from artificial calculations. Mr Salmond also knows that if recalculated for external trade, according to official government analyses, Scotland's National Income falls by at least one seventh. He also knows that half of Scotland's tax revenues cannot be captured within its borders, and that with capital flight and disinvestment both Scotland's output and government revenues will shrink. This is why retaining £sterling is so vital. Without that there is no prospect of avoiding having to finance a very large balance of payments deficit, especially with the rest of the UK, not even with the addition of Scotland's share of North Sea oil & Gas output, trade and tax revenue, and also to avoid needing a foreign currency reserve of about 25% ratio to GDP, according to the Bank of England. His Finance Minister, John Swinney, will be equally aware of these realities. Both politicians know full well that Scotland's financial services sector has no practical economic choice but to relocate to England, a very large hole in the hull of Scotland's National Income and tax-base. Yet, both Salmond and Swinney are unrestrained in their rhetoric, pushing an absurdly bullish macroeconomic forecast. Their selective gaming of economic facts is only matched by the astonishing willingness of what looks like half Scotland's voters to believe in politicians' prediction? That voters anywhere today should gamble so hugely on politicians' assurances is amazing, doubly so in Scotland, a country with a reputation hitherto for canniness and caution, the financial mess of its major banks notwithstanding. The nationalist politicians know they are misrepresenting macroeconomic facts and risking years of deep recession. They are cosseted in this enormous irresponsibility only by a sizable % of febrile nationalist voters prepared to pay any price for historic sovereignty. If Mr Salmond's assurances were a public company's investment prospectus or AGM statement, both would breach company law and become liable to future class actions. The independence campaign has ignored, or enormously discounted, the costs and risks of sovereignty that include massive falls in both government revenue and national income, necessitating deep spending cuts and other austerity measures to reduce the external deficits, triggering years of deep recession likely to take at least a generation (20-30 years) to recover from. This is not merely the political and economic costs of 'uncertainty', but a future cash-flow certainty. There is a warning in this too for UK voters when considering leaving the EU. Scotland is a far smaller part of the UK economy than the UK is of the EU. It is no more in the interest of the rest of the EU than it is for the rest of the UK to make leaving either costless or painless.

BONUS CULTURE GENDER VIEW

According to data compiled by Bloomberg from and index of 455 companies in 24 markets, banks, insurers and funds managers have disproportionately low %'ages of women in board level management relative to the % of women among all employees.
But, of the total workforce anyway only a minority are financial professionals and there is of course a very small % with line management and professional managerial roles. And, of these, only a tiny % number are bonus-earners (with the notable exception of Goldman Sachs where everyone seems to get some bonus however small in the case of most). What % of women get rich bonuses? In these highest earning echelons women are very under-respresented. We might also note too that in many financial services firms fully trained finance & banking professionals are a minority when they should be the majority? And therefore we can also ask whether professional training and conventional meritocracy based on trained knowledge are also unusually weak factors? How anyone gets to the top is questionable. And as we have seen in respect of understanding financial risk-taking the system works badly.
How the the untrained experts from other fields become top dogs in banking is a complicated story that many argue is responsible for the financial crisis.
Of course, in key jobs on which a business appears to depend critically 'representativeness' should be the least important of employment criteria.
That said, everyone knows and few dispute the "glass-ceiling" exists powerfully in gender bias. But, every prejudice and every trick in the book is bound to be operating at the top among those who are most competitive of all greasy-pole climbers. Under-representation of women is most important but only one of many biases that could be measured.In finance among all sectors, according to Bloomberg, women score the the lowest in matching the %'ages of women managers to workers. This may be unsirprising to those who know the industry from the inside. We may all know some women managers, but it is surprising in a major services industry when in services generally women score highly in both junior and (relatively) in senior jobs. Perhaps in another generation the data may improve significantly for women at the top?
Curiously the "materials sector" that includes mining companies, women are scored ebst in balancing its female workforce and directors, though in that industry just 18% of workers are women, while in finance they are 51% of total workforce.
Women are frequently overlooked in promotion stakes. They get less mentoring and sponsorship than male peers, according to Mervyn Davies, ex-CEO of Standard
Chartered Plc in a government sponsored report. He says the low number of successful female role models often compounds stereotypes.
We might consider asking the question therefore who by gender gets the bonuses in the bonus culture game? We haven't heard much if anything at all of women getting hard-to-square-to-total bank-performance big bonuses. One reason is that they probably don't get guaranteed bonuses to begin with (golden hellos in employment contracts).
Guaranteed bonuses should of course be classed as salary cost and not as "bonus". That would transform some firms' reported cost-ratios. Prime broker traders and their pit bosses are never women. I wonder what women employment is like in hedge funds - a few have had women CEOs (last time I looked).
Another question could be to ask what information is available internally in financial firms re. bonus distributions - probably none. The only information among colleagues is what comes out in media coverage (very general and very few names). What detail is reported to shareholders? - again little or nothing except a line item in AGM papers and annual reports?
One may wonder if bonus-culture is a boys-club device that in no small part disguises wage inequalities also between genders? Among all other reasons to complain about appropriateness of the bonus system gender inequality should be another - a matter too for the equality-police as well as for regulators, share & stock- holders and politicians?
In my view
- guaranteed bonuses should be separated from variable bonuses in the accounts.
- risk ratio amounts in bonus-earners' deal records should be proportionately subtracted from bonuses and withheld until risks in deals mature (are realised).
There is a fear of traders and other star bonus performers migrating if restricted in any one regulatory juridiction. CEOs can rarely change their employer and also their country of domicile. Lower ranked stars can do so much more easily. But allhave, most probably, an exaggerated idea of their individual worth and under-estimate the brand they work for, its long term relationships and the value of its capital. But, of course, so far, the moral and other pressure for lower bonuses is a voluntary not a mandatory requirement on management boards. Regulators have the power under Basel rules irrespective of politicians wishes to make lower or zero bonuses mandatory on any bank. As I have argued elsewhere it is like awarding massive earnings only to goal-scorers on a football team and relatively little to the rest of the team including goal-keepers and defensive backs. But the regulators, when assessing whether to intervene in these matters, are also thinking often about their future careers outside regulatory work among the firms they regulate. That regulators (both internal and external to banks and other financial firms) should have wholly separate career paths is part of Basel rules but these like some equally important other rules are very rarely respected. Regulations and company law and suchlike say nothing of course about gender equality. That is just another morality idea about fairness and social responsibility that banking in general considers to be merely a PR exercise at best with the least priority in an industry so universally despised?

LBG H1 2010 RESULTS COMPARED TO 2009

At above 73p the LBG shares are in profit for the government should it choose to sell its £22-23bn holding. Government decided (Con manifesto pledge) to set up its UK Banking Commission enquiry first (to report no later than Aug/Sept '11) before it will sell its bank shares (worth a total of about £60+bn in LBG & RBS). The Commission will cover similar issues as that of the pre-election "Future of Banking" Commission that involved views from all parties, banks and independent experts (see http://commission.bnbb.org/banking/sites/all/themes/whichfobtheme/pdf/commission_report.pdf).
The shares should show considerable profit gain over the next year or two?
LBG first half 2010 results
One of the interesting features of the interim report is that staff numbers have not been significantly reduced. This is comforting and shows that profitability was not recovered on the back of substantial job cuts. The almost half-nationalised bank (with 24-17% UK retail & commercial banking market share, less than the 30% usually quoted) exceeded market expectations to report underlying pre-tax profit of £1.6bn for the first half of 2010. Like other banks positive results this follows sharp fall in loan loss provisions and higher mortgage lending revenue. My own data below for end of 2009 shows UK banking market shares with LBG having the biggest share, if several percentage points less than the 30% reported to the European Commission when it insisted on the bank selling some of its banking network. The European Commission's competition DG is like national authorities keen that no market or major segment should have market players with more than 25% of the market. LBG could comply with that ceiling easily without selling off operating units and retail networks such as TSB in Scotland, Cheltenham & Gloucester, SW bank etc. There may be issues with regulators remaining concerning insurance and capital, but that too is resolvable.
How integrated the bank's two major banking licenses (Lloyds and BoS + Halifax)should be in operating general ledger and core banking systems is an issue. My view is the bank should retain a group integration at a high level only. The bank needs new core systems, but combining and integrating all systems, not just at this time but at any time, is a potential systems management nightmare best avoided.
Eric Daniels sponsored a top down risk appraisal of the HBoS books and his team should continue to refine the top-down rather than seek to replace it with the far more technically onerous bottom-up approach that I judge would encounter many problems to no additional benefit. The supervisory regulators need to understand the powerful benefits and practical good sense of top-down risk analysis, especially when Basel II systems including off-the-shelf leading black-box products remain buggy and need to move on to dramatically changed new generation products.
The balance sheet has shrunk by 3%, which is modest in the circumstance and could arguably be comforting to government concerned about maintaining bank lending levels.The data excludes repo asset swaps lying with the Bank of England SLS, mainly (over £50bn) inherited from HBoS. These should have amortised substantially.
Looking at the bank's funding it is also comforting to see little change despite the withdrawal of cross-border inter-bank lending and deposits. Funding gap financing has shrunk but only modestly. This suggests that the bank is not experiencing any financing problems, and that positive view should solidify now that the bank is back in profit, albeit it may be helped by the government share-holding.Little change in headline figures of a balance sheet after 6 and 12 months does not indicate no change. More than half of assets and liabilities should have been refreshed in that period and therefore the results show substantial stability in what has been a stress period for banks.
I judge from all the foregoing that LBG management, Daniels & his team, have taken a very mature and sensible approach - this is not eyewash - I genuinely believe from these figures that LBG management is doing a great job.
Insofar as I have criticisms it is entirely in line with the government's concern too about lending to small firms. I am entirely convinced that major UK banks could be doing more and I do not buy UK banks assurances, including that of BBA and even daniels himself who together are holding to a banks' party-line that firms are deleveraging and banks must take extra care to lend prudently only to quality business models etc. I think this is foolish and a blinkered view of two imperatives, 1. to rebuild customer loyalty and to recognise the macro-economic needs of 'UK plc', and 2. to do more to reassure government at a time of considerable anxiety about recovery and dare I say hysteria about urgency in spending cuts.
LBG's own chief economist's view is reasonably benign, but I think UK banks are not sufficiently cognizent of the important role they play in generating the recovery.The FT say that LBG results "are expected to bolster Eric Daniels’ position as chief executive after his position had appeared under threat earlier in the year following moves by chairman Sir Win Bischoff to sound out a replacement. But the bank was forced to defend how much it was supporting business through lending in the first half and the surge in profitability risks fuelling political concerns about the pricing power of the big UK banks. A big factor in the first-half rebound, the first profit since Lloyds made its controversial acquisition of HBOS, was a fall in losses on loans to £6.55bn from £13.4bn a year earlier. The bank also enjoyed higher profits on mortgage lending as it charged wider margins on new loans and funding costs fell. It exceeded its 2 per cent net interest margin target for the full year – a measure of the profit earned on mortgages. Mr Daniels tried to pre-empt possible attacks on the bank’s 25 per cent share of current accounts and mortgages, saying that the UK banking market was “fiercely competitive”".
I don't agree. I don't believe any of the major UK banks, except maybe Banco Santander's UK operations, are being anything like 'fiercely competitive', not yet anyway. The emphasis is on balance sheet consolidation (restructuring and some shrinkage) and on cost-cutting, and then too on possible sale of operating units. I say 'possible sale' because selling banking networks that are not fully equipped banks with stand-alone systems (+ other issues) are not simple but fraught with matters to be resolved only over a number of years. This is shown most obviously by santander's purchase of RBS's William & Glynn network with only £100m premium or down-payment and the rest of the undisclosed price (maybe just north of £1.5bn) to emerge only over the medium term i.e. 3-5 years!
LBG says it is on track to meet its government-set gross lending targets, having lent £15bn of new mortgages and £24bn of business loans in the first half of the year. We may trust the bank to do that except it continues to treat net lending to businesses as passive outcomes of gross lending (mainly loan recycling) and of customers paying down debt. When small firm lending is such a small part of the balance sheet, I wish the banks, LBG included, would at least see the sense and low risk of setting net lending targets that it knows it can fulfill - as a matter of strategic intent.
Mr Daniels said loan applications fell 25% since 2007 and that £3bn of the £24bn of credit it had extended is lying unused, that there was “very little demand” for loans. I wonder if he is getting the true picture from below. It is clear from loan officers and surveys that many businesses are angry at being turned down and are struggling to obtain loans.
The £1.6bn profit figure includes c.£300m one-off from integration of HBOS. The statutory pre-tax profit was £1.3bn, down from £5.95bn in the first half of 2009 – a figure the FT commented "was flattered by accounting gains on the HBOS assets". But, that is as it should be. Daniels was very clear over a year ago about working through the £80bn+ lower than acceptable risk quality of HBoS's corporate loan book, mainly SME and property sector lending.

Interbank lending & LBG at June 2010

A recent note by Credit Suisse banking analysts upgrade medium-term EPS forecasts by 9% and CS's 12-month target price to 68p from 60p (+13%), currently 54p, an expected gain of 26%, but only to get back to the price it touched on 26 April. The adage "sell in May and go away" was never more apt. LBG share price over past 3 months: On 26th May CS upgraded Lloyds to Outperform and flagged that sustained low interest rates would allow for a £4bn increase in mortgage revenues over the next three years. Yes, but meanwhile bank stocks fell, in part Euro sovereign debt crisis and otherwise "Basel III" new requirements, though mainly because interbank funding had again dried up, and because central banks are closing (not shutting) their overnight windows.
Base rate expectations fell since to record lows, but this coincides with spiking of private sector interbank funding rates to a 9 month high over concerns centred on the ECB's parsimony, withdrawing €450bn (£356bn) support package opened a year back to ease European banks over the financial crisis. This should bring ECB liquidity support back to 2006 level. The spread between the three-month US dollar Libor and the overnight indexed swap rate, commonly used as an indicator of banks’ trust in each other’s credit worthiness, almost trebled since May 1. Overall, Europe’s banks are facing a hit equal to about 10% of 2009 earnings to pay for increased funding costs in 2010, according to Citigroup research issued last week. Higher costs of unsecured funding for 24 European big banks would be c.€15bn ($18bn) this year, or 10% of net earnings last year, because of fears (absurdly exaggerated in my view) about sovereign debt exposure. I assume from this that the 24 banks on average currently need to refinance about €40bn, for which they had been relying on ECB over the past year for something up to half.
Europe’s banks are more heavily reliant on wholesale funding over durations of 12 months or less when compared to US or Japanese banks. Bank of England has tasked UK banks with getting longer term funding, but it is unclear what the longer end market looks like. All this bodes badly for governments wishing to disengage from banks this year or next year! The patients are not yet fit to walk without the central banks Zimmer frames. The image below does not show JC Trichet and A Merkel watching two bankers competing. Banks using central bank facilities at the ECB include UK lenders with branch operations on the continent facing a shortfall up to £100bn when the facility is removed. Spanish lenders are especially upset because they especially have been frozen out (or let's call it blackmailed by uneconomically high funding rates to refinance their funding gaps) of wholesale lending markets in recent weeks. They correctly warn of dangers in withdrawing the support given that the debt crisis is obviously still gripping the €uro Area (EA). Perhaps the ECB is trying to signal its confidence in EU President van Rompuy's hastily cobbled together €720bn stabilisation fund. But all must know that so far this is more back of fag packet agreed blueprint than a financially operational fact.
The central interbank base rate of Euribor and Libor may be only 10bp apart and histporically low, but this does not mean banks are finding it at all easy to refinance their short and medium term MTN or copvered bond (Pfandbriefe style) borrowings.Three-month euribor rates - a base measure of the rate banks are willing (plus a sovereign risk and bank risk margin) to lend each other are at 76bp, which should rise depending on how much banks borrow from the ECB in three - month loan programme.
The actual effective wholesale funding rates for MTNs etc. that banks can borrow at vary around 200-600bp (while for some some it is more than double this such as for Greek banks!)
With high borrowing cost and additional reserve requirements and negative real interest for depositors, the pressures on banks to continue to shrink their lending appears unrelenting? It is not unlike the sore head days of Credit crunch in 2008 when banks refused to pay the rates funding gap finance lenders demanded of them for fear of dissolving their profits only to lose far more in share price collapse and asset write-downs. The banks in their restructuring during the recovery period may simply have to accept loan losses for a year or two in corporate lending especially. But unless there is some government involvement and agreement among leading banks to do this, they will be punished by investment analysts; they are between the dogs and he fire hydrant.
CS considers the risk of liquidity regulation and bank taxes has eased as banks won longer time to implement new higher reserve requirements. CS expects a 5 year adjustment period, which is rather long in my view, too long for Euro Area banks before they are in their next bout of full-blown recession?
In the UK, funding is a central difficulty for the banks. They got over £400bn assets off the books, but central bank asset swaps (BoE's SLS & APS) and credit (depositor) guarantee (CGS) cost just over double Libor (85bps over LIBOR), which is therefore where they would like wholesale funding costs to be. For that it would help if UK sovereign ratings are lower, and that in turn would be helped if UK's external accounts improve.
CS, like others, assume that when SLS and APS repo swaps are ended (sometime in next 2-3 years) the replacement cost should be far lower than additional mortgage net interest profits. How it works is not quite like that.
The banks did not receive funding when they repo swap 'sold' their £470bn assets (£185bn + £285bn) which mainly helped to halve UK banks' total funding gap as well as generate preference shares in place of arrangement fees; they received treasury bills and a BoE cheque, which are not meant to be encashable. These can be swapped back. The banks then need to internally or externally fund the gap at the time on the liabilities side of the balance sheet and provide capital reserves to support the assets (depleted by probably 25% amortisation) i.e. £300bn, RWA £150bn = £12bn regulatory capital plus £5bn economic capital buffer = £17bn. We might assume half of this is fundable from retained net interest income profits internally generated capital) and half from own portfolio investments.
Funding gap financing may then increase by a third (based on today's numbers) and hopefully the cost of this will be economic for the banks with respect to corporate lending margins especially i.e. well within them?
LBG averred from APS but must have about £70bn of the SLS assets (my guess, of which £55bn is HBoS legacy). On unravelling the swap repo this may be closer to £50bn for which liabilities need to bulk up.
Following September 2008, central banks expanded their balance sheets to save the banks (and underlying economies) from blackmail by private lenders. Blackmail may be too strong a word since private funding sources discovered they had problems too in maintaining their leverage. It was all somewhat circular; left and right hand confusion. The question for the sovereign debt crisis has to include asking whether ECB did enough. Most would answer a strong no, and certyainly it seemed foot-dragging compared to US and UK central banks. As central banks seek to shrink their balance sheets back down again, alongside governments shrinking their budget deficits, balance sheet shrinkage by commercial banks is likely to have to continue! This could be a deflationary catastrophe. It is only relatively the case 9against a negative trend) that this 'deleveraging; by commericial banks may be less severe with looser liquidity regulation. Mortgage lenders are worried however about their ability to refloat the mortgage market.
LBG is the biggest. And as the biggest in UK domestic banking we might see LBG as a bell-weather for the sector. CS say that lower CPR rates in the mortgage portfolio point to slower balance sheet reduction at LBG. While this is unhelpful for the long-term funding structure of the bank, it should assist medium term profits.
CS now see "9% growth in pre-provision profits in 2009-2012 from a combination of passive mortgage spread widening combined with cost savings provides transparent pre-provision profit growth. Securitisation data also points to stable mortgage arrears and declining unsecured and corporate NPL in the UK." CS think it is too early to reduce impairment forecasts but this is encouraging.
CS also say that "Normalised ROTE could look good in the medium-term: Despite an equity tier 1 ratio of 11% in 2012, we believe the group could generate ROTE of 15% in that year assuming a normalised 70bps impairment charge."
CS's valuation upside: "In the long-term and as a function of higher base rate eroding mortgage margins (more than offsetting additional deposit revenues) we don’t think this level of ROTE is sustainable. But such a scenario is now 3-4 years away. In our valuation, we apply a small premium to TNAV and after adjusting for the unrecognised pension fund deficit we arrive at a 12-month target price of 68p (versus 60p before)."
It seems obvious however that bank shares remain volatile, subjected to short term broker-dealer profit-taking, other short term traders and shorters, and hedge fund macro-strategies. Much will change in the medium term, not least resulting from the government's banking Commission looking at break-up of the big banks - more on this later.

UK BANKS PERFORMANCE Q1 2010

I had to laugh, though no offence intended, when KPMG press released announced breathlessly, "Economy will drive banking performance in 2010, finds KPMG's UK Banks Performance Benchmarking Survey..." OMG, how can that be? How could banks let themselves play second fiddle to the economy. the economy is only the benchmark surely and big banks have for years outperformed that poxy benchmark. But, look where that got to?
Credit Suisse (CS) undoubtedly have one of the very best teams analysing banks and some of my observations (duly marked) below come from them. The problem I see it is that for some time yet banks are short term 'plays' from an investor perspective.
Banks' share price projections are interesting for the next 2 years, but in that time, in the UK especially, much may change as a result of competition enquiry, possible big bank break-ups, new entrants, risk becoming nationally defined as a result of the sovereign debt crisis, possible Euro Area recession imminent, banks reptariating their lending, banking and trading books shrinking, problems governments want to overcome to force banks to grow lending to boost recovery when lending is still in retreat, and the impact of Basel III regulations requiring larger capital, liquidity and economic capital buffer reserves.
Economic recovery and getting a better external sovereign balance depends on manufacturing, which has half the world share today compared to 1980 (2.6%/5.2%). Yet, UK manufacturing on which most of our exports depend has been weak for years and has a long way to climb back to support the coalition government's OBR rosy forecasts. It is 17% of UK GDO but gets bank credit equivalent to 5%/GDP (compared to 30%/GDP in Germany). UK bank lending directly supports 28% of UK exportable tradable good production compared to 42% in Germany! This is a january 2010 graph: If UK banks are to positively help recovery they have to lend more to business and less to property, unless we are merely to try and return to a credit-boom economy and risk higher external trade and payments deficits, which means returning to securitisations to finance those deficits? UK business has headroom to carry a much bigger debt servicing cost. UK banks lend 1.5% of non-finance customer loans to small firms and self-employed (who provide half of all private scetor jobs). In Germany the figure is ten times higher! If UK banks did more to lend proportionate to all economic sectors their performance would both help economic recovery significantly and be assured of gaining from that recovery fully. Instead, the usual risk and shareholder valuations are based on "book values" (net assets) irrespective of their economic composition.
CS believe banks should be valued on book - of course, even if many have market values still below 'book'. My view is they should be valued by a basis point calculation of both sides of the balance sheet to determine the cyclical strength of net interest income. We are still in a period when one-offs including sales of operational units, asset disposals, asset swaps, bad banks, fee income, tax adjustments, state-aid, bonuses (deferred or not), other restructuring, systems investment, redundancies, and so on, dominate net profit before tax, when stability would mean that net interest income has returned to a dependable amrgin and inter-bank lending is economically priced. The recent bank of England Stability Review stated that funding markets (for banks to refinance their funding gaps) have been effectively 'closed' (uneconomically priced) for the past two months of Europe's sovereign debt crisis. There will be more such crises hitting banks' funding.
The Bank of England also notes that UK banks' funding gaps have almost halved. APS played its part in this alongside banks shrinking their loanbooks, which the economy experiences like a hole in the head. I'm presenting a paper in Germany next weekend to economists, MEPs and journalists.
This is about banking and the euro crisis that I've playfully entitled DAS euro BOOT (find version of this on www.asymptotix.eu). I've identified bias in different member states' banking lending that creates and underpins whether states are export-led, credit-boom, or a mix. Regulation needs to have the power to task banks with restructuring their lending portfolios in credit-boom (typically 70% of non-financial customer lending exposed to property and mortgages) and export-led economies (typically 60% of bank lending exposed to industry and trade). The €720bn fund that European Commission President van Rompuy has cobbled together is intended to reassure the markets. It like the Federal reserve's TARP in size and intent. Congress had to vote it and took a large slice to determine the precise allocation and ensure everything was duly reported. I would like to see the European Parliament getting similarly involved because I am doubtful of the European Commission having sole charge of a fund worth five years of Commission budget! It is not the same as US Federal Reserve and Treasury or the Bank of England and HM Treasury, or the ECB, IMF, or the newly envisioned European Banking Authority. The EU and Euro Area simply do not have financial institutions with the power and flexibility of the USA and UK. This European Stabilisation 'Bank' fund is being set up entirely within Commission control for which experience and skill-set, and much else, are not in place, and would normally take a couple of years at the very least of detailed preparation to get right. But, in the crisis there is understandable panic to be seen to be taking action. "Stitch in Time" failed as it is bound to when so many stakeholders have to be appeased politically. The fund is five times the Commission's annual budget, which already tests the Commission's accounting beyond its sometimes tawdry limits! I think the whole matter needs European Parliament's scrutiny starting now.
Banks are so intertwined, unlike competing firms in most other 'industries' that all of the above and more are uncertainties unnerving banks' performances. CS say recent events highlight that “normalised” earnings performance is illusory distraction because of structurally challenged balance sheets. When that is the case, banks can get into self-harming spirals of not extending new lending waiting for others to do so first before they will and so all hang back. When valuations of UK banks can fall 25% in a month, there is considerable nervousness, uncertainty and also short term profit-taking and shorting still dominating the market.
Clear risks remain: Market dislocation is unhelpful for a sector (UK) with an NSFR of 85% (including SLS and APS) and £300bn of wholesale redemptions in 2010-12. The banks (particularly LBG) need funding gap refinancing markets to reopen soon (also called 'term markets', with Bank of England calling on banks to both speed up their medium and longer term note borrowing and shift borrowing to longer term, which is very hard, if not impossible, when margin spreads appear uneconomically high!). The Bank of England said term markets (for banks refinancing their funding gaps) have been closed for 2 months and UK banks need to refinance about £700bn in next 18 months or so! banks are undertstandably reluctant to fully disclose their liquidity financing for fear of being blackmailed by lenders.
CS says "wider LIBOR OIS spreads (are) unhelpful", an under-statement since as all should know this issue is The Credit Crunch i.e. that beast is far from vanquished. This catastrophe is the effect of the sovereign debt crisis's pisspoor political and instutional handling so that what was a way of shorting profits from bank stocks is now a way of shorting them again via shorting governments.
CS believes LBG has more liabilities than assets priced off LIBOR and that this exposure is increasing. maybe, but I can't believe that is a serious problem. CS think Barclays and RBS have a net asset exposure but this is likely to be marginal.
Weaker sterling will lead to what CS call "RWA inflation" whereby Tier 1 capital reserves have to increase. But, in my view the ease with which banks have grown their liquidity reserves suggests they can without too much difficulty increase their Tier 2 capital and by taking loan loss provisions against Tier 2 help to secure their Tier 1 ratios.
CS says this mainly affects Barclays where CS think the 6% drop in £ versus US$ since March 2010 will boost its RWA by around £10bn (£0.8bn higher Tier 1), but I can't see that as a problem, and CS anyway say that euro weakness should partly offset this. They all got Market Risk RWA wrong and many had severe bugs in their Credit Risk accounting engines (the reason for Fortis's collapse). RBS has plans to spend £6bn on new accounting systems. All major banks have a few $£billion of similar requirements medium term, not least new general ledger systems with more headings and risk accounts.
My view is that RWA is a dog's dinner in the banks' calculations and as they improve their systems at regulators' urgent behest there will sizeable RWA increases anyway that eclipse currency moves, even early years of recovery in collateral values. Such effects will be lost like odd socks in the wash when risk data is more accurate, more complete, and above all makes a 'success', any kind of success, of Pillar II of CRD (Basel II), Solvency II, and IFRS accounting standard. Pillar II is really what so-called Basel III is. All of Basel III is already built in or available as discretionary power to regulators within Pillar II. What is that? essentially it is where the banks have to collate holistically all their risks (not just credit, market and operational risks) and relate these to the bank's performance in the context of the underlying economie sin which they do business. Insightful readers will immediately think this is beyond the intelligence of bankers and even of their systems. Yes, that's so and why the banks are resisting like pack-mules on the beaches at Gallipoli. This is the massive heart and core of basel II that aims to transform the management culture of banking, and as all know cultural change is the hardest challenge.

BASIS POINTS IMPACT ESTIMATES
CS estimated the impact of the Basel III proposals as if implemented at end 2009, including an uplift for Counterparty Credit Risk (CS's special feature that it exclusively spotted), would be c280bps for HSBC and c150bps for Standard Chartered. These are sizeable hurdle-rates that should percolate through all of the banks' business units. But, if the cost of borrowing and underlying net interest income can meet this half way or better, then the impact is mitigated. But, that is a big if? CS says their cost impacts compare favourably to an average impact of 470bps for UK's more domestic concentrated banks. In aggregate, UK major banks have only about half of their customer lending domestically.
But there are positives. CS say recent dislocation has left the sector trading 15-20% below 2010 ETNAV, importantly leaving base rate expectations much lower – money markets price in 1.2% at December 2011. This reduces tail risk in problem loan portfolios (corporate lending) and reduces the risk of new NPL formation by UK banks.
Low rates help mortgage revenue, deposits already taken the hit. CS expect the spread on UK mortgage loans to increase 150bps over the next 2 years. Deposit revenue will struggle, but CS believe a drag of £19bn has already been experienced, with income now negative.
CS say UK bank balance sheets are also in better shape. In 2008, balance sheet structures were weak, opaque and poorly marked. Today, the equity tier 1 ratio is 10%, CS estimate that 12% of loans have been written down since 2007, and liquid assets cover 90% of 3-month funding (20% in 2008). This should help on the credit risk side.
More upbeat: In the long-term, CS's structural concerns remain strong. CS think the UK banks are investable and at current levels offer value. CS is conservative in its target price model. CS value Barclays at 365p offering 29% upside, RBS at 54p offering 26% upside, and LBG at 60p offering 20% upside potential. These are strong forecasts, but over 2 years, by which time there will have arrived the shock downward effect of Euro Area recession in my view.
On the major two banks with emerging market and least proportionate UK exposure, CS offer this: CS increased 2010E PBT for HSBC by c13% following the Q1 IMS - driver being lower impairment and stronger GBM performance, particularly in the US. Standard and HSBC delivered upbeat Q1 IMS statements of strong Q1 wholesale banking performance, and lower impairment trends. But, this may also reflect demand on HSBC for funding support for financial firms' restructuring where HSBC participation greenlights others? Funding and liquidity positions "screen" better than UK domestics. CS estimate that HSBC has an Net Stable Funding Ratio (NSFR) around 98% and Standard around 105%, which compares favourably to the UK domestic banks average of c82%, on CS estimates.
Standard Chartered’s capital position looks good. This is partly because its In CS's view, Standard "screens better than HSBC on funding and liquidity and capital regulatory proposals". In part this is because much of their banking is outside hard-core Basel II territory of EU mainly - elsewhere the regulators are behind the curve. CS also sees Standard as a purer play on Asian market growth with greater revenue momentum, whereas the driver of HSBC’s earnings in the near term remains improving credit quality in the US (if, in my view, current high GDP growth continues and there is labour market good news).
In my view there is a big risk on being over-exposed to Asia, China especially, because bank lending there is heavily supported by state funds (all China's foreign reserves are loaned to the banks' liabilities) and there is I believe a crash coming. many investors in Asia may wish to squeeze the last of the upside before parachuting out, but if I was heavily invested there I would be anxious to be one of the first out the door.CS's RBS note is interesting on 3 points looking at the bank's Q1 IMS statement:
1. A return to profitability - excl. exceptional items and stripping out debt charges, the group posted a £0.7bn PBT in Q1 2010 after average quarterly loss of around £1.3bn in H2 2009. To my thinking this is accomplished by window-dressing and not yet reliable. There were improvements in core and non-core. Non-core losses of £1.6bn compared to a quarterly loss of £2.6bn in H2 2009. Core – PBT of £2.4bn from a quarterly profit of £1.3bn in H2 2009. Both benefited from a sharp reduction in impairment charges and trading losses. In my view they suck if there is not a big improvement in net interest income. the debt charges are significant and long lasting when they include APS - and one needs to know if the 3285bn in APS assets are net performing or not, and who gets that money, RBS or BoE and what RBS's management fee is for managing the underlying?
2. Pre-provision profits in core - excl. debt charges, these total £3.4bn in Q1 2010 versus c. £2.5bn in H2 2009. The improvement was (like HSBC and others with investment banking) driven by GBM revenues - but £2.8bn, down 35% on exceptionally strong Q1 2009 (£4.4bn) but up versus a quarterly run-rate of £2bn in H2 2009 - and an abnormally large contribution from Central Items - which spiked £0.3bn from a loss of £0.2bn in Q4 2009 (all excl. fair value on own debt). CS says (old story) "This seems one-off, driven by non-IFRS economic hedges and a one-off VAT recovery of £0.2bn." CS notes that outside of GBM and central items, pre-provision profits were very lacklustre despite an improvement in the core margin to 2.11% versus 2.06% in Q4 2009; I worry that RBS is losing clients?
3. TNAV across the group - CS note this came in at 51p at March 2010 versus 51p at December 2009 with the small profit . The equity tier 1 ratio was 10.6% from 11.0% at December 2009 with RWA up 5% due to Basel I ABN Amro capital relief trade roll off (£16bn) and currency. CS had £15bn ABN Amro impact in the numbers at the full year stage anyway. Overall, the main focus is likely to be the return to profitability in Q1 2010 and hence the potential for the TNAV of 51p to represent a floor to the share price.
But CS has two lingering concerns that to readers who are not professional investors may seem opaque or arcane:
1. Around 12p of the 51p TNAV is non-core, on CS estimates, and likely to deplete further moving forwards. CS think investors are really paying for the 39p in core and any residual left in several years time in non-core. The book multiple is not, therefore, as attractive as it superficially appears;
2. The core business generated around 5.8p in Q1 2009 annualised, but normalised CS think this was nearer 4p. CS assume impairment at 80bps (which boosts the EPS) but assume a more normal revenue run-rate of £9bn per annum in GBM and no contribution from Central items. CS also take out the contribution from the businesses that RBS is being forced to sell by the EC.
To buy RBS therefore, CS say "investors must believe that the pre-provision profitability of the core businesses will improve markedly in the next few years". Otherwise the shares are trading on 12 times forward, normalised earnings which CS doesn’t think is cheap. This is feasible given the continued improvement in margins and cost program, but there are also likely to be headwinds in the other direction like additional taxes and deposit protection levies. In summary, while CS think this is a fairly decent set of numbers from RBS, CS believe the market pre-empted this and don’t think the valuation is cheap.
Finally, no one is guessing openly just now when the Coalition government will sell its RBS and LBG shares maybe when they hit £60bn. But, the government is committed to a year long competition review (no longer than 1 year) that will consider breaking up the banks to split investment banking off, and possibly splitting Natwest from RBS and HBoS from LBG (my guess) and perhaps share sales can then only happen after such mighty decisions are made?
Note that CS is not being very sensitive about the impact on reported earnings of Basel II - this is because Basel III has more of a restructuring internal redistributive effect than a net performance effect, at least not directly on distributed profit, which has other additional hurdles.

LEHMAN BROTHERS: THE SEQUAL - ANTON VALUKAS REPORT

If 'plain vanilla' (envelopes) stand for 'openness' and 'transparency', 'brown manila' must mean the opposite, standing for bribery and corruption,or manilla, an ancient African currency. The Valukas Report is a thriller in manila that needs 2,200 pages (after the investigators read 34 million pages out of 360 billion pages provided, pages almost all of which have never been read by humans, which, by the way, is 20 times bigger than the entire Library of Congress) to get just one bank's shady dealings spotlighted.
The final report is 10-20 times a typical company annual report or a central bank's stability report. Banks' regulatory reports are about 500 pages, banks' risk policies, and the governing regulatory laws and risk accounting standards several thousand pages more. Senator Chris Dodd's Bill is 1,300 pages. How much time do board members of banks spend reading all these essential weighty tomes, or do they rely on news-article or email-sized summaries? Such reports in corporate libraries and computer archive disks, they get laid down like fine wines in cellars. Regulatory law says that's not good enough, not legal; directors of banks should read and understand all of this. But they don't and case law jusgements will now test whether that is a plausible defence for character like Dick Fuld My wine cave is laying down soft commission ’07 and ‘09 vintages, but I’m keenest on the ‘08s – to be trayed to table in future years to flutters and gasps of male and female alarm, panic, and approval, accompanied by my stentorian words, “ye’ll all be recalling 2008 Atlantic Hurricane season when Capitalism turned turtle, hit the rocks? Where were you when Lehman fell like Icarus, AIG, Fannie and Freddy, busted and nationalised, Merrils sold for a song to BoA, Fortis ripped apart by 3 governments, Lloyds’ £10 billion secret Blank cheque to save HBOS? (pronounced ‘aitch-boss’), and central banks’ balance sheets quadruple, oh, and Manchester City used Gulf oil money to pay £32 million for Robinho?”
Then, maybe too, “d’ye mind 18 months later, March 2010, just when we all thought it was safe to go back into the markets, Lehman brothers and Dick Fuld (pronounced 'fooled') was back in the news in stunning 3D, the Anton Valukas report?” A long movie - all the shark-bite facts fit for print on what happened; the how and why of Lehman’s bankruptcy, the most iconic event of The Credit Crunch – showing everywhere near you except in cinemas, starring all your favourite characters, the directors, regulators and producers of September 2008's Towering Infernos! The law firm Jenner & Block, a team led by its Chairman Anton Valukas, examiner for the NY bankruptcy court, in its report just published on Lehman Brothers (also a major bank in the UK at the time, employing 5,000 in The City) portrays the investment bank's chief Dick Fuld and his executive as criminally indictable - for the court to decide if they are guilty or simply gullible, hubristic and incompetent. The case depends on how well they can be personally tied to balance-sheet shenanigans that could land not only them but also their auditor, Ernst & Young, and London lawyers, Linklater's, in court. The shell game played by Lehman Brothers for years was latterly, near the end, worth at least $50bn, another 1 x Madoff (Note: global credit crunch directly-linked writedown losses are in the region of 50 x Madoff; indirect losses are a lot more, possibly another 50 x Madoff).
E&Y say they stand behind their accounting and approval for Lehman's internal accounting - at least insofar as what they could see? Reportedly, emails show that Fuld and his three successive CFOs did know about $30bn growing to $50bn being wrongly (illegally, fraudulently, certainly a breach of Sarbanes-Oxley) moved off balance sheet by redefining loans as asset sales. Regulators, especially the SEC are being satirised for blame alongside E&Y and Lehman's top managers 'cooking the books'.
Of course, Lehman's leverage was obvious even from the published accounts, and capital weakness, even without knowing that $50 billions had been three-card-tricked off the balance sheet.
(Latest news: Other Wall Street bulge bracketeers, Merril-Lynch warned The Fed and SEC months before September that Lehman's liquidity could not be genuine, just as Fuld & Co. claimed their liquidity reserve ratio the highest on Wall Street and M-L's clients were anxious that M-L's liquidity might be too low. The authorities were absorbed in other problems and probably concluded this was a case of bad-mouthing rivalry, pot calling a kettle black! It is not normally hard for banks to free up liquidity if they really have to. I therefore assume the M-L whistle-blowers had the benefit of a Lehman informer, though it is remotely possible that M-L could have calculated that Lehman's leveraging was so totally maxed-out that it must be counting pledged collateral in its liquidity accounting? Valukas confirms that Lehman did precisely that - count encumbered assets as if unencumbered and near-liquid!)
The Valukas report is a must-read for all risk and finance officers, as too for all bank boards and audit partners. NY Governor Erwin Spitzer has on MSNBC concluded it is time for handcuffs i.e. criminal charges, and he wants all emails released for public scrutiny. This is resisted by US treasury and Federal Reserve.
In the movie Casino Royale if Anton Valukas is Bond, Fuld is Le Chiffre, a name meaning number and cipher to hide the true meaning of numbers and text. To get it published 'the examiner', Mr Valukas, had to get to court to ask a Judge to unseal its contents, after many people and firms interviewed for his legal forensic probe refused to agree to lift their demands of confidentiality, afraid for the consequences of revealing what they knew. What obstacles did our hero face? Were the bad guys out to stop him, including maybe some hedge funds and major banking corporations? Anton Valukas (aged 66) spent a year and $34m (or $1 per page of evidence read by human eyes) interviewing 100 people and reviewing 10 million documents before drafting a 2,200 page report. (see comment note 5 below). They investigated various contextual matters too, including if rival banks seeking to benefit by its bankruptcy were partially responsible for it?
Valukas made it to court, put his case in a court filing that the report should be made public, and won! It is unquestionably in the public interest that he succeeded.
There have been other lesser reports uncovering scandal in both the USA and Europe, for example various enquiries into Fortis and the Irish Government's enquiry into Anglo-Irish Bank (for references see end of this essay). If there was an enquiry into Halifax Bank of Scotland, RBS and other banks the findings would in certain areas of property lending and structured products look very similar!
In the first section one statement stands out for me that Lehmans in going for 'aggressive growth' embarked on a 'counter-cyclical' strategy i.e. it decided to ignore macro-economics, which for me is a claim that can also be levelled at RBS in its takeover of ABN AMRO that involved buying that bank's structured product toxic assets - a counter-intuitive hubris on the model of King Canute! Some banks considered themselves above and bigger than the underlying wider economy!Repo 105 worked like this, according to Volume III of the Valukas report: Lehman employed “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, to create a materially misleading summary of the firm’s financial condition in late 2007 and 2008. Similar to ‘channel bulking’ where inventory for sale is booked as if ‘sale agreed but not yet transacted’, Repo 105’ers were nearly identical to standard repurchase and resale (“repo”) transactions used by Lehman and other investment banks to supply short‐term financing, with one difference: Lehman accounted for Repo 105s as “sales” as opposed to financing transactions based on over-collateralization or higher than normal haircut in a Repo 105 transaction. By re-characterizing the transaction as “sales” Lehman removed the inventory off its balance sheet in the days before reporting period cut-offs to reduce its reported net leverage and balance sheet size. "Lehman never publicly disclosed its use of Repo 105," the report says, even though Martin Kelly, the bank's chief financial controller, raised the issue with Ms Callan and her successor Ian Lowitt.
Lehman did not disclose the cash borrowing from the Repo 105s, although it had actually borrowed tens of billions of dollars, hence did not disclose the obligation to repay the debt. The ‘cash’ from the Repo 105s balanced or paid down other liabilities, reducing both total liabilities and total assets.
A few days after the new quarter began, Lehman would borrow the necessary funds to repay the cash borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet. Reportedly, the accounting treatment via Lehman London was approved by the UK lawyers, Linklaters, and by Ernst & Young, Lehman’s independent outside auditor, perhaps with provisos, we don't know yet, but the dialogue between bankers and lawyers, as between traders and risk officers, is often fraught by "I'm the client; you're my servant" presumptions, and by language difficulties, not as merely like different common tongues, more like different species trying to communicate, or not? The Valukas report castigates "Repo 105" – a set of accounting techniques that removed approximately $50bn of assets from the bank's balance sheet for the two quarters before it collapsed. This was not the worst of Lehman Brothers misjudgements, but closest to outright criminality. To date most of the criminal charges that a few hundred bankers have been arraigned for to date have been 'insider trading', knowing and saying one thing in private while something quite opposite in public, which can also be a breach of fiduciary duties and banking law codes of conduct. Then there was Madoff's blatantly 'naked' Ponzi scheme. Lehman Brothers' errors are a mix of these and several other wrongdoings such as ignoring their own internal risk limits and being totally casual about capital reserves, especially liquidity reserves - something all banks now have to deal with, with much higher capital and liquidity reserves.By divorcing the collateral assets from the loans and then leveraging on these in market trading, these assets could no longer be backed by liabilities on the balance sheet and so had to be hidden - a clear case of balance sheet misrepresentation that shareholders and regulators will be very angry about and will be severely cross-examined in court with appropriate lessons drawn.
Repo 105 was part of an effort to scrape together as much firepower as possible to buy high coupon asset backed securities when they suddenly became cheap in 2007. It was for a very aggressive bank with vaulting ambition to rival Goldman Sachs itchingly achingly tempting in the midst of a financial crisis to buy distressed ABS CDOs cheap for bumper 40% yields - over 35% above what were already high coupons to face value on supposedly highly rated bonds whose cash-flows were supposedly ensured by insurance and standby capital enhancements. This ran into deouble-default risk i.e. the outcome of systemic domino effect crisis that this and other banks totally under-estimated.
Lehman had a history of counter-intuitive bets - who didn't. Lehman bet that securitized bonds were only temporarily cheap. Other banks such as UBS, ABN AMRO, Fortis and RBS, even BarCap except it was lucky in not closing take-over ambitions for ABN AMRO, UBS or Lehman Brothers in its entirety; all made the same mis-judgement and all under-estimated how destructive the mark-to-market writedowns would be to their capital reserve ratios, cash-flow and bottom line.
Leverage had by late 2007 become a focus of the ratings agencies as an indicator of bank risk, which meant Lehman had to focus on reducing its publicly known leverage to avoid credit rating downgrade, a bank with $700bn in tangible balance sheet assets (excluding $900bn derivatives) supported by only $23bn equity of which only $7.3bn was cash or near-cash. This chart shows quarterly leverage trends up to Lehman's collapse. If Lehman Brothers used false accounting to reduce its leverage ratio, the question arises as to how precisely did the other investment banks concoct their deleveraging? The bet that ABS would be sustained in asset value by robust underlying positive cash-flows and recover their sale value was a disincentive to dumping ABS CDOs and betting off CDS, quite apart from the siezed up, very illiquid, market available for doing so - and the gambit hope that values would bounce back soon proved delusionery.
CMBS and RMBS containing large amounts of subprime loans continued falling in asset values even when the underlying cash-flows remained relatively firm. They became almost totally illiquid in the secondary market because too many holders could not refinance their short term borrowings used to buy these long term assets; too many players had to sell i.e. they couldn’t find ready buyers without the price falling catastrophically. Hedge Funds were even hanging back waiting for discounts of 70%, and only when the ensuing recession looked like touching bottom before they'd pounce!
Lehman could not shrink its balance sheet by selling its structured product assets without incurring large 'realised' losses that would hit not only its p/l but negatively expose the bulk of its remaining assets. Recognising this, eventually, the bank knew (like RBS also recognised in the hardest way) that it had instead to find a buyer for the whole bank - even then it found that no one wanted to buy the bank except without its distressed assets, its massive property and property-related portfolios - a problem Bear Stearns had spectacularly encountered in late 2007 and first quarter 2008 - everyone knew they were selling anything they could in private deals at 20c in the $. Was it too late for the others to learn the clear lessons?
It is genuinely hard for banks (most banks) to wake up to a changed world and see themselves reflected as others now see them; their subjectively imagined beautiful brands now so distorted by how the markets and short sellers (especially their erstwhile hedge fund compadres) were reflecting back another image, a suddenly entirely negative one that just looked like errant distortion of fundamental 'hold to maturity' values? Experienced traders know that trading on fundamentals is like a stopped watch that only tells the right time twice in every credit cycle. In Lehman's case, the execs must have known that their beautiful numbers were only skin-deep.
Repo 105 that the bank increasingly used in 2007 and 2008 even breached its own internal cap on Repo exposure (about $22bn as of summer 2006), which from a regulatory perspective is an illegal failure of governance, given that limits are reported to, and approved by, the regulator, in Lehman’s case the SEC.
Valukas's findings are designed to help the court and the bank's trustees establish what legal grounds exist for future claims. The explosive report highlights:
- Use of accounting tactics designed to move $50bn off Lehman's balance sheet;
- Work of auditor Ernst & Young;
- Barclays' subsequent purchase of Lehman's US assets; and
- Evidence to "support the existence of a . . .[valid] claim that JP Morgan breached the implied covenant of good faith and fair dealing by making excessive collateral requests to Lehman. "The demands for collateral by Lehman's lenders had direct impact on Lehman's liquidity pool."
- None of Lehman's directors breached their fiduciary duties in the run-up to Lehman's downfall, but they should have exercised greater caution in decisions taken, but did not cross the line into "gross negligence".
The mis-application as assets that were really encumbered as repo collateral is not a practise that was exclusive to Lehman Brothers, but practised, according to insiders, by other prime brokers - related to the practise of 'rehypothecation', a term that should now attain star-billing alongside 'sub-prime' and 'toxic assets'?The report also discusses the long-running legal battle between Barclays (a shareholders' suit for $10bn compensation). Barclays bought the bulk of Lehman's US brokerage assets after it collapsed – and Lehman's trustees. Mr Valukas found the appearance of a "limited amount of assets (belonging to Lehman)were improperly transferred to Barclays". Lehman's trustees' (administrators and also the shareholders) claim that Barclays received an $8bn "windfall" when it bought the assets? As I and others have commented before, Dick Fuld, Lehmans capo di capo is Hollywood Casting's villain as recognised by Main Street. Seeing him in court will be a major crowd-pleaser. Whether the intricacies of argument and counter-argument will be over-ridden by Fuld's unappealing demeanour remains to be seen. We will not see a "Save Dick Fuld" "let Fuld go free!" campaign. We all remember Arthur Andersen's demise following similar enquiry and cases related to the collapse of ENRON! Doubtless the global big 4 audit firms beefed up their professional indemnity cover following ENRON. If E&Y is severely damaged or goes under then I foresee the force of law also being turned more assiduously onto others, other banks, auditors and the credit ratings agencies!
Was Lehman murdered or is it a clear case of suicide?JPMorgan and Citigroup helped trigger Lehmans downfall, but they were involved in similar hypothecation practises (see below) - something they came to regret. Hank Paulson has since publicly regretted his failure when US Treasury Secretary to negotiate a rescue - torpedoed when Barclays backed off from buying Lehman as a going concern (going as in going bust) for lack of US Federal Reserve guarantees plus the FSA's refusal to waive a shareholder meeting, and Barclays's own board's nervousness.
Valukas also found that the two Wall Street banks, JPM and Citi, demanded significant amounts of capital and extra guarantees from Lehman (collateral margin calls - how Citicorp also sank Bear Stearns 6-9 months earlier!) in the run-up to Lehman's downfall. JP Morgan Chase requesting $5bn (£3.3bn) just three days before Lehman's bankruptcy filing.
Ironically, neither bank (others too) has in the 18 months since Lehman's fall been able to calculate exactly their assets and liabilities with Lehmans outstanding at the time of its bankruptcy, possibly also because they didn't wish to just then, and not so long as quarterly results remained highly market sensitive, and not so long as banks were turning to toast. In this febrile atmosphere there was the idea, I believe, that one bank had to be sacrificed to lance the boil, take the heat, and maybe make others look good, at least better comparatively - a bone to the baying dogs - and no better-looking fall guy than arrogant Napoleonic Dick Fuld. There were moral hazard arguments and the idea of teaching banks a lesson they won't forget - arguments for not saving Lehman Brothers. The influential American central banker, FT columnist and ex-MPC member at The Bank of England, Wim Buiter, to take but one example, worried a lot about 'Moral Hazard'. He wrote at the time, in September '08, "... since Bear Stearns crashed, the US Treasury has, through its de-facto nationalisation of Freddie (Mac) and Fannie (Mae), taken an additional $1.7 trillion of debt on its balance sheet, as well as a $3.7 trillion exposure to mortgage- and MBS-guarantees, with a fair value of around $350bn. If the US Treasury, either directly or indirectly … were to offer financial support for a rescue of Lehman or for any other investment bank (or commercial bank, for that matter), the floodgates could open and the fiscal-financial position of the US Federal government could be materially affected. Japan not that long ago shared a sovereign credit rating with Botswana. A trillion here, a trillion there and the US Federal debt could lose its triple-A rating!" With benefit of hindsight this was looking at the problem down the wrong end of the microscope. One can argue that the U.S. economy was experiencing a normally severe recession shock until the failure of Lehman Brothers, with, until then, the business cycle index bouncing around -0.5. After that shock, financial market conditions sent the economy sharply downward.
There were fire-sales, but Buiter's fair value of ABS at 90% discount to face value of the underlying assets was an absurdly low estimate - anything below 40-70% discount was absurd.
But, the floodgates opened anyway; credit crunch worsened again after Lehman went into Chapter 11, with an immediate vertigo-making credit default swap spike and then fell more gradually, but remained high for 7 months. Near-normal interbank lending rates have not yet returned a year and a half year after Lehmans was left to collapse. Lehman was not however a wound that could be cauterized by bankruptcy as the 'moral harzardists' wishfully imagined - massive bleeding continued, spurting red ink - it was explosive. The fall-out detonated by Lehman's bankruptcy cost a lot of valuable time to secure financial integrity and economic recovery. The threat to USA's sovereign debt status proved also to have been greatly over-exaggerated. Federal authorities did have to provide far more funding, liquidity and capital support to banks than before Lehman's bankruptcy. Those who said don't save the bank because of moral hazard and let's save on bank-aid costs failed to see that the risks were all pointing systemically - Lehman could not be quarantined and treated as if a special case! With the expansion of the Federal Reserve's balance sheet, despite being practically 'netted off-budget' as far as Federal Debt was concerned, there was limited sovereign risk increase, but far less than the doomsters anticipated, not least because these matters are relative and all other countries' sovereign debt credit default spreads widened more than that of the USA. A major problem for UK and USA authorities is they cannot bring themselves to risk telling the public that government can generate vast amounts of financial funding without directly risking taxpayers' monies. Who would believe that or believe the politicians, least of all when they try to indicate 'don't worry, this is all going to turn out fine and be very profitable for the Treasury and paying down future budget deficits'? Double-entry book-keeping lies far beyond the mental-map of media and the voters in Main Street - somewhere in the unknown regions as in medieval maps where 'there be monsters!'As I've explained in many previous essays and published papers, governments have stepped in to replace private funding sources to replace 100% of various countries total commercial bank capital when banks generally are losing twice their total capital, once to the credit crunch market risk write-downs and once again to the recession, to credit risk losses. It is not the case that only some banks are helped. Rescuing some banks directly rescues all banks. Unlike other markets banks do not merely compete with each other but trade and lend and borrow with each other; they are all intimately inter-dependent in a myriad of ways that are impossible to unravel, and involved in every aspect of our economies, as the USA's economy is material to every other part of the world. This is why the world was temporarily shocked into a global recession, and why every country's central bank Stability Review reports begin with financial data from the USA and the implications of USA Government and financial authorities' actions. The idea is therefore ludicrous to raise the cost of USA sovereign risk especially in the context of what all governments across the world have to do to save and recover their economies and the financial system where private, not public, indebtedness is the overwhelming problem. Credit default spreads widened on rising government debt but should not be interpreted as a sovereign debt crisis as if there is no private sector context. The chart below shows just a few sovereign debt CDS comparisons, but many other countries found their CDS rising higher than the USA's, which over time moderated as the graphic shows. Moody's again today, perhaps currying favour with the recovering Euro Area confidence, has issued another report seeking to fan the flames of anxiety not about minor OECD country sovereign risk, but about US sovereign risk! - trying to suggest that US National debt could be unaffordable or unsustainable etc. Credit Rating Agencies are extremely important to financial markets, perhaps of greater real power than the regulators. This fear-mongering is analytically insupportable and grossly irresponsible, pandering to ignorance - for example, suggesting primitively that the days of the 'almighty dollar' as the world's major reserve curency etc. is now threatened? Paul Krugman cogently commented at the time of Lehmans collapse, "So the word seems to be that Lehman will be liquidated — hey, no more taxpayer takeover of risk, no more moral hazard; but to cushion the markets against the shock, the Fed will start accepting lower-quality assets, such as equities, as collateral for its credit lines — hence, more taxpayer takeover of risk, and more moral hazard. Oh, kay. By the way, I’m not sure this was the wrong thing to do. But it drives home the essential craziness of the situation."Of course, there is the argument that Lehman brothers deserved to go under because of its excessive and irresponsible greed and possibly illegal blinkered risk-taking. But, that is not the whole picture. The Fed claimed it had calculated that the network risk, the systemic domino effect, would be less than for other banks and could be easily contained therefore. That judgement has proved to be quite wrong, and an example of regulators themselves taking high risks based on gut-feel.Of course there were wrong-doings, civil and criminal charges and court cases to be waded through - save the bank or not? - neither decision was going to change that; was it? The Valukas Report shows there are good grounds for legal prosecutions.
Lehman directors, including chairman Dick Fuld and former finance director Erin Callan, failed to disclose key practices. They had certified misleading statements. The claims are in a 2,200-page, nine-volume report by Anton Valukas that Judge James Peck said read "like a best seller". We knew some of this already, for example that its prime brokerage mis-applied collateral. Lehmans was one of 3-4 prime brokers that dominated 50% of the prime brokerage market that lent money to hedge funds (leveraged on hedge fund pledged collateral) and that transacted hedge fund market trades, which could be 30-50% of all exchange volume. Lehmans used the collateral to trade on its own account. What we now learn is that it mis-accounted for the collateral. Such collateral with prime brokers was large-scale. The role of the hedge funds and prime brokers in the credit crunch is now firmly under the spotlight and provides more grist to the debate between the EU and USA over hedge fund transparency and regulation. It will focus too on precisely the practise that Valukas is alluding to formally called rehypothecation, one that was all smoke and mirrors but for which in truth the hedge funds themselves were equally culpable.
Hedge funds were very happy to be leveraged up to the hilt and didn't care what prime brokers did with their assets because they didn't think a big bank could collapse. Now they worried about collateral damage, not just to their own collateral pledged assets but to their own solvency.A recent IMF report, “Deleveraging After Lehman - Evidence from Reduced Hypothecation”, says the demise of Lehman put a crimp in things and discouraged such recycling (of asset collateral). The report says “…rehypothecation was acknowledged to be positive for the global financial system, prior to Lehman.” The report concludes that the practice of rehypothecation dropped off as hedge funds post Lehmans' collapse had for the first time to think the unthinkable: what if their own prime broker went belly up?
As The Independent wrote last Autumn, “Funds have found that assets such as equities whose recovery from the prime brokerage division should have been straightforward are in doubt because of “rehypothecation”. The small print of the contracts said that Lehman could use the securities itself, including lending them out to short sellers. This meant the assets were reclassified as unsecured, putting them further down the queue for repayment and raising the prospect of big losses. Hedge funds may have up to $70bn in Lehman prime brokerage accounts, with the value of rehypothecated non-cash assets estimated at $22bn.” Therefore, if re-hypo 'ization contracted for then rehypothecation itself was appropriately contracted for, it was not illegal? But, divorcing assets from liabilities in the balance sheet and hiding the difference is illegal! In mid to late '08 Repo business by primary dealers fell of the cliff.The IMF working paper (by Manmohan Singh of IMF and James Aitken of UBS) found that collateral held by prime brokers that is eligible for rehypothecation fell not just because of Lehman, but also because clients of other major prime brokers pulled in the reins - reducing the assets available for rehypothecation. As the table below from the paper shows, the total rehypothecatable assets held by the largest 4 prime brokers fell from about $3.1 trillion in May 2008 to $1.1 trillion only 6 months later. When Lehmans went down billions of rehypothecated funds were lost in the ether. Not a mistake the hedge funds will be repeating. All this will be understood by bankruptcy judge James Peck. But the court may become overwhelmed by the 16,000 claims still outstanding to be vetted and valued. His written judgment will be the next major publicly available report on the matter. There are $824 billions worth of 64,000 claims filed being sorted through - $666bn (number of the beast?) against LBHI, $88bn against LB special financing, $28bn Structured Asset Securities Corp., $20bn Lehman Commercial Paper. About half so far is for guarantees and a quarter is lehman's medium term note programs and other suchlike borrowings. Over 80% of claims against LBHI are by only 5 creditors. In sorting all this problems remain in lack of transparency in getting access to the bank's bank accounts with other banks - according to Alvarez and Marshall, the firm sorting out the mess left behind, much of which may also end up in court!
The Valukas Report, on the collateral provided for repo swaps, shows that this was accounted for as if the collateral assets had been bought and loans fully granted as if unsecured. This is a clear example of risk taking and fraudulent accounting treatment that would have been outlawed and clearly seen by regulators if Lehmans had been a deposit-taking bank regulated by The Fed under Basel II, and not an investment bank only regulated by the SEC. At the time of its collapse it was reported that the bank collapsed under $60bn of toxic debts. There were other large accounting transfers between balance sheet headings. If there is ineptitude, it must focus on the year before the bank's collapse. Generally speaking, Lehmans had sufficient warning to examine its dealing and clean up its balance sheet. The issue should have been clear to Lehmans and everyone else following the collapse, and rescue of Bear Stearns by JPMorgan. Citicorp collateral managers phoned Bear to request a margin call. Bear execs issued expletives and slammed the phone down. The enraged Citicorp Noo Jorkahs sold the collateral (mainly ABS securitised bonds) in a fit of pique at huge discount - they foolishly thereby began the devaluation of ABS instruments including their own bank's issues and holdings.
The case opens on April 26. Anton Valukassays there is evidence for a possible claim against Ernst & Young. Note that the report was lodged with the court in February, and only made public yesterday after Judge Peck agreed to it being unsealed. The firms involved have therefore had a few weeks to consider their positions. Spokesmen for JP Morgan Chase, Barclays and Ernst & Young declined to comment. The Lehman estate has a claim of $10bn originally (now $11bn) against Barclays; that it paid too little for the investment banking and broking business. Barclays rejects this and has a counter-claim for $3bn of securities that were missing from what it believed it had bought? Citigroup said in an e-mailed statement it is reviewing the report, and that a preliminary analysis shows the examiner “has not identified any wrongdoing on Citi’s part.”
Repo 105 masked the size of Lehman's balance sheet as the pressure grew for investment banks to reduce their leverage in late 2007. If Repo 105 wasn't lethal it was certainly poisonous, according to the FT; Lehman had been abusing it as far back as 2001, using repo agreements to finance assets but, unlike with typical repo transactions, treating them for accounting purposes as sold. This let Lehman cover up its true leverage, making it seem lower. Lehman used its overseas subsidiary (London) to make that work, sometimes. Bart McDade, the Lehman executive in charge of shrinking the balance sheet has referred to Repo 105 as "another drug we ran on" - sounds like a breach of fiduciary duty - although Valukas doubts it.There is a "colourable claim" (strong case?) as Valukas calls it - against Fuld and the firm's three finance chiefs in its final year: Chris O'Meara, Erin Callan and Ian Lowitt. And, Ernst & Young could be on the hook for professional negligence for allowing the repo trades to be wrongly accounted for. Via his lawyer, Fuld has disavowed knowledge of Repo 105 or how it worked. The Daily Telegraph says "the 2,292-page report is a page-turner even without this damning revelation. It paints a far more detailed picture than previously available of senior management believing their own hype, ignoring growing risks, and their deputies' concerns, as they built up bigger positions in illiquid assets like commercial real estate and private equity. They overrode the bank's own risk limits on a regular basis and didn't include these positions in stress test scenarios.
Whether or not Fuld and his associates end up on trial, Valukas has at least drafted a fantastic management guide. It's the best document yet from this crisis on how to prevent future failures. It should be mandatory reading for current and would-be bank chiefs - and their regulators.".Was Lehman Brothers insolvent in terms of unable to meet its cash payments and liquidity risk obligations? Gordon Brown heard the news when at a post board meeting party in London of Goldman Sachs and, with the implications being clear for all banks in extreme difficulties, promptly went into a huddle with Victor Blank of Lloyds TSB to agree its takeover of Halifax Bank of Scotland and waive the reference to The UK Competition Commission!
LEHMAN BROTHERS COLLAPSE
In 2008, it appeared that Lehman's problems were its unprecedented losses due to the continuing subprime mortgage crisis, from having held on to large positions in subprime and other lower-rated mortgage tranches when it securitized the underlying mortgages. Lehman had projected itself as having the world's best pricing and risk analysis of asset backed securities! Whether Lehman voluntarily invested (like RBS, especially when buying ABN AMRO's investment bank) or was simply unable to sell on the bonds was unclear. In Q2 '08 Lehman reported losses of $2.8bn and sold $6bn in assets. In H1 '08, Lehman stock fell 73%. In August '08, Lehman reported it would lose 6% (1,500) of its staff, just ahead of Q3 reporting in September. In late August shares in Lehman rose 16% when state-controlled Korea Development Bank looked to buy it, then fell 45% on 9th September when KDB faced objections from regulators and could not attract backers for the deal and the S&P 500 fell 3.4%. The Valukas report says, "As late as September 10, 2008, Lehman publicly announced that its liquidity pool was approximately $40 billion; but a substantial portion of that total was in fact encumbered or otherwise illiquid." In its accounts to end of 2007, lehmans reported the following substantial liquidity pool reserves. We can now question whether these numbers were faked? Valukas report notes that, "From June on, Lehman continued to include in its reported liquidity substantial amounts of cash and securities it had placed as “comfort” deposits with various clearing banks; Lehman had a technical right to recall those deposits, but its ability to continue its usual clearing business with those banks had it done so was far from clear. By August, substantial amounts of “comfort” deposits had become actual pledges. By September 12, two days after it publicly reported a $41 billion liquidity pool, the pool actually contained less than $2bn of readily monetizable assets." The answer is YES - insolvent to the tune of $39bn (or $32bn if bonus pools are counted in - if memory serves, they were $2.5bn in USA set aside before the bankruptcy and a bonus pool of $5bn transferred to NYC from London the night before Lehmans announced its bankruptcy!)
Consider how $billions of bonus payments square with inadequate capital. $23bn of equity was not enough to be carrying $700bn assets and liabilities plus a $trillion of derivatives positions. The leverage was 30 times gross, 16 times net.
Lehmans was an investment bank, but like others too it had turned itself into the equivalent of a hedge fund, which is strictly not kosher for a company with ordinary shareholders, quoted and trading on the regulated stock exchanges. Morgan Stanley and Goldman Sachs, the USA's two leading investment banks, have disclaimed that they employed any repo accounting tricks to hide assets. They have yet to say they did not indulge in rehypothecation of collateral or entertain strategies based on excessive leverage?
On September 10, 2008, Lehman had announced a loss of $3.9bn and intent to sell a majority stake in its investment-management business, mainly Neuberger Berman. The stock slid 7% that day. On September 13, 2008, Tim Geithner, then president of the Federal Reserve Bank of New York called a meeting on Lehman, which included possible emergency liquidation of its assets. Its empty liquid reserves may have emerged then? Lehman initiated talks with Bank of America and Barclays. On the 12th or 13th bank of America backed off and on Sunday 14th agreed to buy Merril-Lynch for $50bn which saved it (3 times bigger than Lehmans) from the worst of the crisis. It appeared by early September 14 that a deal was reached with Barclays to buy and save Lehman from collapse. There were conditions: no CMBS, asset management or property portfolio, only the core investment banking, plus access to the Fed Prime Broker credit facility, discount on net asset value, financial support of The Fed and confirmation of Lehman's liquidity so that Barclays could calculate the impact on its own capital ratios. The U.S. government, suddenly concerned about moral hazard, did not announce any plans to assist Lehman. One idea was a contingency plan for Chapter 11, and to create a 'bad bank' for Lehman's toxic assets supported by a consortium of US banks, but not financially by The Fed, which would only act as facilitator. Lehman, however, could only 'estimate' roughly its liquidity pool, and The Fed would not offer financial support guarantees? In fact, the New York Fed (Tim Geithner) asked Barclays (John Varley) to guarantee Lehman's financial obligations during the acquisition period, while it itself would provide no level of financial support - which is an unusual request given that due diligence was not possible in the short time available, and must have been clear to anyone would be unacceptable to the Barclays Board! THIS WAS THE DEAL BREAKER!
The FSA also requested a formal proposal for it to approve that included support from The Fed or it could not approve the impact on Barclay's capital ratio or waive the legal requirement for the deal to be put to Barclays shareholders for their approval. That was Saturday 13th. On Sunday, capital impact and liquidity were still unknown, and unless 3rd parties, The Fed, guaranteed Lehman's immediate financial obligations, there could be no waiving of the prior need for shareholder approval - which would take weeks including producing and publishing detailed financial statements - no one would believe a statement that Lehman Brothers' last set of interim (unaudited) accounts could be accepted as materially unchanged.
Lehman was deluding itself when it thought it could find a quick-footed opportunistic buyer such as state-owned KFD, Bank of America, or Barclays Bank, without first producing forensically reliable accounts and allowing some form of comprehensive due diligence. In the case of BoA and Barclays it was of course expecting a deal similar to Bear Stearns six months earlier where the Federal Reserve would strong-arm the deal and provide substantial (undisclosed) financial support. Once bitten, twice shy?
No one, not The Fed, could accept Lehman's $40-60bn tangible assets as collateral in exchange for Treasury Bills, not since Lehman had maxed out on that to the extent of hiding $50bn of effective borrowings, and certainly not before TARP funds were authorised by The Senate, which did not vote TARP through until October 6th. If The Fed risked an unquantifiable massive band-aid guarantee to Lehmans that looked like golden parachutes for a buyer of the distressed bank, would that have lost the long delayed and now acrimonious TARP vote in The Senate. The Fed balance had not yet ballooned. Hank Paulson at this time still considered aid to banks as an on-budget, on-balance-sheet matter, hence the TARP proposal to ask Congress to vote $700 billions. He later regretted that approach once he recognised how the balance sheet could be grown by swapping bills for banks' assets at a big discount giving The Fed plenty of room on the liabilities side to grow the bank's assets without seeking federal Budget support. That began after Lehman's bankruptcy. Had Fuld and his coterie understood any of this, could they have managed somehow to hold on and win more time? The answer was, it seems, no. Lehman was on the rack of illegal short selling and had run out of money; he had ignored liquidity risk, Banking 101, and let his traders have the bank's reserves plus $50bn. All that was left was maybe $7.5bn bonus pool, and if his staff didn't get their blood-money the bank was dead anyway - no one was going to accept shares or share options though many were forced to take their bonuses in shares that by then were mere short-sellers' ticker-tape.The Fed position veered from moral hazard reflux, through realisation that it had no tangible basis for balance sheet financing of Lehman, to merely facilitating a rescue and then to a contingency fall-back plan of providing support but only once Lehman Brothers was in bankruptcy Chapter 11 administration. Fact is, The Federal Reserve did not have wriggle-room. Fuld and the Lehman executives were living in la-la land expecting their status and iconic brand to, by force of national financial system blackmail, compel The Fed into a replay of Bear Stearns's rescue.
Where were the Lehman Board non-execs, carrying the fate of world finance on their agendas for the previous 18 months - 9 were retired, 4 over 75 years old, 1 a theatre producer, 1 construction magnate, another a former Navy admiral, only 2 with direct experience in the financial-services industry, one of whom was former US Bancorp chief Jerry Grundhofer, and another Henry Kaufman. (see Comment 3 below), one of the most famous economist statesmen of his day, close friend of Paul Volcker, head of Henry Kaufman & Co., ex-Salomons chief economist, famously bearish on interest rates and bonds, and someone who was invested heavily for years with SEC god Bernie Madoff; could even he be conned by improbable sets of accounts? He said very sensibly in 2006 on the eve of the calamity, "Some investment banks are beginning to look more like hedge funds than investment banks. That’s an enormous departure from the past. The dilemma is that we know less about the financial system today than we did 20 or 30 years ago. So much occurs beyond the balance sheet? The build-up of derivatives is extraordinary.” - 'Exactimundo!', as Tarantino might script it in gangster rap. Henry Kaufman pictured above.
The name of Bear Stearns must have come up time and again in every Lehman's crisis meeting? But how Bear was resolved was not a game-line or play-rules that The Fed could or would play again, not for Dick Fuld and his fictitious liquidity reserves. How could Hank Paulson (soon to be outgoing Treasury Secretary, brother to the head of a major short-selling hedge fund) and Ben Bernanke (with his contract renewal coming up subject to Congressional and Senate Committee votes) have played the politics of bailing out Lehman?
It was obvious to all except perhaps Fuld that this was too hard a sell, and wise heads such as Kaufman and Grundhofer on the board and Tim Geithner at NY Fed knew this. Lehman had assets and collateral lying in several places, but what were they worth? When JP Morgan settled its cash and securities collateral at Lehman, which took until February 2010 to achieve. Lehman owed JPM $557m for which it had pledged collateral originally with a face value of $8.57bn, later discounted 9% to $7.58bn that it is hoped may recover a bit more in time! By end of Saturday 13th, despite all the time and efforts over previous days if not weeks, boards and committees of all parties sitting in their offices,but the deal was really already dead. Lehman had to own up that it no longer had liquidity to fund its daily operations. This showed that somewhere in the senior level bowels of the bank people knew what the cash position truly was. On the evening of September 14, SEC Chairman Cox had phoned the Lehman Board and conveyed the Government’s strong suggestion that Lehman act before the markets opened in Asia.
On September 13 and 14, there continued to be insufficient information available to formally structure or restructure a deal that could be put before the Barclays Board and the FSA, but the deal really died on the 13th. Lehman decided in the evening of the 14th that it would file for Chapter 11. This was confirmed by the NY Fed which agreed to provide financing to keep the bank afloat. That evening The Fed was also organising a special OTC derivatives operation to protect Lehman counterparty creditors i.e. to net off Lehman's derivatives exposures. On Monday morning, the 15th, as the Japanese markets opened, at 1:45 a.m., 7:56am London time, LBHI filed for Chapter 11 bankruptcy protection. Over the weekend from 6 p.m. Friday, 12th at the Federal Reserve building in Lower Manhattan, there was a series of crisis management meetings with Henry Paulson, Tim Geithner, other Fed and Treasury officials, and top bankers. Treasury and the Federal Reserve had already stepped in to rescue events over previous months such as forcing a shotgun marriage between Bear Stearns and JPMorgan Chase and backstopping $29bn of troubled assets, and agreeing to bail out Fannie Mae and Freddie Mac, sitting on $6 trillions of insured mortgages. The idea was of supporting these until recovery returned, supporting their restructuring of mortgage contracts to minimise defaults and foreclosure repossessions. Foreclosures are now rampant, however, affecting 5% of all mortgagees in negative equity. With that whirlwind hanging over the economy it is no wonder there is popular wrath demanding that the banks be allowed to go bust. Some commentators are concluding that short-sellers (for which read 'hedge funds') were right to drag down and profit from banks' falling share prices! The bankers were told by Treasury and The Fed that the government would not bail out Lehman and that it was up to Wall Street to solve its own problems. When Lehman’s stock fell over previous weeks other firms stopped doing business with it, threatening its viability.
Like sharks need to keep swimming, banks need to maintain a flow of liquid business, or they die. All Wall Street bankers and brokers became concerned about their own viability. The fates of Merrill Lynch and Lehman Brothers appeared linked; Merrill had the USA’s largest brokerage force while Lehman’s main customers were big institutions. But in the credit boom both firms, like Bear Stearns too, had piled into real estate and land, also inadvertently due to foreclosures on large property development deals, and were thereby weakened with inadequate capital and writedowns. The Fed over the weekend had to decide to save AIG with a $40bn loan prior to its nationalisation. On Sunday, the 14th, Barclays withdrew its bid, but actually that decision was made on the 13th; Barclays had been backed into a corner with no way forward, and was now privately considering buying Lehman free of encumbrances out of Chapter 11, which it then did eventually do.
The major sticking point was no financial protection guarantees from The Federal Reserve, which was arguably callous given the speed at which Barclays had to decide to take the risk to buy Lehmans or not, subject to FSA approval. What did the Fed know about Lehman's liquidity position when it first refused support for the Barclays deal and then had to provide some when lehman went into bankruptcy administration? It may have been backed in a corner too, as blind to the true accounts as Lehman itself appeared to be uncertain about? Or was it also really a case of let the bank go under as shock discipline for the other banks, as was later suggested to be the concluding view of Hank Paulson, US Treasury Secretary, and as punishment for the 100 hedge funds that used Lehmans as their prime broker and could now lose tens of $billions?

IMMEDIATE AFTERMATH
Hedge fund losses were not clear but could be gauged somewhat by large withdrawels from money marlet funds. Lehman's collapse precipitated a $550bn run on money market funds on Thursday, September 18. This was dire news that Treasury Secretary Henry Paulson presented to Congress behind closed doors, prompting Congressional approval of Paulson’s $700bn TARP fund, despite many legislators' deep misgivings. It was a shock or a “shock therapy”. Why did the money market wait until September 18th to register its shock? A report ofy the Joint Economic Committee pointed out that the $62bn Reserve Primary Fund had “broken the buck” (fallen below $1 per share) due to its Lehman investments lost on September 15, and the fund had to suspend redemptions for a week. What dire event happened on September 17th? The SEC has reported that it was a record day for illegal naked short selling. Failed trades climbed to 49.7m – 23% of Lehman trades. A few banks round the world reported loss exposures to Lehmans of about $5bn, but that could only be the iceberg's tip. Hedge Funds may have lost $10-20bn, but we don't know? Banks may have lost a similar amount - but it seems that not only do we not know, they don't yet either?
Neuberger Berman asset management was sold for $2.6bn. Nomura created a $1bn bonus pool to secure it staff in the shell of Lehman's European and Asian operations which it bought for $225m. Barclays paid $1.75bn to buy Lehman's US shell. At the time some creditors' lawyers said they'd sue Fuld for return of his salary, which was over $100m for the previous 2 years, $300m over 8 years. For all other banks round the world, credit default spreads on loans to banks spiked very sharply upwards endangering many from being able to refinance their funding gaps. Banks sold assets at discounts, shrank their balance sheets and several were nationalised. The Credit crunch had a new pull like hanging nooses round the necks of hundreds of banks. Lehmans is often described as the world's largest bankruptcy, but Fortis Bank could be calculated to be in the same ballpark. One result afterwards, as central banks had to massively weigh in with liquidity and capital for banks, was that regulators and governments did not want to risk another credit shock to interbank lending and became determined not to let another major bank crash and burn. Hence the moral hazard argument (insofar as there was such a palpable risk which I dispute) that posited moral hazard as an overwhelming reason for not saving Lehman Brothers was undone, because such moral hazard (if defined as governments acting as lenders of last resort, as safety nets) became stronger than ever. Wim Buiter had said, "one of the reasons why finance has got too big is that it has always enjoyed an implicit state guarantee, which has had the effect of creating excessive moral hazard. State subsidy will always ultimately produce bloated, uncompetitive and publicly disadvantageous industry." That view has a lot of mileage left in the tank, but banks got to be where they are also because they believed in implicit guarantees of the markets. How big banks got to be so big, from $billions to $trillions in a generation is a big study. Whatever the reasons, the state could not absolve itself from dealing with the systemic risks to the whole financial system. On 6th October '08, in the aftermath of the Lehman's debacle, I wrote, "Seems as if individual supervision (of banks) got confused with the systemic bigger picture. Lehmans rehypothecation of other firms' collateral and a host of other accounting issues and wide-ranging counterparty exposures are so much more difficult to unravel when in the hands of administrators than if in the hands of another bank. This must be a lesson whenever the choice arises again between fees for accountants and lawyers or letting a bigger merged entity work its way through the balance sheet. Maybe this is the lesson that's been learned in the cases of Fortis and HBoS?"
My view then seems borne out by Alvarez and Marshall's report on their mammoth task published in December 2009. Had say Barclays taken on this Herculean job with Federal Reserve support, as part of a deal to buy Lehman Brothers as an ongoing concern, then my guess is that it could have been more easily sorted out in negotiated fashion with the creditor banks. $824bn in claims is a big number of systemic proportions by any measure, supported by less than $16bn in cash and tangible investments (remaining at 30 Sept.2009). Maybe the job might have overwhelmed even BarCap and The fed, but actually I doubt that. The big post-Lehman realisation dawned that now no governments were going to let any major bank again go into uncontrolled bankruptcy. So the Too-Big-To-Fail bank issue became centre stage in regulators' mind leading to what we are now seeing - Liquidity Reserve Funds, Counterparty risk funds, higher economic capital buffers, living wills, Volcker Rule (Dodds' Bill before Congress, now 85% agreed), a cap on market size of banks, cap on % share of national deposits, and increasingly likely break-up of the biggest banks. When all that feeds through, we have to ask how much worse could banks' deleveraging and balance sheet shrinkage get such that economic recovery double-dips or is otherwise postponed for a year or two longer than expected?There remained the question of whether the bank fell or was pushed? The pushers include other banks, the authorities, and hedge fund short-sellers. Although Lehman Brothers filed for bankruptcy on Monday, September 15, 2008, it was actually “bombed” on September 11, when the biggest one-day drop in its stock and highest trading volume occurred before bankruptcy. Lehman CEO Richard Fuld maintained that the 158 year old bank was brought down by unsubstantiated rumors and illegal naked short selling. Although short selling (selling shares you don’t own) is legal, the short seller is required to have shares lined up to borrow and replace to cover the sale. Failure to buy the shares back in the next three trading days is called a “fail to deliver.” Christopher Cox, who was chairman of the Securities and Exchange Commission in 2008, said in a July 2009 article that naked short selling “can allow manipulators to force prices down far lower than would be possible in legitimate short-selling conditions.” By September 11, 2008, according to the SEC, as many as 32.8m Lehman shares had been sold and not delivered – a 57-fold increase over the peak of the prior year. For a very large company like Lehman, with plenty of “float” (available shares for trading), this unprecedented number was highly suspicious and warranted serious investigation.
Everyone under-estimated the wider impact of Lehman's bankruptcy. This is akin to not foreseeing the credit crunch, but worse for the fact that the credit crunch was not yet over, not by a long way. There appeared to be an immediate profound wide economic cost of September '08. It may be long debated whether recovery was delayed by letting Lehmans fail, and how much more $trillions of asset values were thereby lost, if half of that only temporarily, and millions of jobs, which take longer to recover. Recovery so far has been jobless, but that may soon change, not least with the help of the just-passed by Congress of a $150bn job creation bill.

AFTERMATH 18 MONTHS LATER
Despite, or because of, letting Lehman Brothers crash and burn, central banks in USA and Europe had to up their game massively. Markets touched bottom in April 2009. Bond values recovered in the fourth quarter 2009, by which time USA and UK were now out of technical recession. But, the ratings agencies were fairly merciless in continuing to keep many banks teetering on down-grade and now also government sovereign debts. Calls persist for letting banks go under, using the moral hazard argument. This has turned into arguments for breaking up big banks, for not letting them become so large again to be Too Big To Fail! This is somewhat daft because while break-up of at least some of the very biggest banks is now inevitable, the failure of any one bank of any significance has detrimental effects on the integrity of any country's financial sector and will always be economically significant. The Volcker Rule has firm traction, to force banks to concentrate more on traditional or narrow banking and cut back on proprietary trading, or even split investment banking from commercial banking to return to some form of Glass-Steagal. At end of 2009, the focus of concern was temporarily moved from banks' balance sheets and private debt to government budget deficits and debts. Politics has conspired to divert attention from private debt to public sector debt, which is bizarre since the latter is so much smaller than the former and until the crisis scarcely grew while private sector debt more than doubled! For example, Moody's issued a sombre report for 2010, in the face of very positive growth forecasts by USA and UK Treasuries. The global ratings agency Moody's was especially culpable for mis-pricing $trillions of asset backed securities. If it too ends up in danger of going out of business, perhaps it can defend itself by appearing as if killing it would look like killing the messenger of bad tidings. It has issued a serious of negative reports. Most recently, it lent its voice to add to fears of future tax rises and spending cuts by saying these could trigger social unrest in a range of countries from the developing to the developed world. This year we see such riotous protests in Greece. It said that in the coming years, evidence of social unrest and public tension may become just as important signs of whether a country will be able to adapt as traditional economic metrics.
Ratings Agencies have an interest in fanning flames of anxiety when they are in line for court actions and regulators' severe attentions! Will we see new credit insurance instruments called Riot Default Speads? Signalling that a fiscal crisis remains a possibility for a leading economy, Moody's said that 2010 would be a “tumultuous year for sovereign debt issuers”, and lo, hedge funds took up the clarion call and staked out Greece, Spain and others, including the UK, but not the USA - Buiter so far wrong again? Moody's, perhaps recognising the value of red rags in election years, added that the sheer quantity of debt to be raised by UK and other leading nations would increase the risk of investor fright. This is plain ignorance and shows it own failures to examine banks capital and regulatory change which is creating more than enough enforced demand on banks to buy all of the new government bond issues.
Strikingly, however, it added that even if countries reached agreement on the depth of the cuts necessary to budgets, they could face difficulties in carrying out the cuts. This is novel commentary by financial analysts? The report said: “In those countries whose debt has increased significantly, and especially those whose debt has become unaffordable, the need to rein in deficits will test social cohesiveness. The test will be starker as growth disappoints and interest rates rise."
This is entirely subjective since there is no metric for showing when any OECD country's debt becomes unaffordable! The sovereign debt crisis is being given disproportionate attention, almost as if many (not all) politicians are only too happy to return to the pre-credit crunch politics they feel comfortable with while the problems of global banking are too much of a headache; hard to align with values of die-hard support for enterprising capitalism. For a problem that has consigned forests of newsprint and $billions of broadcast and Internet time, the general understanding of the financial crisis remains foggy at best. This is banking's age-old defence, to be impenetrable behind its armour of knotty jargon. That is now no longer a reliable defensive moat, but banking's Achilles Heel, a further sign to the populace of banks' defensive arrogance. In the popular imagination of 'Main Street', 'complexity' is how 'Wall Street' steals! The clamour is growing and may be unstoppable for the break-up of the biggest banks, and that can be traced back to Lehman Brothers in USA and Fortis Bank and ABN AMRO in Europe. The G20 agenda has work to form agreements for such break-ups when legal technical obstacles were identified by FDIC that prevented the break-up of Citicorp/ Citibank. The Volker Rule also has gained traction to cap banks from own portfolio investment trading, and may yet go further to a return to Glass-Steagal as many legislators support, if banks do not do more to aid recovery. What should also emerge is awareness of how much banks (in credit-boom economies) in the past two decades shifted their lending and investment from supporting productive income generating business to supporting unearned income asset gains, from lending to business to lending to property development, other financial institutions and mortgages. Even the bulk of lending to business was property and mortgage related using short term if recyclable funding.
The original role of banks serving trade finance, managing money transaction services, and the transmission mechanism of rouing savings to productive industry has become a backwater, relatively trivial in the banks' balance sheets compared to financial engineering derivatives, and far smaller than mortgage and financial structured product lending for mergers and acquisitions mainly to the biggest corporations who can look to banks like just another form of financial services enterprise, in the cosseted world of High Finance, overwhelmingly only going where the numbers and bonuses are biggest.
BANKS' DELEVERAGING
Commercial banks are forced by narrow circumstances to shrink their balance sheets and narrow their funding gaps, with the determination of a military campaign, and net off their derivatives exposures.
In 2009, U.S. banks posted a 7.5% fall in total loans outstanding, the steepest percentage drop since 1942, according to the FDIC. The drop in the UK is also about 8%. It may smack of vengefulness, voluntary or involuntary, in severely cutting households and businesses' credit - enough to almost negate governments' attempts to reflate economies through deficit spending, and which makes quantitative easing especially important as an additional spur to the rump of the economy.
By continuing to act as a drag on the real economy's recovery our big banks are playing with a fire, a fire that may consume them politically and even economically as assuredly as they consumed each other in the credit crunch? The banks have still not yet woken up to appreciate and respect their collective role in, and dependence on, the total economy. Their counter-arguments that loans have fallen because customers are demanding less credit is demonstrably false. Surveys continue to show that credit conditions, access to bank loans, continue to be the single biggest factor in business confidence. 90% of cross-border trade and much of domestic trade relies on trade finance from banks. Banks have tightened credit conditions, cuts overdrafts to businesses and households, refused small firms and SME loan requests as a matter of policy to narrow funding gaps rather than because of borrowers' quality i.e. taking the short term view, being subjective about margins and self-obsessed at the expense of customer loyalty, basically calling governments' bluff in the face of governments' requests to maintain or raise loan levels to small business especially. Retail banks continue to operate credit scoring systems that tell them not to lend to customers with irregular cash-flows for example, the very customers they make 80% of their retail branch net interest and bank charges profits from?A generation or two ago honourable Japanese, Prussian Germans, and maybe old school tie Brits would have died of shame - and by their own hands too!? In fact, on top of the annual rate of about 50 financiers suiciding in normal years only about another dozen bankers have killed themselves in Credit Crunch years - usually after losing money and careers, but all the Credit Crunch suicides seem relatively junior in the wider pressure cooker of the Credit Crunch, and of Madoff scams, property and stock speculation losses.
Few, only 2 out of the additional 12, appear to have 'offed' themselves for the unbearable shame of losing clients' money, not because they lost their own money? These are the homourable ones - many in Main Street may wonder why there have not been more bankers feeling terminal shame?
And, by the way, I am not recommending that anyone should do away with themselves!
But, who these days remembers Charles Barney of Knickerbocker Bank, a glorious building on the corner of 5th Ave and 34th street who honourably shot himself in 1907?
Yet, the vry next year his bank re-opened and all creditors were paid in full. It may be 2014 before economies are back on a relatively even keel and all credit crunch accounts are settled? It will take longer than that before bankers restore some sense of honour and moral authority in their profession.
Even before the crisis, surveys found that 85% of customers mistrusted and hated their banks, and feared them. What other sectors other than attorneys, politicians, and second hand car salesmen have long survived drenched in such dislike and disrespect? Today, bank customers despise and satirize their bankers.
Bankers are very slow in waking up to what this means and longer still before determining that something has to be done to change how for too long banks have grossly under-valued customer loyalty, and, as many will also now conclude, been lying when claiming 'shareholder value' as their no.1 priority.
In its self-promotion, Lehman's advertising strapline was "Lehman Brothers: Where Vision Gets Built" - as the Valukas report shows us may now be a vision likened to several of Dante's 'circles of hell' applied to financial markets:-

SEE ALSO
Lehmans
(15 sept. '08) http://bankingeconomics.blogspot.com/2008/09/lehman-brothers-bankruptcy.html
(17 Sept.'08) http://bankingeconomics.blogspot.com/2008/09/lehman-bros-administration-scenario.html
http://www.qfinance.com/blogs/ian-fraser/2010/03/18/time-for-sarbox-to-be-rethought-post-valukas
FSA statement to the enquiry into Lehmans: http://www.fsa.gov.uk/pubs/other/lehman.pdf
RBS: http://lloydsbankgroup.blogspot.com/2009/03/rbs-citizens-bank-and-greensandwich.html
On Anglo-Irish Bank: http://lloydsbankgroup.blogspot.com/2009/03/basket-case-of-basking-shark-anglo.html)
http://lloydsbankgroup.blogspot.com/2008/12/banks-property-losses-next-year-so-last.html
Comprehensive site on Lehman Brothers fallout and for Valukas Report, see
http://lehmanlotto.blogspot.com/2010/03/report-of-anton-r-valukas-examiner.html