Lehman Report: Were Securities Regulators Out to Lunch?


A recent report detailing Lehman Brothers Holding's deliberate misstatements in the investment bank's public filings before its spectacular bankruptcy in 2008 makes one wonder whether government securities regulators were out to lunch. The answer is apparently, yes.

From the public's point of view, the most disheartening section of bankruptcy examiner Anton Vakulas's report on Lehman's downfall has got to be the section on government, where he spells out the failure of the U.S. Securities and Exchange Commission -- the government's chief securities watchdog -- to regulate Lehman. He also details the Federal Reserve's short-sighted approach toward Lehman. The Fed, which had more information on Lehman than the SEC and was also focused on Lehman's health, simply wasn't interested in Lehman from a regulatory or compliance standpoint.

With any luck, the story of the government's apparent lack of oversight of Lehman will reinvigorate efforts in Congress to overhaul financial regulation in a meaningful way. Unfortunately, the Lehman case also shows that having the power to regulate is insufficient; those with the power have to choose to use it.

The Focus Was on Liquidity and Risk Management

The trouble started with the SEC's "Consolidated Supervised Entities" program, which was how the SEC regulated investment bank holding companies like Lehman. The primary focus of the regulatory program was the investment banks' liquidity and risk management. Recognizing the banks' vulnerability to a liquidity crisis, the program ostensibly required the banks to maintain sufficient liquid assets to survive a year without access to unsecured funding and without having to liquidate a substantial position.

Under the program, the banks were also required to have internal risk controls that the SEC approved and monitored, theoretically to prevent the banks from taking on more risk than they could handle.

Finally, firms in the regulatory program had to assess their soundness by undergoing regular stress tests. The story laid out in Vakulas's report suggests none of these crucial sets of regulations were meaningfully enforced with Lehman.

After Bear Stearns, All Governmental Eyes Focused on Lehman

By the time Bear Stearns collapsed in March 2008, key people in government -- Secretary Henry Paulson at Treasury, Federal Reserve Chairman Ben Bernanke, Federal Reserve Bank of New York President Timothy Geithner and SEC Chairman Christopher Cox -- knew Lehman could be next, according to interviews each had with Vakulas. The concern was based on Lehman's Bear-like business model: High leverage, low capitalization and lots of illiquid assets. Immediately after the Bear Stearns collapse, both the New York Fed and the SEC sent teams to Lehman to review and monitor it.

Liquidity at Lehman and elsewhere was the SEC's key concern, as reflected by a February 2008 memo detailing the scope of the liquidity inspections the SEC would be conducting. The memo said the staff would focus on ensuring the assets counted in the liquidity pool could be available as cash to the company "immediately, usually within 24 hours."

Despite evidence that the SEC communicated its 24-hour definition to Lehman -- the memo was in Lehman's files -- the SEC didn't enforce it. Lehman's liquidity pool definition was based on its ability to monetize the assets within five days.

In fact, a former senior staffer in the SEC's program, Matthew Eichner, told Valukas that the memorandum's steps were never formally implemented as part of the regulatory program. What's more, he said the chaos surrounding the Bear Stearns collapse prevented the SEC from fully implementing the memo.

That explanation seems bizarre. One bank the SEC regulated had just failed, and the SEC knew another one might similarly crater. That seems like a really important time for a regulator to implement the necessary measures to ensure the health of the banks it regulates.

Lehman Failed Its Stress Tests on at Least Three Occasions

One way the SEC assessed liquidity was through stress tests. According to Valukas, after Bear's collapse, the New York Fed implemented more rigorous stress tests. The SEC referred to them as "Bear Stearns" and "Bear Stearns light." Lehman failed both. The New York Fed then developed another set of assumptions for a test, and Lehman failed that, too.

The only stress test Lehman could pass, Valukas reports, is one Lehman itself devised. As Valukas dryly notes: "[I]t does not appear any agency required any action of Lehman in response to the results of the stress testing."

Although Valukas's report doesn't similarly connect the dots about the SEC's oversight of Lehman's risk management, he does report that risk-management systems were very important to the SEC. He also reports that Lehman radically changed its risk management in 2007 and 2008 to allow significantly increased levels of risk. Valukas doesn't report any SEC action to force Lehman to change its risk-management systems.

Lehman Told the Public an Inflated Liquidity Number

According to Valukas, when calculating Lehman's liquidity, the SEC excluded several billion dollars of assets that Lehman had pledged to or deposited with its clearing banks -- assets that Lehman counted in its publicly reported liquidity number. The New York Fed took a similar approach. Both institutions recognized that the pledged assets weren't really liquid enough to count because they couldn't be converted to cash whenever Lehman needed the funds.

However, the problem with Lehman's reported liquidity was worse than the SEC knew. According to Valukas, not until the eve of Lehman's bankruptcy did the SEC realize that more than a third of the supposed liquidity pool was illiquid.

The SEC's ignorance was due to a lack of information sharing between the New York Fed and the SEC, as reported by Valukas. The knowledge gap may have also stemmed from inadequate scrutiny of Lehman's liquidity pool by the SEC.

Little Concern for How Lehman's Liquidity Was Publicly Reported

Both the SEC and the Federal Reserve monitored Lehman's liquidity, believing that an accurate assessment of it was essential to understanding the health of Lehman. Both calculated numbers significantly lower than Lehman's publicly reported figure, obviously believing their metrics more precisely measured Lehman's health. But neither entity thought it appropriate or necessary to ensure that the markets had equally accurate information, according to Valukas.

New York Fed Officer Jan Voigts explained to Valukas that since the Federal Reserve did not regulate Lehman, "how Lehman reports its liquidity is up to the SEC and the world."

More troubling, former SEC staffer Eichner explained to Valukas that "we applied a much different standard [for including assets in the liquidity pool] than did anyone else" and thus the SEC "was very comfortable living with a world where the numbers in public were the ones the firms worked out with their accountants."

It's impossible to understand the SEC's "comfort" with the disclosure situation. The main purpose of the securities regulations enforced by the SEC is giving investors accurate information. To top it all off, the SEC perceived liquidity as the most important economic metric of Lehman's health.

The SEC and New York Fed's attitude toward the liquidity pool reporting is another significant factor in Valukas's judgment that no Lehman officer breached a fiduciary duty by how Lehman publicly reported its liquidity.

Why Was the SEC So Out to Lunch?

A bit of regulatory history gives the SEC's weak oversight of Lehman useful context. In 1999, Congress passed the Financial Services Modernization Act, which enabled investment banks to grow much bigger and take on much more risk. At the same time the act failed to give any regulator the authority to oversee the new investment bank holding companies.

The European Union stepped into the regulatory void in 2003, imposing rules on such companies operating at least in part within the EU -- which included Lehman, Bear and all the others -- unless those companies were subject to equivalent regulations elsewhere.

Lehman and its brethren preferred SEC regulation to EU regulation, and in response to the EU's regulation, the SEC created the Consolidated Supervised Entities program. Although the SEC couldn't require the investment banks to submit to this regulation, they all voluntarily opted in to escape the EU rules. Note that absent the regulatory action by the EU, the SEC would have had no power over Lehman and the others when the crisis hit.

The SEC'S "Regulation" of Bear Stearns Was a Prelude

The SEC's voluntary regulatory program was ineffective, based on a 2008 report by the SEC's Office of Inspector General (OIG) that Congress commissioned in the wake of Bear's collapse. The report critiqued the regulatory program in general and its regulation of Bear in particular.

According to the OIG report and Valukas, despite being aware of many red flags at Bear -- high leverage, inadequate capital, lots of illiquid securities -- the SEC did not require a change in Bear's policies. For example, the SEC did not impose a leverage ratio limit to reduce the leverage risk at Bear, set realistic minimum levels of liquidity or sufficient capital requirements (at Bear or any other similar firm), or require changes to correct deficiencies in Bear's risk-management systems.

When Valukas asked the SEC if it had changed its approach to Lehman after seeing drafts of the OIG's report on Bear and the regulatory program in the summer of 2008, the SEC officer in charge of Lehman told him no. His response: "We were tied to the mast here; the opportunities for re-engineering were quite limited, and to imply otherwise is wrong." Whatever that means.

Because all of the investment banks that opted into the SEC's voluntary regulatory program have since converted to conventional bank holding companies subject to Federal Reserve regulation, the original regulatory gap created by the Financial Services Modernization Act is gone. Then-SEC Chairman Cox ended the SEC program, calling it a failure.

Could Better Enforcement Have Saved Lehman?

If effective regulation had begun with the initiation of the SEC's voluntary program in 2003, Lehman could very likely have been saved, and none of the firms would likely have crashed the way they did. What if the SEC had stepped up enforcement in March, 2008? Maybe. Lehman's myriad bad business decisions had already enormously damaged the firm. That's why, when Bear went, everyone thought Lehman would be next to go.

However, Lehman could have perhaps gone out a la Bear, in a facilitated sale to another bank. But by the time Lehman went bankrupt in September, it was so sick no one would buy it.