Transcript Lawrence G. McDonald

THE FALL OF LEHMAN BROTHERS
& FINANCIAL REFORM
Lawrence G. McDonald
Lehman Brothers’ Stock Chart
Lehman Brothers’ Chairman & CEO
Richard S. Fuld, Jr.
Lehman Brothers’ Board Members
They had an average age of 70,
overseeing $750 billion of systemic risk
Corporate Governance
1) Abolish Chairman & CEO
2) Term Limits for CEOs & Board Members
3) Risk Committee Members On Board
4) Former CEOs As Board Members
Re-Vamping the Regulators,
the Watchdogs Of Finance
1. Incentives for poorly paid regulators with TARP
money.
2. Coordination Of Regulators; SEC, FDIC, FSA, Office
Of Thrift Supervision, Comptroller of the Currency,
Insurance Commissioner.
3. In 2007 there were 3,798 people working at the
SEC. Only 24 people were assigned to regulate the
ten largest investment and commercial banks.
America’s Banking System
1. 15 Years Ago, the Combined Assets of the Six Biggest Banks Totaled
17% of GDP*
•
•
By 2006, that number was 55%
By 2009, it was 63%
2. Three U.S. banks have over 40 % of the global market for stock
underwriting**
3. Five banks have over 95 percent of the market for over-the-counter
derivatives**
4. The biggest four banks have half of the market for mortgages and
two-thirds of the market for credit cards.**
*Sources, FDIC, Cleveland Fed & NCUA
**Simon Johnson, professor, MIT's Sloan School of Management
The Gramm-Leach-Bliley Act of 1999
The government created these mega-giants. Thanks in part to acquisitions of Countrywide Financial Corp.
and Merrill Lynch., the assets of Bank of America have jumped 36 percent from before the financial crisis to
$2.34 trillion. JPMorgan bought Bear Stearns Cos. and Washington Mutual Inc. and has assets of $2.14
trillion, up 37 percent. The top four banks now have 40 percent of the nation's deposits.
Massive flaws STILL in our
banking system
1. Regulatory Arbitrage
2. REPO 105 & Liquidity Pools
3. Poor Global Regulatory Coordination - Basel II & III
4. “Big four accounting firms are “too BIG to fail.”
Charlie Munger
Derivatives Language: Cause
Cause #1: When Lehman
failed Hank Paulson and his
team in DC had not remotely
quantified the risk of Lehman’s
$7 trillion derivatives book to
our 17 counterparties.
Cause #2: A scary percentage of
Lehman’s CDS / derivative
trades were not settled, this was
problem with all banks, key
stroked by hand
Effect: Lynch Amendment:
financial firms may not own more
than 20% of an exchange.
Lincoln Amendment: Force banks
to spin off their derivatives
business or keep it in a subsidiary
separate from the part of the
company that may receive
Federally-insured deposits.
Derivatives required to go onto a
public exchange that would
provide investors with details on
the transactions.
Derivatives Language: Effect Inside the
Dodd Frank Bill
• The $375 million lobby efforts spent by the street over the last 18 months
have clearly paid off.
• Lincoln Language (Sec. 716): House Agriculture Committee Chairman
Peterson (D-MN) successfully moved an amendment which weakened
the original base Lincoln language.
• Credit Default Swaps will be allowed to be held in a separately capitalized
Bank Holding Company within a big commercial bank. Originally this was
expected to be a true spin off. Of course no specifics on actual
capitalization requirements yet, which means this was an active
battleground.
• Modifications would allow banks to retain interest rate and foreign swaps,
and cleared investment grade credit derivatives.
Derivatives Language: Effect
• What’s left of the Lincoln amendment has a two-year base phase-in,
regulators are given some leeway to extend full implementation for three
years. Definition of Major Swap Participant: The SEC and CFTC are
given broad leeway to define the definition of an MSP.
• - The Senate rejected the “Lynch Amendment” language governing
limits on clearinghouse ownership. Instead, the final Bill adopted
language which strengthened a regulatory initiative to set conflict of
interest ownership guidelines through the regulatory process.
• End-User Exemption: End users are exempt from the exchange trading
requirement and would include non-financial commercial entities who
own, use, produce, process, manufacture, distribute, merchandise, or
market goods, services, or commodities (including coal, natural gas,
electricity, ethanol, crude oil, gasoline, propane, distillates, and other
hydrocarbons) either individually or in a fiduciary capacity.
Risk Management: 1980s Drexel Burnham /
S&L Crisis to 1990s Long Term Capital
Management = 10x, LTCM to 2008 Lehman =
100x! : Cause
Cause #1: What is Proprietary Trading?
38% of Lehman Brothers Net Tangible
Equity in 3 Investments: Suncal, Coeur
Defense, Archstone Smith
Cause #2: Lehman Gross Leverage
reached 44x
Cause #3: One Trader at Morgan Stanley
cost the Firm $8 billion
Cause #4: Lehman Brothers owned 7
Hedge Funds, leverage on leverage
Speier Amendment: 15:1
leverage limitation. Volcker
Rule: Banks prohibited from
proprietary trading except for
transactions that benefit
customers. Volcker Rule: This
part of the bill included a
prohibition for bank holding
companies to engage in
proprietary trading and certain
relationships with hedge funds
and private equity funds..
Risk Management: Effect
-
Volker Rule: modified from its initial form to include multiple exceptions for
permitted activities, as well as “de minimus” allowances for investments in
hedge funds and private equity. While proprietary trading was also more
specifically defined based on what has been commonly referred to as the
Merkley-Levin amendment, there is still a fair amount of regulatory discretion
provided during the rulemaking phase.
-
“De minimus” investments may be made in hedge funds and private equity
funds, so long as the banking entity does not have more than 3 percent of total
ownership of the fund and that investment does not represent more than 3
percent of its Tier 1 capital. There is a 2 year phase-in, with Federal Reserve
approval for these investments.
-
There is a study by the Financial Stability Oversight Council, due within 6
months of enactment that will make recommendations for implementing
enhanced safety and soundness, as well as how to minimize risky activity.
Risk Management: Effect
-
The Dodd Frank Bill states that rulemaking to implement the new restrictions
must occur within 9 months of completion of the study listed above.
-
Affected institutions will have 2 years to conform to the new restrictions, with the
ability to appeal to the Federal Reserve for extensions each year, for up to 3
years. There is the potential for a maximum of a 5 year phase-in period, subject
to Federal Reserve approval.
-
For illiquid funds, the period can be extended by the Federal Reserve up to 5
years, from having a contractual obligation in effect on May 1, 2010.
-
Firms can be asked to raise additional capital during the phase-in period, starting
15 months after the bill’s enactment.
-
The bill calls for banks to hold more money as a cushion against risks, but it
doesn't say how much.
-
It also was mum on the amount of cash that firms dealing in derivatives need to
set aside in case those bets sour.
Consumer Protection: Cause
Inside the Dodd Frank Bill’s
Consumer Protection Agency
Cause #1: Lehman Brothers Originate to
Distribute Machine. 2003: $500 to $600 million a
month of subprime, Alt A mortgages. By Late
2006: $3 billion a month origination
Cause #2: 10,000 Lugheads at BNC and Aurora
Loan Svs “some of the most despicable human
beings on planet earth.”
Cause #3: 300+ Shadow Banks in 2007 don’t
exist today
Cause #4: Ratings agencies actively gamed by
Wall St.
Would create a freestanding Consumer Financial
Protection Agency.
Allows the Comptroller of the Currency to pre-empt
state consumer protection laws.
Prevents new consumer protection regulator from
overseeing auto dealers.
Create a Bureau of Consumer Financial Protection as
an independent division within the Federal Reserve.
Give more power to state attorneys general to make
laws that are tougher than the Federal standard.
Durbin Amendment: Require Federal Reserve to limit
debit card interchange fees and allows retailers to
offer discounts to customers based on how they pay
for their purchases.
Consumer Protection: Effect
•
Durbin Amendment on Debit Card Interchange Fees ($20 billion interchange
fee system): Durbin compromise language on debit card interchange fees
remains intact. Federal Reserve itself, rather than the Consumer Financial
Protection Agency (CFPB) will remain rule-writing and enforcement powers.
The Fed would be allowed to consider monies spent fighting fraud when
determining whether interchange fees are “reasonable and proportional.”
•
Bureau within the Federal Reserve to regulate consumer financial products like
mortgages and credit cards. The bureau would also oversee payday lenders
and check cashing businesses. Auto dealers and pawnbrokers are exempt from
the bureau's regulation even though the Department of Defense wanted auto
dealers included because of past instances of exploiting members of the
military. House members originally wanted this watchdog to be a freestanding
agency.
•
Lenders must verify that borrowers are able to repay the loans that they issue.
Lenders would pay penalties for irresponsible lending.
Consumer Protection: Effect
•
The Dodd Frank Bill would ensure that consumers benefit when refinancing a
mortgage. It would eliminate fees -- known as "prepayment penalties" -- for
paying off a mortgage early.
•
Franken Amendment on Ratings Agencies: Two year SEC Study will be
conducted, dead on arrival in the conference process. But the door was left
open for the SEC to figure out a better way to match rating agencies with
financial firms. But if it can't, the SEC is required to follow the original plan
proposed by Sen. Al Franken...in two years.”
•
There are 10 SEC-approved "Nationally Recognized Statistical Ratings
Organizations," or rating agencies.
•
Obviously, the three that are well-known are Moody's, Standard & Poor's and
Fitch.
FDIC and Federal Reserve
Accountability: Cause
Cause #1: Abuses of Fed and Treasury Powers
during Lehman Failure unprecedented.
Bottomless pit Emergency Powers Section 13-3
of the Federal Reserve Act. In unusual and
exigent circumstances, the Board of Governors
of the Federal Reserve System… Can do what
ever it well pleases…
Cause #2: Makes Iran Contra look like child’s
play
Cause #3: Countrywide, Fannie Freddie, Merrill,
Massive support of the CP market, AIG
Cause #4 Powerful connection / bond Paulson
Blankfein. Horrible Fuld Paulson Relationship
Allows GAO to audit balance sheets of
the Fed and its regional banks.
Requires disclosure after 1 year
Requires a one-time GAO audit of Fed
operations within one year
Requires Fed to disclose the names of
recipients of emergency credit on its
website by Dec. 1
FDIC and Federal Reserve
Accountability: Effect
•
Financial Stability Oversight Council: The council. Headed by the Treasury
Secretary would monitor systemic risk across the entire financial system
and make recommendations to the Federal Reserve to alleviate that risk.
The ten-member council would include the heads of the federal financial
agencies.
•
Fannie and Freddie Kick the Can Down the Road: New Bill does nothing
to address the problems, and sustainability, of mortgage giants Fannie
Mae and Freddie Mac and their $5 trillion mortgage portfolio.
•
No Resolution Fund: The House wanted to create a $150 billion fund to
pay for any future bailouts. The fund would be paid for by the banks. This
provision was gutted. Conferees agreed that this could only be created
after a massive collapse. This is the fund that Republicans successfully
painted as a permanent bailout fund when Democrats in the Senate tried
to include a similar, but only $50 billion, fund.
FDIC and Federal Reserve
Accountability: Effect
•
Government Accountability Office Study of the Federal Reserve: The
GAO will be able to do a full audit of the Federal Reserve. This is still a
major provision, but conferees did not accept the more strict language in the
House bill that would require an audit every year.
•
Too big to fail language still alive allowing the Federal Reserve to bail out a
bank holding company in trouble with their derivatives book. Government
protections for troubled swaps businesses are still under discussion. The
Federal Reserve could use emergency powers in the event that a swap
entity’s failure posed systemic risk.
Resolution Authority: Cause
Cause #1: When they let Lehman fail this was a
by product of a deadly game of Chicken between
Treasury Secretary Hank Paulson and Lehman
CEO Dick Fuld
Cause #1a: Lehman restructuring firm, Weil
Gotshal called in much to late in the game as a
threat?
Original docket: Judge Peck presented with 12
pages vs. 250 pages expected for a huge
bankruptcy.
Prime Brokerage Clients saw their portfolios for
sale in the street.
Bankruptcy bigger than Enron, Worldcom General
Motors, Chrysler combined
Effect: Originally, Large institutions would be
charged regular fees that would go into a $150B
fund to cover any future failure.
FDIC would have authority to tap credit line at the
Treasury to cover the costs of failure.
Miller-Moore amendment: Requires secured
creditors of failing institutions to take losses up to
10% on claims before they could recoup losses
from restitution fund.
Senator Breakfast: McConnell and Cornyn
Prevents creditors from receiving payments in
excess of what they would have won in U.S.
Bankruptcy Court.
Resolution Authority: Effect
•
Special Assessment on financial companies with more than $50B and hedge
funds with more than $10B consolidated assets under management
•
This assessment of up to $19B will be levied on “financial companies” with
more than $50B in assets and hedge funds with more than $10B in assets
under management.
•
Wall St. paying with their own blood. Assessment viewed as necessary to
offset the estimated $20B in increased bureaucratic costs the legislation
would impose and which would otherwise contribute to the national deficit.
•
Financial Stability Oversight Council (FSOC) would collect and determine
assessments on an annual basis (approximately $4B a year) working through
the FDIC.
•
First assessment would come due no later than September 30, 2012.
Resolution Authority: Effect
•
Assessments would be required to be levied according to a “risk matrix” which
FSOC and the FDIC would establish by rule and would vary based upon an
individual firm’s “complexity of operations or organization, interconnectedness,
size, direct or indirect activities…as well as the risk posed to the financial
system.”
•
Other Factors Determining Assessment: Extent of a company’s leverage, offbalance sheet exposures, Extent and nature of a company’s transactions and
relationships with other financial firms, Company’s importance as a source of
credit and liquidity; including for underserved and disadvantaged communities,
Amount and nature of the company’s financial assets and liabilities, including
the degree of reliance on short-term funding.
•
Federal supervisory agencies will be empowered to make on-site inspections
of a financial company’s books and records to carry out the assessments.
•
The FDIC would have the authority to liquidate failing firms while the Treasury
Department fronts the money to do so. There would also be a repayment plan
so that taxpayers are guaranteed to get the money back.
Investor Protection
SEC to define "private equity
funds" and "venture capital
funds.“
$100 million AUM threshold for
SEC registration; state
regulation for those under
threshold
SEC to define "venture capital
funds.“
$150 million AUM threshold for
SEC registration; state regulation
for those under threshold.
Private funds required to
disclose information needed to
assess potential systemic risk to
investors, counter-parties and
creditors.
Major Actions July / August 2010
•
Good news for hedge funds, venture capital and private equity investors: Senate
continued consideration of tax extenders legislation (HR 4213), but again were
unable to garner the 60 votes needed to end debate on the measure. Majority
Leader Reid (D-NV) had pulled the bill from the Senate floor as of late Thursday.
•
Another black eye for the Obama Administration: Democratic leadership has
spent considerable time wooing three “moderate” Senators – Sens. Snowe (RME), Collins (R-ME) and Ben Nelson (D-NE) – all of whom voted no on the motion
to proceed.
•
Expect separate new legislation on Fannie Freddie, Ratings Agencies,
Securitization
•
Consumer Protection Agency head likely to be chosen very soon. Larry
Summer’s pal Elizabeth Warren is viewed by many in Washington as Borkable,
look for a fight here.
Basil III Proposal