Of Lehman and Goats

As Stephen Lubben has remarked on this blog, the litigation filed by Lehman against JPMorgan regarding JPMorgan's alleged role in Lehman's demise is heating up. Late last week, JPMorgan filed a colorful amended counterclaim, citing how Lehman had described the collateral it had given JPMorgan as "goat poo" internally and other things besides. The issue of Lehman's collateral underlying its funding arrangements is a highly interesting one, not least because it ought to provoke some thought about how far we have come in managing and regulating liquidity risk. Clearly, Lehman, then the fourth-largest investment bank, was playing with fire in trying to fund its daily business activities by putting down "goat poo" as collateral, and not just that, putting the system at risk by doing so. Lehman's access to liquidity in its last days was highly dependent on its access to secured credit, and when lenders belatedly asked for more and better collateral, fell days later.What have regulators done since then? ECB's Governing Council Member Christian Noyer brought up this issue a couple of weeks ago, stating that there were faults in the definition of liquid assets under the new Basel III framework. The Basel Committee has developed liquidity ratios as monitoring and preventive mechanisms, including a Net Stable Funding Ratio ("NSFR"). This is defined as the amount of available stable funding to the amount of required stable funding, which banks must maintain at 100% or higher (logically). Required stable funding is calculated as the sum of the value of assets held by an institution, weighted by a factor (the Required Stable Funding factor, or RSF) that reflects each asset type's liquidity. Essentially, the less liquid an asset, the more stable the funding that must be required for it. It's worth mentioning that because of the regulatory focus on liquidity, financial institutions around the world can expect to be subject to similar scrutiny, whether or not they are supposed to be Basel III compliant. Under this rule, banks would now face this logic: unencumbered assets are assigned RSF factors ranging from 0-50%, while encumbered assets generally receive a 100% RSF. Simply put, if an unencumbered asset becomes encumbered, a bank's liquidity takes a hit. This distinction, based on whether the assets are encumbered, seems logical. However, it turns out that Lehman was playing a pretty fine distinction between what was encumbered and what was not. Let's turn to interesting facts in Lehman's case that were revealed in the Examiner's Report. Lehman held a lien-free Overnight Account with JPMorgan into which the former could transfer securities overnight, if there were no outstanding obligations to JPMorgan. These assets generally had to be returned to Lehman's liened accounts every morning as they were being used for collateral in short-term repos that Lehman conducted to obtain funds. It was only overnight that these assets were, in the daily course of things, unencumbered, but because Lehman reported liquidity at the end of each day and declared them part of its liquidity pool. So not only were these collateral partly made up of "goat poo", they were being double-counted by Lehman. So what does the story tell us? It's not just new rules on liquidity requirements that the industry needs, but clear rules on how to define and calculate liquidity metrics. It's worth noting that Lehman's collateral posted with JPMorgan in August 2008 included more than $5 billion of CDOs, including Spruce, Pine and Kingfisher – all of which were downgraded to junk soon after Lehman's filing. Most of these CDOs were self-priced by Lehman. What's worse, these CDOs were not even structured as true-sale transactions (title to the assets remained with Lehman entities), accounting for the steep deterioration of the value of these assets. There's yet one more twist to this tale. The FDIC has recently issued an Interim Final Rule on the Orderly Liquidation Authority, with the comment period ending in March. The new rules, including clarification on the valuation of secured creditors' collateral and that secured creditors will absorb losses along with unsecured creditors for any unsecured portion, are supposed to incentivize institutions to opt for highly liquid and less volatile collateral. However, if Lehman were not able to post such collateral (the Examiner's report suggested that Lehman informed JPMorgan that it had no other collateral to pledge), and forced to fail even faster, would the systemic implications have been worse? It appears that part of the rationale behind the various actions of Paulson, Geithner and Bernanke during the worst of the crisis was to slow down the crash in investor confidence and give institutions time to make emergency plans, raise additional capital, and so on. Increasing the amount of conservatism in the system can make institutions stronger but might also simply make weak institutions fail faster, at the wrong time. Of course, the solution is not to be less conservative, but make sure we have the right failure containment systems in place. The trade-off between creating moral hazard and reducing systemic risk is a difficult one.

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