6Pre-announcement of second quarter earnings Conference Call, LBHI_SEC07940_592160, p. 5: ‘Lehman Brothers announce expected second quarter results. Expected to report a net loss of $2.8bn’, 9 June 2008.
8Citi's Corporate Bond Research Report (28/5/08) stated that Lehman followed a prudent funding practice and unlike Bear Stearns did not rely on customer balances in its prime brokerage operation to fund its balance sheet, and that it had reduced its leverage to 16X and that its exposure to subprime mortgages was $4bn, an amount that Lehman considered to be manageable, and planned to reduce its commercial mortgage exposure/CMBS to $5bn. Views amongst its analysts differed, however, with Ryan O'Connell commenting that ‘another Bear-Stearns type funding squeeze is overblown for Lehman’.
9Quoted by Zachery Kouwe, New York Post, 18 March 2008.
10Examiner's Report, p. 1396. See also memorandum from Margaret Sear, Lehman et al. to Files, 11 April 2008 at p. 1 (accounting policy memorandum).
11In reply to questions from Mr Bachus during the Committee on Financial Services, US House of Representatives, Washington DC, 17 March 2010.
12Jan Voigt's email to Timothy Geithner, 9 April 2008. Reference: Meeting with Lehman's senior management team, 20 March 2008. Jan Voigt, Examining Officer Operational Risk Governance, Federal Reserve Bank, New York.
14Willem Buiter, ‘Three Hits and Three Misses for the Fed’. Maverecon, Financial Times, 17 March 2008.
15Regulatory Reform. Primary Dealer Credit Facility, Board of Governors of the Federal Reserve System, 2 August 2013.
16Under the provisions of the Dodd-Frank Wall Street Reform & Consumer Protection Act 2010, the Federal Reserve Bank is obliged to provide transaction data and detailed information about its loans to depository institutions and others. This information was published on 1 December 2010.
17Quoted in ‘Morgan Stanley used Credit Program 212 times’ , Wall Street Journal, 1 December 2010.
19Final Transcript LEH-Q3, Preliminary Lehman Brothers Holdings Inc. Earnings Conference Call, 10 September 2008, Thomson Street Events, pp. 4ff.
20Memorandum for the record, which is a paraphrase of the interview dialogue. Interview with Annette Nazareth, SEC Commissioner from August 2005 until January 2008, 1 April 2010.
21Testimony Concerning Turmoil in the Credit Markets by Erik Sirri, Director of Trading and Markets, before the House Committee on Financial Services, 7 May 2008.
22‘Turmoil in the U.S. Credit Markets: Examining Recent Action Federal Financial Regulators before the U.S. Senate Committee on Banking, Housing and Urban Affairs’. Testimony of Christopher Cox, Chairman of the SEC, 3 April 2008, p. 13.
23Robert Colby, Testimony Concerning the Consolidated Supervision at US Securities Firms and Affiliated Industrial Corporations, Before the House of Representatives Financial Services Committee, 25 April 2007, p. 1 (my italics).
24Testimony Concerning the Turmoil in the Credit Markets; Examining the Regulation of Investment Banks by the SEC before the Senate Sub-Committee on Securities, Insurance and Investment, 7 May 2008.
27Office of Inspector General Response to Chairman Cox and Management Comments, Appendix VIII, pp. 116 and 117–18.
28Memorandum for the record (not a transcript). Meeting with Members of the SEC Regarding the CSE Programme, 18 March 2010. Mike Maccahiaroli, Director of Trading and Markets; Sam Fortstein, Assistant General Council; Sarah Hancur, Office of the General Counsel.
29Ibid., memorandum of the interview with Annette Nazareth.
1Lehman Brothers Press Release, 10 September 2008.
2Q3 2008 Preliminary Lehman Brothers Holdings Inc. Earnings Conference Call, 10 September 2008. LBHI_SEC07940_612771.
3‘Rating Action: Moody's places Lehman's A2 rating on review with direction uncertain’, Moody's Investors Service, 10 September 2008.
4James B Stewart, ‘Eight Days. The Battle to Save the American Financial System’, TheNew Yorker, 21 September 2009, p. 5; Henry M Paulson Jr, On the Brink:Inside the Race to Stop the Collapse of the Global Financial System (Business Plus, Hachette Book Group, 2011), pp. 123 and 155.
5Timothy F. Geithner, ‘Stress Test: Reflections on Financial Crises’, Deckle Edge, May 2014, p. 177.
7Ibid., p. 184. LTCM, Long Term Capital Management, had collapsed in 1998: ‘Back then, a group of 14 Wall Street firms had banded together to craft a $3.6bn package, receiving 90% of the imperilled hedge fund, which they liquidated over time.’ Ibid., p. 178. Paulson hoped that a similar consortium of banks would come to the rescue of Lehman Brothers.
8Work had been carried out by staff of the New York Federal Bank on a liquidation consortium consisting of major bank and investment bank counterparties of Lehman – most notable in tri-party repo, credit default swaps and other OTC derivatives to discuss possibilities of joint funding mechanism that avert Lehman's insolvency. The Memorandum added:
‘FRBNY financial commitment (this section to be overhauled by Dudley, Schetzel)
— we should have in mind a maximum number of how much we are willing to finance before the meeting starts, but not divulge our willingness to do so to the consortium.
Term of any liquidity support should be long enough to guard against a fire sale but on a short enough fuse to encourage buyers of Lehman assets to come forward.
— referable to style FRBNY commitment as much as possible as a backstop rather than lending.’
Referenced in the Examiner's Report, FRBNY to Exam 003516, 10 Sept 2008.
9The diary of events relies on Henry Paulson's record of events in his book, On the Brink, and also on Appendix 15, Narrative of 4 September to 15 September in Lehman Brothers Holdings Inc. Chapter 11 Proceedings, Examiner's Report. Both of these seemed to me to present the most careful accounts of the way in which the events of the weekend unfolded. My interpretation of events differs from the views expressed by some of those involved, however.
13Those present included Wall Street's most prominent CEOs: Jamie Dimon from JP Morgan, John Mack from Morgan Stanley, Lloyd Blankfein from Goldman Sachs, Vikram Pandit from Citigroup, Brady Dougan from Credit Suisse and Robert Kelly from Bank of New York Mellon.
20Statement of the Financial Services Authority (UK). In September 2009, the FSA received a request from the Examiner appointed by the US bankruptcy court to provide information about their involvement in the attempt by Barclays Bank plc to buy Lehman Brothers Holdings Inc during the period 12–15 September 2008. These sections draw on that report.
21Alistair Darling, Back from the Brink, 1,000 Days at Number 11, p. 121.
26Opinion on Motions seeking modification of the Sale Order pursuant to Rule 60(b), the Trustee's motion for relief under the SIFA sale order, Barclays cross-motion to enforce sale orders and the adjudication of related adversarial proceedings, p. 11.
27Statement by Thomas C Baxter Jr, Executive Vice President and General Counsel, Federal Reserve Bank of New York, to the Financial Crisis Inquiry Commission, 1 September 2010, pp. 3–5.
67Chairman B Bernanke, US Financial Markets, before the House Committee on Financial Services, 24 September 2008.
68New York Times, 15 September 2008 and Financial Times, 16 September 2008.
69M Kacperczyk and P Scnabl, When Safe Proved Risky: Commercial Paper During the Financial Crisis of 2007–2009, NYU Stern Business School, November 2009, pp. 18–19.
70Figures released by the US Department of Commerce, Bureau of Economic Analysis, 28 July 2011.
Chapter 4: Regulating the ‘Big Five’
1Lawrence White, ‘The Gramm-Leach-Bliley Act of 1999: A Bridge Too Far? Or Not Far Enough?’, Suffolk Law Review (2010). White also points out that by February 2010, there were 543 FHCs in the USA, including 40 foreign banks.
2The Glass-Steagall Act was passed in 1933, in the aftermath of the stock market crash of 1929, the collapse of thousands of commercial banks between 1929 and 1933, and the Great Depression. The securities activities of commercial banks were thought to have been the reason for bank failures. The Act separated commercial banks from investment banks, and the latter were not allowed to take deposits.
3Section 16 as incorporated in 12 U.S.C. 24 (Seventh).
4See 12 U.S.C. 377 and 378, repeal of Public Law 106–102 and Repeal of Public Law 106–012 Title I para. 101(a).
5J Barth, D Brumbaugh and J Wilcox, The Repeal of Glass-Steagall and the Advent of Broad Banking, OCC Economics Working Paper 2000–5, April 2000, p. 2.
6Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), also known as Government-Sponsored Enterprises, are unusual organizations in that they are shareholder-owned, profit-seeking corporations, but subject to government housing policy requirements as laid down by the Department of Housing and Urban Development. Fannie Mae was established in 1938 after the Great Depression in order to get the housing market moving by purchasing mortgages from banks, thus freeing up capital for the banks to lend. Freddie Mac was established in 1970 to compete with Fannie Mae. Neither corporation provides mortgages, but purchases mortgages from lenders, pooling loans to create mortgage-backed securities, which are then sold with guarantees against defaults on the underlying mortgages, to investors. Their purpose is to provide a stable source of funding for residential mortgages, including loans for housing to low-to-moderate income families. Their mortgage-backed securities (MBSs) were not guaranteed by the US government.
7Barth, Brumbaugh and Wilcox, The Repeal of Glass-Steagall and the Advent of Broad Banking, pp. 4–5.
14Remarks made by Vincent Cable on the BBC's Radio 4 ‘Today’ programme, as reported in the Guardian newspaper, 8 September 2010.
15Opening Statement by Governor Daniel Tarullo, 10 Dec 2013.
16Under the Office of the Comptroller of the Currency's regulations before and after the GLBA, banks could not underwrite or deal in MBSs or any other non-governmental securities, but they could do this before and after the GLBA. After GLBA, banks could be affiliated with a securities firm which undertook such activities. Reference is made to the OCC regulations. These apply to almost all the large banks, such as Bank of America and Citibank, which as national banks are regulated and supervised by the OCC.
17For the full story, see Oonagh McDonald, Fannie Mae and Freddie Mac: Turning the American Dream into a Nightmare (Bloomsbury Academic, 2012).
18Annette Nazareth, Testimony Regarding Certain Pending Proposals by the EU Commission, Before the House Committee on Financial Services, 22 May 2002.
19Federal Register, Vol. 69, No. 118, 21 June 2004, Rules and Regulations.
21Basel refers to the Basel Committee on Banking Supervision, promoting an international regulatory framework for banks. It does not have the power to impose regulatory or supervisory powers but in fact the regulatory framework results from discussions between central banks and banking supervisors; its proposals are subject to detailed consultation and most countries seek to incorporate Basel's regulatory framework into their regulatory framework. The framework known as Basel II has been superseded by Basel III, which, following the financial crisis, is a comprehensive set of reform measures designed to strengthen the regulation/supervision and risk management of the banking sector and improve its ability to absorb shocks.
22Testimony Concerning Certain Pending Proposals by the European Commission by Annette Nazareth, Director, Division of Market Regulation, SEC, before the Committee on Financial Services, 22 May 2002.
23Testimony Concerning the Consolidated Supervision of US Securities Firms and Affiliated Industrial Loan Corporations by Robert Colby, Deputy Director, Division of Market Regulation, US Securities and Exchange Commission, 25 April 2007.
Chapter 5: The Largest Bankruptcy in American History
1Harvey R Miller, ‘Examining the Causes of the Current Financial and Economic Crisis of the United States and of the Collapse of Lehman Brothers’, before the Financial Crisis Inquiry Commission, 1 September 2010, p. 12.
2This chapter inevitably draws on the Report of Anton R. Valukas, Examiner on the Lehman Brothers Holdings Inc for the Bankruptcy Court, Southern District of New York, Chapter 11. It was published on 11 March 2010. The Report is over 2,000 pages long. The Examiner and his staff reviewed five million documents and conducted 250 interviews. The documents are readily available, but, although the Examiner quotes from the interviews, the full text is not available.
3Examiner's Report Vol. I, Executive Summary, pp. 16–17. The Repo (repurchase) is a way for investment banks to borrow money from a large company and in return, the bank sells the company an asset, usually a bond, to protect the company, so that if the bank goes bankrupt, the company can sell the bond and retrieve the cash. The bank also agrees to buy back the bond at the end of the loan (usually after a very short term), less an agreed level of interest, which is paid to the company. Lehman took rather less cash than the bond was worth, so that the transaction was properly recorded in the accounts as a sale rather than a loan.
11Lehman was able to argue, ultimately successfully, that since it over-collateralized the borrowings, the counterparties would not complain about a default by Lehman on the repurchase leg, since the counterparty/transferee would incur a gain of 5 per cent or 8 per cent if that occurred. In effect, Lehman netted liabilities and assets that had disparate counterparties, contrary to basic GAAP rules. Unless the counterparties are identical, a risk remains for the transferor, which means that it did not sell the assets, i.e. if the issuers of the bonds announced that they were defaulting, that would not excuse the Transferor's obligation to ‘buy back’ the now worthless bonds. The accounting procedures could have been greatly streamlined by reinforcing the rules: ‘no offsetting of assets and liabilities already in place: unless both legs have the same counterparties, with a formal agreement in place to settle net, the transaction must be reported “broad”, which means in the context of Lehman's accounting, as a secured borrowing. Accountancy rules have not been improved in this way.’ Source: private comment from Dr Barry Epstein, lead author of Wiley GAAP, 1985–2010.
14Mary Shapiro, Evidence to the House Committee on Financial Services on 20 April 2010.
15B J Epstein, ‘When Window-Dressing Becomes Fraud: Repo 105 was Much More than Window Dressing’, Russell, Novak & Co LLP.
16FASB, Accounting Standards up-date 2014–11. Transfers, Servicing, Effective Controls for Forward Agreements to Repurchase Assets and Accounting for Repurchasing Finances.
17Transcript of Lehman Brothers Holdings Inc for Second Quarter 2008 Earnings Call, 16 June 2008.
18Quoted by the Examiner, op. cit., p. 205, from transcript of a speech by David Einhorn, Presentation to Grant's Spring Investment Conference, Private Profits and Socialised Risk, 8 April 2008, p. 9. At that same conference, Einhorn, manager of Greenlight Capital, announced that he was shorting Lehman stocks – an unusual announcement for a hedge fund manager, but also a way of ensuring that others would short the stocks as well, thereby increasing his profits. He had also been a board member of New Century Capital, a subprime mortgage company which had been forced to file for bankruptcy in 2007.
19‘The Confidence Man’, New York Magazine, 15 June 2008.
21Examiner's interview with Mark Walsh, 21 October 2009, p. 244.
22‘Mark Walsh, Lehman's Unluckiest Gambler’, New York Observer, 10 January 2008.
23‘How Lehman Brothers got Its Real Estate Fix’, New York Times, 5 March 2009.
24Examiner's interview with Mark Walsh, 21 October 2009, pp. 225–6.
25Mezzanine is debt capital that gives the lender the right to convert to an ownership or equity interest in the company if the loan is not paid back in time or in full. Mezannine debt capital is subordinated to debt provided by senior lenders such as banks and venture capital companies.
26Lehman Global Real Estate Product Control, Global Real Estate Markdowns Presentation, January 2008, pp. 1–2, quoted by the Examiner, p. 229.
5Quoted in The New Yorker: ‘Eight Days. The Battle to Save the American Financial System’, 21 September 2009.
6As reported in The New York Times, 13 December 2008.
7H Miller, Bloomberg, 28 April 2010. It should also be noted that no exact figure for the number of outstanding derivative contracts is available. Various estimates of the number and the amounts outstanding are provided by experts, including regulators. It is not possible to find an exact figure from any reputable source, which explains why the numbers vary throughout this chapter.
8Financial Crisis Inquiry Commission: Examining the Causes of the Current Financial and Economic Crisis of the United States and of the Collapse of Lehman, Testimony of Harvey Miller, 1 September 2010.
9H Miller, ‘Too Big to Fail: The Role for Bankruptcy and Antitrust Law in Financial Regulation Reform’, before the Subcommittee on Commercial and Administrative Law of the House of Representatives Committee on the Judiciary, 22 October 2009, p. 8.
12Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’, 2011 and 2014; Basel Committee, ‘Report and Recommendations of the Cross-Border Bank Resolution Group’, 2010. For ‘living wills' for large banks in the USA Title I Dodd-Frank, New insolvency regime, Title II Orderly Liquidation Authority.’
13Bank for International Settlements, Monetary and Economic Department, ‘OTC Derivatives Market Activity’, May 2009, pp. 1–2.
15A derivatives contract is an ISDA Master Agreement, supplemented with a schedule. These together set out the fundamental contractual terms of all derivatives transactions which are executed between the parties. Each individual transaction is documented with a confirmation. There may be several confirmations, corresponding to individual derivatives transactions under a single Master Agreement and Schedule. There are typically multiple trades associated with each derivative contract.
16Kimberly Summe, ‘An Examination of Lehman Brothers Derivatives Portfolio Post-Bankruptcy and whether Dodd-Frank would have made any differences’, Harvard Business Law Online, April 2011.
17The exact size of Lehman Brothers Special Financing Inc (LBSF)'s derivatives portfolio pre-bankruptcy has not been published, but it was estimated to be $33 trillion in notional value. When the US estate filed for bankruptcy, it reported that it was counterparty to 930,000 derivative transactions documented under 6,100 ISDA Master Agreements. A figure of 1.3 million contracts is sometimes given, and at other times a lower figure of 960,000 is given.
18K Ayotte and D A Skeel Jr, ‘Bankruptcy or Bailouts?’ Journal of Corporate Law, March 2009, Vol. 33, no. 3, p. 494.
29The Act in question is the Commodities Futures Modernization Act, signed into law by President Clinton in December 2000. The Act excluded a wide range of derivatives from the Commodities Exchange Act 1974.
30Alan Greenspan before the Committee on Agriculture, Nutrition and Forestry and the Committee on Banking, Housing and Urban Affairs, US Senate, 21 June 2000.
31Remarks by the Deputy Comptroller for Capital and Regulatory Policy, Charles Taylor, OCC, 3 March 2014, Institute of International Bankers, Washington DC.
8The four agencies are: the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC) and the Office of Thrift Supervision (OTS).
9Interagency Appraisal and Evaluation Guidelines, 27 October 1994, p. 2.
10Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, 12 December 2006, Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System and Federal Deposit Insurance Corporation.
12K Friend, H Glenos and J Nichols, ‘An Analysis of the Impact of Commercial Real Estate Concentration Guidance’, April 2013.
13Cap*105 calculated the current capitalization of the underlying property (i.e. the outstanding debt plus equity invested to date) and then multiplied this number by 105 per cent to estimate the value of the collateral as of a specific valuation date. The additional 5 per cent represented the presumed appreciation of the collateral. It was designed to limit valuations in the midst of rising real estate prices in order to keep the presumed appreciation of the property within limits. Its use was obvious if real estate prices were rising rapidly. The method did not seem to make use of inputs from the market. But as prices began to fall, the method led to an over-valuation of the property used as collateral.
14However, the internal rate of return method (IRR) was supposed to be based on at least some inputs from the market. Under the discounted cash flow method, an IRR model assessed the value of the collateral by calculating the net present value (NPV) of all monthly discounted net cash flows (NCF). This was done by calculating the NCF produced by the asset by taking the monthly expected revenue and subtracting the monthly expected expenses. Then the IRR model applied a discount rate in order to reach the NPV of the NCF. To arrive at the fair value, the discount rate should reflect the yield an investor would require to purchase the property. But Lehman applied a discount rate based on their expected rate of return or an interest rate associated with the underlying loans at origination, not the yield the investor would want to buy the property.
15Examiner's Report, Section IIIA(i), Lehman's issues with TriMont's Data, pp. 312 and 332.
16Examiner's Report, Lehman's Syndication Efforts, p. 317.
33Basel Committee on Banking Supervision, Consultative Document: ‘Fundamental Review of the Trading Book: A Revised Market Risk Framework’, October 2013, p. 4. As part of its rapid response to the financial crisis, Basel initiated a requirement to hold capital against credit risk, which had not been considered previously. The VaR model is also likely to be abandoned in favour of ‘expected shortfall’.
34Office of Thrift Supervision, Report of Examination of Lehman Brothers Holdings Inc., New York, NY, Docket S2511, pp. 1–2. Examination Start Date, 8 July 2008. No completion date is given. The Report itself was probably designed to prove that OTS had taken appropriate action in relation to Lehman and the emerging problems in the markets.
35Examiner's Report, Examiner's Conclusions, Business and Risk Management, Executive Summary, p. 50.
36Examiner's Report, Section III, A. 1, Risk Section, (d) Lehman Increases Risk Appetite to Accommodate Additional Risk Attributable to Archstone Transaction, pp. 133, 141 and 153.
1Press Release: ‘International Valuation Standards Council and The Appraisal Foundation Agree to Bring Greater Consistency to Appraisal Standards’, 24 October 2014. The Appraisal Foundation is authorized by Congress to set out appraisal standards and qualifications, applying USPAP. The Appraisal Standards Board sets the rules for developing an appraisal and reporting the results. It provides the recognized standards for real estate, personal property and business appraisal. Since 1992, the Office of Management and Budget has required federal land acquisition and direct lending agencies to conform to USPAP.
2The sources used to inform the brief descriptions of the methodology for commercial real estate properties and development land include the following: RICS Guidance Note, Discounted Cash Flow for Commercial Property Investment; RICS Valuation Information Paper, Valuation of Development Land no. 12; RICS Commercial Property Valuation Methods 1997; and RICS Valuation Professional Standards 2014. The methodologies used in the USA between 2005 and 2008 were similar. The Interagency FAQs on Residential Tract Development Lending in 2005 is the main source of guidance for valuation. In both countries, the methodology used and the standards set have been subject both to criticism and revision.
3These sources are given in B J Curry, ‘The Trouble with Rates in the Subdivision Development Method to Land Valuation’, The Appraisal Journal, Spring 2013. The first is a resource for gross margins, net profit, financial ratios and profit margins. The second two are sources for residential development property yield rates.
14The model was developed by David X Li in two papers: ‘The Valuation of Basket Credit Derivatives’, CreditMetrics Monitor, April 1999, pp. 34–50, and ‘On Default Correlation: A Copula Function Approach’, Journal of Fixed Income, 2000, 9/4 pp. 43–54.
15Jon Gregory, ‘Quant Congress: Gaussian Copula “Failing Dramatically” in Pricing CDOs’, Risk Magazine, 8 July 2008.
16D MacKenzie and Taylor Spears, ‘The Formula that Killed Wall Street? The Gaussian Copula and the Material Cultures of Modelling’, School of Social Science and Politics, University of Edinburgh, June 2012.
17D Beltram, L Cordell and C Thomas, ‘Asymmetric Information and the Death of ABS CDOs’, Federal Reserve, International Finance Discussion Papers, March 2013, p. 5.
18S Bergman, ‘CDO Evaluator applies Correlation and Monte Carlo Simulation to the Art of Determining Portfolio Quality’, Standard & Poor, Structured Finance, 12 November 2001. Full details of the model S&P used for CDOs composed of mortgage-backed securities are given in this article.
19From a technical point of view, this meant that S&P added Monte Carlo statistical methodology to the Gaussian Copula.
21At least 44 SEC rules and forms incorporated agency ratings, as of June 2008. See JP Hunt, ‘Credit Rating Agencies and the “Worldwide Credit Crisis”. The Limits of Reputation, the Insufficiency of Reform and a Proposal for Improvement’, Columbia Business Law Review, 2009, I, pp. 109–209 for a detailed review of the role of rating agencies in financial regulation in the USA.
22Quoted in Beltram, Cordell and Thomas, ‘Asymmetric Information and the Death of ABS CDOs’, pp. 6–7.
23Quoted by Cordell, Huang and Williams, Working Paper No 11, May 2012, Working Papers Research Department, Federal Reserve Bank of Philadelphia.
24N Vause, ‘Counterparty Risk and Contract Volumes in the Credit Default Swap Market’, BIS Quarterly Review, December 2010.
25Otis Casey, ‘The CDS Big Bang’, Markit Magazine, Spring 2009.
26Ingo Fender and Martin Schneider, ‘The ABX: How do the Markets Price Subprime Mortgage Risk’, BIS Quarterly Review, September 2008.
30Testimony before the Financial Inquiry Commission, 30 June 2010.
31ISDA, ‘The AIG and Credit Default Swaps’, November 2009.
32Quoted in ‘On How AIG Got Deeply Involved with Credit Derivatives’, Washington Post, 31 December 2008.
Chapter 9: Monitoring Value
1A Emmerich, W Savitt, S Niles and S Ongun, The Corporate Governance Review, 3rd edn (ed W J L Calkoen) (Law Business Research Ltd, 2013), p. 401.
2At the time of the collapse there were four federal banking regulatory authorities: the Federal Reserve Bank, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision. The Dodd-Frank Act abolished the Office of Thrift Supervision and its role was transferred to the Office of the Comptroller of the Currency. The Act also established the Consumer Finance Protection Bureau.
6The full story may be found in her testimony to the Oversight and Investigations Sub-committee of the House Energy and Commerce Committee on the Financial Collapse of the Enron Corporation, 14 February 2002.
7Testimony Concerning the Impact of the Sarbanes-Oxley Act, 21 April 2005, W.H. Donaldson before the House Committee on Financial Services.
18A Valukas, responding to questions after his testimony before the House Committee on Financial Services, 10 April 2010.
19Statement by Anton Valukas before the Senate Committee on Banking, Housing and Urban Affairs, Sub-committee on Securities, Insurance and Investment, on The Role of the Accounting Profession in Preventing Another Financial Crisis, 6 April 2011, p. 3.
21Quoted by Valukas, ibid., p. 32. Interestingly enough this was attached to Lehman's Quarterly Report, 10-Q filed 10 October 2006, which is when Fuld decided to move into the commercial and residential real estate market in a more aggressive fashion.
33The Examiner's Report gives access to the minutes of some board meetings and the presentations made to the board. The minutes typically cover reports from the various sub-committees, which do not contain the views of the sub-committee, nor do they record any issues the board may have raised in response to those reports or to the management presentations. There were private sessions from which the CEO was excluded, but the minutes do not give any indication at all of the contents of those discussions.
34NYSE Listed Company Manual, para. 303A(7)(c)(iii)(D) & Cmt (2010).
35Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations, p. 15.
36F Guerrera and P Thai-Larsen, ‘Gone by the Board? Why Bank Directors did Not Spot Credit Risks’, Financial Times, 25 June 2008. The observation concerning the last two may not be entirely fair. It depends on the way in which they were able to reapply their skills and experience.
37Proxy Disclosure Enhancements, SEC Release NOS 33-9089; 34-61175; IC-29092; File No S7-13-09.
8Quoted in John Lippert's article, ‘Friedman would be Roiled as Chicago Disciples Rue Repudiation’, Bloomsberg, 23 December 2008.
9George Soros, ‘The Crash of 2008 and What it Means’, in The New Paradigm for Financial Markets (Public Affairs, 2009), p. 165.
10E Fama, ‘The Behaviour of Stock Market Prices’, Journal of Business, 38 (1965a) and E Fama, Financial Analysts Journal, 21 (1965b); E Fama, ‘Efficient Capital Markets II’, Journal of Finance, Vol. 46, Issue 5, December 1991 (a defence against a vast array of criticisms).
11E Fama, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, Journal of Finance, Vol. 25, Issue 2, May 1970.
12John H Cochrane, ‘Eugene F. Fama, Efficient Markets and the Nobel Prize’, Magazine, 25 November 2013. Not only is Professor Cochrane a long-standing colleague of Fama's, but also his son-in-law.
13‘Eugene Fama, King of Predictable Markets’, Interview with Jeff Sommer, New York Times, 23 October 2013.
14M Sewell, ‘The Efficient Market Hypothesis: Empirical Evidence’, International Journal of Statistics and Probability, Vol. 1, No. 2, 2012, p. 165.
15A Lo and C MacKinlay, A Non-Random Walk Down Wall Street (Princeton University Press, 1999), pp. 6–7.
16A Lo, The New Palgrave: A Dictionary of Economics, 2nd edn (New York, Palgrave Macmillan, 2008): ‘Efficient Market Hypothesis’.
17R Posner, ‘A Failure of Capitalism’, January 2010, cited by J Cassidy in ‘After the Blowup’, New Yorker, 11 January 2010.
18Quoted in the Wall Street Journal and Markets, 28 April 2009.
19Posner, quoted in the New Yorker, 11 January 2010.
23R Shiller, ‘Do Stock Prices Move too Much to be Justified by Subsequent Changes to Dividends?’, American Economic Review, June 1981, p. 424.
24R Shiller, ‘From Efficient Markets to Behavioural Finance’, Journal of Economic Perspectives, Vol. 17, 1, Winter 2003, p. 89.
25This ‘dictum’ is from a private letter from Paul Samuelson to John Campbell and Robert Shiller and is quoted with approval by Shiller both in articles and in his book, Irrational Exuberance. The letter no doubt followed from Professor Samuelson's Opening Address to the Federal Reserve Bank of Boston's conference on ‘Summing Up on Business Cycles’, in which he stated that, ‘We have come a long way, by moving, in two hundred years towards the micro efficiency of markets: Black-Scholes option pricing, indexing of portfolio diversification, and so forth … But there is no persuasive evidence … that macro-market inefficiency is trending towards extinction.’
29‘Speculative Asset Prices’, Prize Lecture, 8 December 2013, p. 461.
30The first is Bayes' Law, developed by the Reverend Thomas Bayes, published posthumously in 1763. It was the first expression of ‘inverse possibility’, or ‘conditional probability’ whose value depends on the value of another probability. These also come into play when we wish to decide how much confidence we wish to assign to a given belief. Like most of the early probability theories, Bayes' Law is derived from gambling, and the Reverend Bayes was a gambler. It is not known whether or not he was successful. The theory was rejected until it was used by Alan Turing in decoding the Nazi Enigma machine. Later, the development of the Markov chain Monte Carlo algorithm was crucial in the revival of the Bayesian inference. The second refers to the Subjective Expected Utility model (SEU) developed by L.T. Savage's Foundations of Statistics. This described the way in which people should decide, not the way in which they actually make decisions: to maximize their ‘selective expected utility’ – a subjective judgement of probability and value. A person has well-defined preferences and will select the option that is likely to provide the maximum satisfaction. The subjectivity lies in the estimation of the probability of the anticipated events or conditions. It has since been argued extensively that the empirical evidence contradicts his theory.
31N Barberis and R Thaler, ‘A Survey of Behavioural Finance’, Social Science Research Network, September 2002, ch. 18, p. 1053.
32A Kumar and CM Lee, ‘Retail Investor Sentiment and Return Comovements’, Journal of Finance, Vol. 61, Issue 5, October 2006, p. 2485.
33Brad B Barber and Terrance Odean, ‘All That Glitters: The Effect of Attention and News of the Buying Behaviour of Individual and Institutional Investors’, The Review of Financial Studies, Vol. 211, No. 2, 2008, pp. 812–14.
37P Woolley and Dimitri Vayanos, ‘Taming the Finance Monster’, Central Banking Journal, December 2012. (My emphasis.)
38Remarks by Secretary Henry Paulson Jr at the Ronald Reagan Presidential Library, HP-1285 Press Room of the US Department of the Treasury.
39E Thomas and M Hirsh, ‘Paulson's Complaint’, Newsweek, 25 May 2008.
40W Bagehot, Lombard Street: A Description of the Money Markets (Reprint Project Gutenberg), p. 104.
41R Swedberg, ‘The Structure of Confidence and the Collapse of Lehman Brothers’, Markets on Trial: The Economic Sociology of the U.S. Financial Crisis, Research into the Sociology of Organizations, 2010, Vol. 30 A, pp. 76–7.
43Gary Gorton, The Panic of 2007, Prepared for the Federal Reserve Bank of Kansas City, Jackson Hole Conference, August 2008, Abstract.
44The ABX.HE indices were based on credit default swaps, tracking the price of credit default insurance on a basket of such deals. The Index referenced 20 subprime mortgage MBSs. Doubts have been raised about the validity of currently available models for the pricing of credit risk, especially for portfolio instruments, such as MBSs.
45Gorton, The Panic of 2007, pp. 3, 11. In addition, Gorton points out the reasons for believing that house prices will always go up. The USA had not experienced a large, nationwide decline in house prices since the Great Depression. Between 2001 and 2005, homeowners experienced an increase of 54.4 per cent in the value of their homes. The S&P/Shiller quarterly home price index declined by 4.5 per cent in Q3 2007 versus Q3 2006, the largest drop since the index started recording data in 1988.
46D Einhorn, ‘Private Pofits and Socialised Risks’, Grant's Spring Investment Conference, 8 April 2008.
Mayer Lehman Brothers' long history began with three brothers,
immigrants from Germany, setting up a small shop in Alabama, selling
groceries and dry goods to local cotton farmers. Their business soon evolved
into cotton trading. Dick Fuld made a series of acquisitions, designed to
lessen Lehman's dependence on fixed-income trading, and focus attention
on mergers and acquisitions, investment banking and raising capital. He
began the process of restructuring the company so that it consisted of three
major operating units: investment banking, equities and fixed income. He
refocused the company's activities on high-margin business such as
mergers and acquisitions, bringing in experienced senior staff to manage the
business. The description of the company's activities reflected both
the move away from fixed income trading, and Fuld's ambitions for
This chapter examines the regulation of the Big Five investment banks in the
context of the changes which took place in the structure of banking after
the repeal of the Gramm-Leach-Bliley Act 1999 (GLBA). It also examines the
introduction of the European Union's Consolidated Supervision Directive
in 2004. The Act did not 'repeal' the Glass-Steagall Act in its
entirety, but only repealed sections 20 and 32, which prohibited member
banks from affiliating with organizations dealing in securities. The Federal
Reserve became the 'umbrella' supervisor for any Financial Holding
Company owning a bank; under its 'streamlined supervision' remit,
the Federal Reserve was limited in its day-to-day authority to oversee
functionally regulated non-banking subsidiaries of the holding companies.
Though the Securities and Exchange Commission had adequate tools and
statutory backing for taking on the consolidated supervision of the Big Five
investment banks, its inability to carry out effective supervision was
On 10 September 2008, Dick Fuld presented what would be the firm's last
earnings report, announcing the loss of $3.9bn, the second quarterly loss
that had increased from the previous quarter's loss of $2.8bn. It also
released some plans and proposed actions, which included the increase in
total stockholders' equity, spin-off of certain commercial real estate
assets, and a potential deal with a Korean sovereign wealth fund. All of the
proposed actions were no more than plans, as opposed to completed deals or
agreements. Just two days after Mayer Lehman filed for Chapter 11, Barclays
announced that it would acquire Lehman Brothers North American investment
banking and capital markets operations and supporting infrastructure. That
included Lehman Brothers' New York headquarters and two data centres,
all for $1.75bn, a price which the New York Times described as a 'fire
sale' and which was much less than Lehman expected.