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Capitol Report: Reforms haven’t eliminated risk of another Lehman-type failure

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A person carries a field after leaving the Lehman Brothers European Headquarters construction in Canary Wharf in east London on September 15, 2008.

Reforms made according to the chapter of Lehman Brothers in 2008 won’t save you a repeat, experts advised MarketWatch.

As the 10th anniversary of the Sept. 15, 2008 chapter of investment bank Lehman Brothers approaches, MarketWatch checked out whether the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 and different reforms will save you another monetary disaster if there’s a messy failure of a non-bank monetary establishment like Lehman.

According to the law’s preamble, Dodd-Frank’s purpose is,“To promote the monetary stability of the United States through making improvements to duty and transparency within the monetary device, to end too large to fail, to offer protection to the American taxpayer through finishing bailouts, to offer protection to consumers from abusive monetary amenities practices and for different functions.”

MarketWatch checked out two spaces of reform on account of Lehman’s chapter and the impact the failure had at the monetary disaster: the new Dodd-Frank orderly answer authority that replaced chapter for “too large to fail” banks, and the elimination through accounting same old setters of the loophole that enabled the use of Repo 105, an accounting method Lehman that still allowed stability sheet “window dressing.”

Anton Valukas, the Lehman chapter examiner, wrote in 2010 that figuring out whether the chapter submitting made the monetary disaster worse was beyond the scope of his investigation. However, what came about subsequent suggests the Lehman chapter submitting had a vital affect at the depth of the disaster.

• The Dow Jones Industrial Average DJIA, -0.31%  plunged 504 points on September 15, 2008.

• American International Group AIG, -0.43%  was at the breaking point on Sept. 16 and the federal government intervened with a monetary bailout package that in the long run value more $182 billion.

• Also on Sept. 16, the Primary Fund, a $62 billion money market fund, introduced that – because of the loss it suffered on its exposure to Lehman – it had “broken the greenback,” this is its percentage value had fallen to less than $1 consistent with percentage.

• On Oct. three, 2008, President Bush signed the $700 billion Troubled Asset Relief Program, or TARP, rescue package, into law.

An orderly answer

In 2008, the Fed did have vast authority to lend to banks in bother “in ordinary and exigent instances” as long as the mortgage was “secured to the pleasure of the Federal Reserve Bank,” according to the Federal Reserve Act. At the time of Lehman’s troubles, on the other hand, there have been important disagreements in regards to the “true value” of Lehman’s property and whether it was insolvent or no longer.

Laurence Ball, an economics professor at Johns Hopkins University, advised MarketWatch in July that the professional version of why Lehman gained no executive bailout and needed to report chapter is wrong.

“At this level it's possible to go back and put in combination the numbers, there is enough information on what Lehman’s property had been, what its liquidity wishes had been, and if one if truth be told does that workout, it's clear that Lehman did have considerable collateral for the mortgage it had to continue to exist. So, if the Fed had requested is there enough collateral, the answer would obviously had been yes. They could have made a mortgage, it would had been felony, it shouldn't have been very risky, and almost definitely the whole monetary disaster and Great Recession would had been less serious,” said Ball.

The Dodd-Frank Act of 2010 nonetheless lets in the Fed to arrange emergency mortgage facilities however prohibits it to bail out an insolvent firm. The Bankruptcy Code defines “insolvent” as a “monetary situation such that the sum of such entity’s money owed is larger than all of such entity’s assets, at an even valuation.”

At least five companies should be eligible to borrow from the Fed’s emergency mortgage program, so the loans can’t be created to suit just one bank. One bank cannot borrow to lend to another this is insolvent.

Dodd-Frank gave the new Financial Stability Oversight Council, made up of most sensible regulators led through the treasury secretary, the authority to designate as Strategically Important Financial Institutions, or SIFIs, any monetary firm that “could pose a risk to the monetary stability of the United States” if they failed or engaged in risky actions. That designation topics the firm to stricter oversight from the Federal Reserve, together with stricter capital requirements, participation in stress tests, the requirement to create residing wills or chapter contingency plans.

Before Dodd-Frank, the FDIC’s answer authority was restricted to industrial banks. According to the Brookings Institution, when investment banks Lehman Brothers and Bear Stearns and insurer American International Group ran into bother, they were not eligible for FDIC receivership since they were not industrial banks.

They had a selection of both pointing out chapter, as Lehman did, or asking for emergency support from the Federal Reserve, as Bear Stearns and AIG did. Citigroup and Merrill Lynch, for example, got here close to failing and gained temporary taxpayer make stronger.

Systemically necessary monetary institutions can include a maintaining company and probably several more pieces such as an investment bank, broker-dealer, hedge budget and personal fairness companies, and perhaps even an insurance coverage company. Each piece, together with the maintaining company, could also be subject to a different regulatory authority or maybe no regulation at all and is subject to a different test for insolvency.

Title II of the Dodd-Frank Act now gives the FDIC prolonged authority to include all of the bank maintaining company. Its Orderly Liquidation Authority can finance the wind-up of a bothered firm through the Orderly Liquidation Fund.

Non-banks, on the other hand, should be designated SIFIs to be subject to the enhanced regulatory oversight that may inform regulators assist is needed and make the firms eligible for FDIC answer.

The FDIC launched a report in 2011 entitled, “The Orderly Liquidation of Lehman Brothers Holdings Inc. Under the Dodd-Frank Act,” that examines how it will have structured an orderly answer of Lehman Brothers Holdings Inc. had the law been in impact in advance of Lehman’s failure. The FDIC concluded that it will have acted “decisively to maintain asset value and construction a transaction to promote Lehman’s valuable operations to interested consumers.” Those actions could have “promoted systemic stability and made the shareholders and collectors, no longer taxpayers, undergo the losses.”

“The very availability of a comprehensive answer device that sets forth in advance the foundations under which the federal government will act following the appointment of a receiver could have helped to stop a ‘run at the bank’ and the resulting monetary instability,” according to the FDIC report.

Access to the OLF might be thought to be a aggressive benefit and a just right explanation why to wish to be a SIFI. But, as an alternative, advanced non-bank monetary institutions have fought the label.

MetLife MET, -0.24%   rejected it and fought the SIFI designation. General Electric GE, -0.88%   restructured itself to transform smaller and due to this fact ineligible.

“The process appears at a wide variety of systemic possibility from any roughly establishment. The drawback is institutions can struggle it as MetLife has achieved and as Prudential Financial PRU, -0.45%   most probably will,” says Mayra Rodríguez Valladares, managing principal of MRV Associates a consulting firm thinking about monetary regulatory and possibility primarily based supervisory issues.

“Surely Lehman would have fought a SIFI designation, identical to BlackRock has fought it and different non-bank institutions resist the extra regulatory oversight and the extra value that incorporates it,” said Rodríguez.

BlackRock BLK, -0.11%   is the world’s biggest money supervisor with $6.three trillion in property.

Mike Konczal, a fellow with the Roosevelt Institute where he works on monetary reform, advised MarketWatch in an interview, “triggering OLA for any establishment calls for a lot of folks to turn the key. It’s no longer that easy,” said Konczal.

“If the Trump administration doesn’t use the SIFI instrument, the financial system continues to be in peril,” according to Konczal.

Because OLA hasn't ever been brought on for a non-bank, it’s no longer certain it'll work.

“The FDIC is great at resolving banks,” says Rodríguez, “however It's not that i am so positive that it would be really easy peazy to resolve a posh establishment that includes a hedge fund, dealer dealer, and investment bank.”

Lehman’s stability sheet “window-dressing” with Repo 105

Lehman chapter examiner Valukas wrote that the investment bank had got rid of approximately $49 billion in debt from its 2008 stability sheet via the use of Repo 105 transactions. In a Repo 105 transaction, Lehman pledged property, in most cases Treasury securities, with a worth of 105% or more of the money gained.

Accounting regulations authorized the transactions to be handled as gross sales which allowed Lehman to scale back its asset stability, because the cash gained was less than the value of the property it had pledged. However, the money it gained was no longer recorded as a mortgage, and the duty to pay off the mortgage and repurchase the Treasury safety was no longer identified as an building up in liabilities. Instead, the best to repurchase the collateral was recorded as a brand new asset, a by-product right to purchase securities sooner or later.

Valukas concluded that the transactions had no business purpose, according to the examiner’s report. Lehman’s “number one cause for undertaking tens of billions of bucks in Repo 105 transactions at or close to each quarter-end in past due 2007 and 2008 was to quickly take away the securities inventory from its stability sheet with a view to report lower leverage ratios than Lehman if truth be told had,” Valukas wrote.

Lehman additionally, “did not disclose its use – or the significant magnitude of its use – of Repo 105 to the Government, to the score businesses, to its investors, or to its own Board of Directors. Lehman’s auditors, Ernst & Young, had been conscious about however did not question Lehman’s use and nondisclosure of the Repo 105 accounting transactions,” the chapter examiner’s report said.

In 2010, the SEC proposed a rule according to Lehman’s lack of disclosure of the Repo 105 liabilities. The proposal, known as “Short time period borrowings disclosure,” said that “a important part of a company’s liquidity and capital resources is ceaselessly its access to momentary borrowings for running capital and to fund its operations…Recent occasions have proven that a lot of these preparations can be impacted, on occasion seriously and swiftly, through illiquidity within the markets as a whole.”

In a comment letter to the SEC on its proposal, then Sen. Carl Levin wrote, “Inaccurate accounting treatment of repurchase agreements was no longer confined to Lehman Brothers. Other investment banks, such as Bank of America BAC, +0.03%   and Citigroup C, -0.67%  , have, according to SEC inquiries, said that they erroneously recorded repurchase agreements as gross sales slightly than as financing transactions.”

In April 2011, the FInancial Accounting Standards Board changed the rule that allowed Lehman to regard the repos as gross sales. FASB tweaked repo accounting regulations again in June 2014 when MF Global, a global broker-dealer led through former N.J. Governor Jon Corzine, collapsed. MF Global could no longer meet margin calls when the value of European sovereign debt it used as collateral in repo transaction collapsed.

MF Global had recorded profit in advance from making an investment within the sovereign bonds after which using them as collateral in so-called “repo-to-maturity” contracts with out fully disclosing its repo mortgage liabilities.

The SEC’s 2010 proposal for better disclosure was never finalized. A spokeswoman for James Kroeker, who is now the vice president at the FASB however who was the SEC’s chief accountant at the time of the proposal, declined to answer a request for comment at the never-finalized proposal.

A spokeswoman for the SEC showed the proposal for enhanced disclosures was never finalized however declined additional comment.

J. Edward Ketz, an accounting professor at Pennsylvania State University, advised MarketWatch that regardless of the reactive fixes, “Managers will keep on the lookout for loopholes that allow off-balance sheet treatment for repos. Auditors have to ensure they ‘know what they don’t know’ and that all off-balance sheet preparations are disclosed within the footnotes,” Ketz said.

In July the Treasury’s Department’s Office of Financial Research proposed to collect more information at the U.S. repo market, to “enhance the facility of the Financial Stability Oversight Council to identify and monitor doable dangers to U.S. monetary stability through final the knowledge gap on centrally cleared repo transactions.”

A Fed report said in early 2017 the Fixed Income Clearing Corporation processed about $400 billion every day in same-day settling overnight centrally cleared repo transactions collateralized with U.S. Treasury securities.

Source: The Federal Reserve Bank, February 27, 2017

Even if this proposal is approved, the U.S. bilateral repo market would nonetheless be within the shadows according to Gregg Gelzinis, a research associate at the Center for American Progress, an impartial nonpartisan coverage institute.

In triparty repos, a clearing bank provides collateral valuation, margining, and management amenities to verify the terms of the repo contract are met. In a bilateral repo, the lender drives the valuation and margin requirements on collateral pledged through the borrower.

“There’s a gap right here in a market that was systemically necessary all through the monetary disaster and nonetheless is. It is disappointing that the SEC never finalized the disclosure regulations since it would have aligned non-bank disclosures with bank maintaining company requirements,” Gelzinis advised MarketWatch.

Francine McKenna is a MarketWatch reporter primarily based in Washington, covering monetary regulation and legislation from a transparency viewpoint. She has written about accounting, audit, fraud and company governance for publications together with Forbes, the Financial Times, Accountancy and the American Banker. McKenna had 30 years of enjoy at banks and professional-services companies, together with at PwC and KPMG, before becoming a full-time writer.

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