Bear Stearns & Lehman Brothers: Too Big To Fail?

William Ryback

World Bank/ Federal Reserve System/ International Monetary Fund

Seminar for Senior Bank Supervisors from Emerging Economies

October 20, 2010

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William Ryback Currently a consultant Chairman of the Banking Board at Toronto Centre 2007-May 2008, Special Advisor to the Financial

Supervisory Service in Seoul, Korea 2003-2007, Deputy Chief Executive at the HKMA,

responsible for banking supervision, policy and development

During his 36 year career as a Bank Supervisor in the USA, he served in a number of senior executive positions at both the Office of the Comptroller of the Currency and the Federal Reserve Board

He is a past Chairman of the Association of Bank Supervisors of the Americas (ASBA) and the EMEAP Working Group on Bank Supervision

He was a member of the Basle Committee on Banking Supervision and has participated in IMF and World Bank missions in Thailand, Japan, Korea, Indonesia and Israel

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BEAR STEARNS

A Study in Market, Management and RegulatoryFailure

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KEY ISSUES

Weak supervision can lead to a financial institution taking undue risk and failing to maintain sufficient capital against the constellation of risks it faces

Identifying when an institution is too big to fail when no small depositor interests are at stake

Oversight of a financial holding company where there is no legal authority

Meeting legitimate and reasonable requirements of host supervisors

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THE COMPANY Founded in 1923 Based in New York Engaged in capital market activities including

equities, bond trading and investment banking(80%); wealth management (8%);and global clearing services (2%)

10 offices in U.S. 12 overseas offices in Europe, South America, and

Asia $395 billion in assets $11 billion in net equity Notional contracts $13.4 trillion; 14% through listed

exchanges

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THE CULTURE 1930’s securities market for utilities 1940’s merger and acquisitions relating to

transportation 1960’s retail business & wealth management 1970’s City of New York Securities 1980’s Corporate takeovers

- SEC action for parking stock 1990’s first securitization of CRA loans 1997 SEC action for aiding and abetting a failed

brokerage firm Run by PSD’s 2005-2007 Most admired securities firm by Fortune

magazine

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THE PROBLEM

Bear Stearns hedge funds Complex derivatives backed by home mortgages Highly leveraged Investors trying to flee but market liquidity evaporated Merrill Lynch seizes collateral but finds no market Market fears that BS must dump securities in an already

weak market further pushing down mark-to-market values

In July 2007 both funds failed, stranding investors Reputation tarnished In November S&P’s downgraded BS from AA to single A

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THE SUPERVISORS Gramm-Leach-Bliley left hole in supervision of

investment bank holding companies EU requires a consolidated supervisor SEC sets up consolidated supervised entities program in

2004- voluntary- no longer in effect

BS supervised by State of New York and SRO’s Inspector General’s Report

- CSE program failed in the oversight of BS- questions about adequacy- aware of heavy concentrations but no action- no leverage ratio limit

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THE SUPERVISORS (II) Inspector General’s Report

- aware of risk management and shortcomings including lack of expertise but no corrective action required

- lack of senior management’s attention to detail and sluggish response to problems not commented

- BS used high leverage to take outsized market bets- violated SEC requirements that certain work be performed by outside

auditors and allowed BS staff to do the work

Board of Directors and Senior Management not required to set risk parameters for bank

Late regulatory filings deprive investors of current information

No evidence of coordination among supervisors

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Corporate Governance

• In addition to its executive management Bear Stearns had 9 non-executive director’s:

- 2 equity investors- a priest- a toy executive- an oil executive- mobile phone executive- professional board member- Lawyer- Academic

• Ages of the Board members ranged from 59 to 80• All were FOJ’s• Often absent CEO • No delegation authority• No centralized risk management

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Corporate Governance (II)

• No defined business strategy• No capital planning• Liquidity was based on “theory” that markets will operate in an

orderly fashion and provide reasonable price levels for all asset classes

• Absence of a true consolidated supervisor should have required a sterling Board with ample expertise in major business lines

• No outside verification of business risk models• Executives were growing their business lines to gain a larger share

of the bonus pool without control

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THE LAST WEEK At the start of the week of March 10th 2008 BS was a damaged

company hoping to survive The week before Moody’s had downgraded some mortgage-

backed securities issued by an affiliate citing greater risk of loss

On Monday the start of the week a credit default swap on BS debt rose sharply

The cash position of the firm was $18 billion – not robust but BS thought it had ample back-up lines to survive

Clients begin to move large funds out of the firm European and other banks begin to close lines and refuse to

roll-over funds Trading partners begin to look for other institutions to settle

trades BS issues press release stating the firm’s position remains

strong and liquidity is ample

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THE LAST WEEK (2) The recent management changes appeared cosmetic to the

market and the new CEO lacked the skills to manage through the problem

The lender of last resort is looking at ways to assist BS but there are technical, political and operational impediments

By Thursday the firm is out of cash and must either find new sources of liquidity or file for bankruptcy

On Friday, JPMorgan agrees to provide a $30 billion line of support backstopped by the FED for 28 days

BS thinks it has four weeks to find an investor The JPMorgan rescue package does nothing to calm the

market and the exodus continues Friday evening the Secretary of the Treasury tells BS

management they have the weekend to arrive at a more permanent solution

JPMorgan is the only way out and begins its due diligence

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THE LAST WEEK (3) JPMorgan finds it difficult to arrive at a price and

originally thinks $8 to $12 a share may be doable After much internal debate a price of $4 a share is

considered The Secretary of the Treasury believes the price a little

generous and the closer to zero the better JPMorgan offers $2 a share – the share price on Friday

was $30 a share and down from the high of $176 a share Over 30% of the stock is owned by staff and much of

their personal net worth is represented by BS stock JPMorgan offers $10 per share and the deal is closed

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LEHMAN BROTHERS:

A Case Study of an Investment BankFailure

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Key Issues

• When is an institution too integrated in the financial system to risk a failure?

• An institution will fail where there is a lack of market, regulatory, shareholder, management and rating agency oversight

• Regulatory requirements are met through substandard mechanisms and not challenged by the requiring agency

• Greenspan “theory” of market discipline creating a moderation in risky behavior proves faulty

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THE COMPANY Started business as a goods supplier to cotton farmers

in 1840 Moved into buying and selling cotton Opened office in New York Formed New York Cotton Exchange, the first

commodities futures company in U.S. Instrumental in organizing Coffee and Petroleum

Exchanges After Civil War helped Alabama issue first bond

underwriting of former confederate state Expanded its business to include selling and trading

securities, joined NYSE, set up Merchant Bank in late 1800’s

Great success in underwriting

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The Company (II) Last family member left in 1969 Internal fighting between investment bankers and

commodity traders Acquired by American Express in 1984 and

engaged mainly in brokerage activity Spun out of AE in an IPO and became Lehman

Brothers Holdings, Inc Richard J. Fuld is elected Chairman Lehman’s global headquarters are destroyed

during attack on World Trade Center on 9/11

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The Problems Chairman Fuld was an autocratic leader that isolated

himself within the company The firm followed a common Wall street template of

taking big risk and reaping large rewards Fuld’s motto was “never surrender” Lehman had a well rounded business serving

corporations, governments, institutions and high net worth clients

Late to enter subprime mortgages and early exit Retained an outsized position in very risky tranches at

the bottom end of the securitization chain

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The Problems (II) Balance Sheet was overweighed in commercial real

estate Company considered itself an expert in commercial

property lending Management maintained an overly optimistic view of

value of portfolio Changes in regulatory rules moved securities firms

away from net capital rules that had been in place since 1925

Companies could now compute capital needs without haircuts and discounts on asset categories

Leverage constraints of 12 to 1 were abolished

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The Problems (III)

Lehman became addicted to debt to leverage earnings

Short term debt funding long term assets Inexperienced Board Risk Committee only met twice a year Fuld believed Lehman should command a premium

and not a discount Bank was able to raise bits and pieces of capital

but no longer term strategic plan

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The Regulators Gramm Leach Bliley Act allowed financial holding companies

to be formed Federal Reserve was umbrella supervisor for all financial

holding companies but was required to use functional supervisors as first line

Act was silent with respect to Investment Bank Holding Companies

In order to satisfy EU requirement for a consolidated supervisor SEC set up the Consolidated Supervised Entities or CSE program

Serious flaws in program Voluntary Unclear whether any real authority Inexperienced Supervisors No coordination between multiple supervisors

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The Downfall

In early 2008 CFO of Lehman arrogantly dismisses question from analyst about need for capital

Stock price collapsed after FED assisted bailout of Bear Stearns

Bank was still making a small profit in 1st quarter despite a $1.8 billion write-off

Bank began to shed assets but not aggressively The sale of assets crystallized losses and 2nd quarter

losses at $2.8 billion were outside market expectations President is dismissed and CFO is demoted No aggressive strategy to deal with mounting problems

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The Downfall (II) Crucial staff defections Lehman raises a little capital and tries to sell 25% to

Asian financial company Fuld believes Lehman cannot fail because it has access

to FED borrowings On September 7th U.S. Treasury moves to take over

Freddie Mac and Fannie Mae because of large losses Lehman forced to move up earnings announcement Losses for 3rd quarter are $3.9 billion Lehman plan to split bank into a good bank and a bad

bank is not viewed well by market

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The Downfall (III) Head of Equity for Lehman: “if this is all the 31st floor has

we are toast” Next day JP Morgan asks for substantial additional

collateral to continue clearing for Lehman Rating agency threatens downgrade if Lehman does not

have a credible resuscitation program On Friday, September 12th Lehman suffers massive

withdrawals and other firms ask for additional collateral At the beginning of the week Lehman Brothers boasted a

Tier 1 ratio 0f 11% - almost three times the minimum Federal Reserve asks Heads of other Investment banks

to meet at FED at 6:00PM Attending from Government are Paulson, Bernanke,

Geithner, and Cox Paulson tells assembled group no bailout for Lehman Group asked to reflect on events and meet again at 8:00

AM the next day

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The Downfall (IV) B of A was doing due diligence and decided hole was

too big in Lehman’s Merrill Lynch decides it cannot survive and solicits a

bid from B of A On Saturday the group reassembles at the FED to

look at - potential fall out of LB failure- value of LB’s commercial real estate portfolio- possibility of industry led bailout

Barclays interested in acquiring some of LB but technical problem regarding need for a shareholder vote is impediment to quick deal

SEC Chair calls LB Board on Sunday evening Geithner tells Wall Street to “spread foam on the

runway – Lehman Brothers has failed”

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Reasons for the Collapse

• Fuld and the Lehman Board had a totally unrealistic view of the intrinsic value of the bank

• Underlying the misjudgment was a fatal failure to understand the fragility of Lehman’s business model or the nature of the financial meltdown

• Lehman took on an outsized bet on real estate even after the crisis began in a misguided attempt to match earnings of GS and MS

• Fuld received highly filtered facts – no one was willing to bring him bad news

• President Joe Gregory kept piling on risk by making huge investments in commercial real estate at the top of the market (he had a personal spending problem)

• In the two years before its collapse Lehman’s was an institution obsessed withy growth – management was not interested in the details

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Reasons for the collapse II

• Lehman’s was a symptom of the crisis not the cause• Manipulation of the balance sheet (Repo 105 transactions)

disguised the true leverage position of Lehman’s)• No pressure from market or regulator’s to reduce risk, curtail

leverage, or supplement capital• The Corporate Governance structure was such that Lehman was

on auto-pilot to fail: a president of the firm eager to please the boss and hungry to

take on risk each unit was managing its own risk profile with little or no

interaction an executive team not noted for healthy debate internal power struggle between two key players (US & UK) an overbearing CEO a Board of Director’s of old men woefully lacking in any

banking expertise, risk management, or related skills

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Reasons for Collapse (III)

• The Board was comprised of internal management and 8 independent non-executive director’s:

- One member was noted as the worst CEO of all time by a national news magazine

- a theatrical producer- a retired naval officer- a professional Board attendee- ex-managers of an energy company, a U.K. mobile phone

company, and Spanish TV- a former member of a financial firm- average age was 67- all were FOF’s

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Bear Stearns and Lehman

• Both Bear Stearns and Lehman were relatively small and undiversified

• Both companies denied having liquidity problems although it was evident on the street

• Bear and Lehman had big leverage by historical standards• No plan B for liquidity arrangements in event of market distress• Neither company had a capital restoration plan• BS and LB did not stress test their portfolio’s believing assets were

not impaired• No outside verification of risk models or balance sheet valuations• Market value of both firms were highly uncertain because assets

were so toxic• Lehman used accounting gimmicks – called Repo 105 transactions

– to temporarily reduce leverage over accounting periods while at the same time touting its “low” leverage as a positive for investors

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Bear Stearns and Lehman (II)

• Bear Stearns was not a “main stream” investment bank while Lehman was considered aggressive and arrogant

• Bear Stearns was considered of systemic importance – Lehman was not

• Why?

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What was Paulson Thinking? Paulson thought markets had a long time to prepare for

Lehman’s failure Banking system was safe and sound and could

withstand a large bank failure A failure of a large bank might stimulate Congress into

providing funds for TARP program No way FED or Treasury could have intervened No legal mechanisms to provide funds to an insolvent

company Paulson had warned Fuld to find a merger partner or

sell itself to a stable firm

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What Happened Next

Money Market Funds lost money on Lehman’s failure sparking a panic among small investors

Private sector pulled away from AIG as the Market believed it too would fail – FED steps in to rescue

By Wednesday credit markets seized up entirely –Interbank market closed; corporate debt instruments interest charges rise from 7% to over 10%

At the end of the month Congress votes down TARP

Markets accelerate downward spiral

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What happened next (II)

• Stocks tanked (DJIA 14,000 in 10/07; 8,400 in 10/08; 6,600 in 03/09)

• Consumer spending and business investment declined sharply• Employment collapsed (6.2% in 09/08; 9.5% in 06/09)• Market thought government had lost control – no one could know

which financial institution would be protected and which would not• AIG received a massive bailout• Uncertainty rose• Panic followed• Companies hoarded cash by cutting inventories, jobs, and

investment• Disappearing jobs and wealth (stock market losses totaled $3.9

Trillion in six months; accumulated equity in housing sunk at a rapid pace) caused consumers to postpone discretionary spending (autos, home appliances)

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ACTIVITY : PUBLIC POLICY CONSIDERATIONS

1. Should the lender of last resort have stepped in earlier in either BS or LB or both? What are the issues involved?

2. Should the market have been more aggressive in finding a non-government solution to Lehman’s problems? How would this be arranged?

3. If the Federal Reserve had been more proactive in taking a role in macro-prudential supervision could Bear Stearns have survived? Would the credit underwriting standards have been better? Should the Central Bank take on such a role?

4. What principles, if any, were violated in the Government’s handling of the Bear Stearns situation? Why save Bear Stearns and allow Lehman Brothers to collapse?

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Activity: Public Policy Considerations

5. Should large financial institutions be accorded government protection against failure and, if so, should this policy be made public? Is constructive ambiguity a good policy?

6. How important is recognizing differences among depositor and creditor classes in devising appropriate liquidation strategies and equitable depositor payout schemes?

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Lessons learned

Program Leader presentation of lessons learned

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WHEN CAN DISTRESSED FIRM SURVIVE

• Firm has attractive ongoing Business Strategy• Has a means of correcting deficiencies• New management in place or enhanced• Assets are correctly valued• Full disclosure• Debt servicing is clear and business continuity

seems likely• Regulatory or supervisory actions are in place or

pending

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LARGE FINANCIAL FIRMS ARE RARELY CLOSED

• Systemic threat to system• Disruption of creditor/borrower relationships• Danger of credit crunch• Could destabilize other healthy banks• Payment and settlement system disruptions• Infection to other banks through interbank

lending mechanisms• Undermines public confidence

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UNDERLYING CAUSES OF WEAKNESSES

• Quest for growth and market share• Weak loan administration• High concentrations• Mindset that capital does not matter and no capital

planning• Poor internal controls• Over reliance on volatile funding• Poor strategic planning• Weak supervision• Board oversight is not evident• Belief that economic cycles have been eliminated• Over reliance on external ratings

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CONTINENTAL ILLINOIS, BEAR STEARNS & LEHMAN BROTHERS

• Continental Illinois was 8th largest bank in U.S. when it failed in 1984

• Bear Stearns was 7th largest Securities Firm and 3rd largest investment bank when it failed in 2008

• Lehman Brothers was 4th largest investment bank

1. LB, BS & CI were caught up in an asset and credit bubble

BS = Housing and Subprime CI = Oil and GasLB = Commercial Real Estate

2. LB, BS & CI had long records of success in financing theassets that led to their demise and were consideredexperts in the field

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CONTINENTAL ILLINOIS, BEAR STEARNS & LEHMAN BROTHERS (Contd.)

3. Fraud, accounting irregularities, and improper record keeping accompanies bubbles

BS = fraud in mortgage originations increased losses in subprime loan pools it bought

CI = fraud in oil loans it bought from Penn SquareNational Bank

LB = repo 105 transactions mislead funds providers andand investors

4. LB, BS and CI were dependent on short term funding to carry long term assets

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Continental Illinois, Bear Stearns, and Lehman Brothers (contd)5. Too intertwined in the financial system to risk failure

CI = sixty to one hundred failures of smaller banks if themoney center correspondent bank collapses

BS = counterparty to huge volume of derivative contracts withglobal repercussions in a failure; largest settlement bank for hedge funds

LB = ?

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FINAL THOUGHTS• Inadequate liquidity in markets and individual firms• Capital adequacy weaknesses both level and mix• Leverage in financial system was too high and way

above historic norms• Asset quality was poor and governance over the credit

granting process was weak or non-existent• Solvency was a real issue but went unrecognized• Valuation process of market to model proved to be

weak and mark to market too rigid although accountants claim it was misused

• Opaqueness in the market was the norm rather than the exception especially with respect to SIVs

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FINAL THOUGHTS II• Complexity of structured products and derivatives• Rating agencies’ lack of competency• Poor supervision – looking at bank policy rather than

credit quality• Supervisory gaps were large • Pushing supervision away from central banks caused

information shortcomings• Monetary policy• Excessive reliance on wholesale funding to grow the

business• Lack of appropriate pricing mechanism in the credit

market• Remuneration structures

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FINAL THOUGHTS III

• No exit policies for existing government interventions• Lack of contingency planning by banks and

governments• Strategic planning by financial institutions was not

evident

• Consolidation of the industry creates too many “too big to fail” situations

• Lack of alternatives to government intervention

• Weak management in financial institutions goes unchallenged by market, directors, supervisors, and shareholders

Questions ?

Comments

Thoughts

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Thank You