The lessons of Lehman Brothers, Chicagoan Anton Valukas says, haven't been learned.
He would know. As the man charged by the bankruptcy court with getting to the bottom of what caused the largest bankruptcy in history, the Jenner & Block chairman and former U.S. attorney in Chicago oversaw more than 250 interviews and the review of about 34 million pages of records about Lehman's collapse.
The bottom, Valukas said, looked like this. Lehman played shenanigans with its balance sheet, which its board didn't know about and its auditors ignored. And it blew through its own risk limits when it doubled down on commercial real estate in 2006.
The government was oblivious to the balance sheet tricks but knew about the commercial real estate bet. The regulators, who were posted inside the bank's headquarters, just weren't sophisticated enough to understand the consequences of it.
So what's needed now? Valukas wants risk limits that are, in fact, limits. He wants banks to be forced to hold onto more cash. And he wants those fishy things known as derivatives to be traded on open markets.
Of course, all of that is outlined in the financial reform bill Congress passed in 2010.
"But the question is: What are we going to do in terms of the actual regulations which will prevent or make less likely these things from happening again?" Valukas said in an interview. "And that's where the battle is going to take place. Hundreds of millions, maybe billions of dollars, are being spent on lobbying right now to write those regulations because if you take and start controlling the risk issues, then you're going to reduce the ability of Wall Street to make these humongous salaries or income."
Valukas' findings are contained in a 2,200-page volume, known as the Valukas Report. More than 200 attorneys, many of them working in Chicago, helped compile it.
Until recently, Valukas was reluctant to sit for many interviews — because of ongoing litigation and the possibility that criminal charges would be filed against bank executives or its auditors at Ernst & Young.
Now that federal prosecutors are unlikely to take any action, Valukas has distilled Lehman's saga to about 20 pages, which everyone can understand and which he agreed to share. I first heard him give this talk at a recent meeting of the Public Affairs Roundtable, an off-the-record, invitation-only gathering hosted by Ronald Miller of the law firm Miller Shakman & Beem.
Valukas' findings shocked me. They seemed to shock everyone in the room. And they continue to shock him, he said.
"What struck me when I completed the interview with (former Treasury Secretary Henry Paulson) was how absolutely close this country came to a total disaster," Valukas said in an interview. "Once Lehman went down, everybody believed that if the government had not stepped in, we'd be talking, not about a Great Recession, but about a flat-out depression. The markets around the world would have completely seized up. I remember being on the plane coming home (from Washington) thinking, 'My God. This is really scary stuff.'"
Valukas found "no misconduct" on the part of Lehman's board. Instead, he said its failure was in not rigorously questioning management's decisions.
Here's how Valukas describes Lehman's unraveling:
Lehman had historically been in the brokerage, or "moving," business, acquiring assets for short-term resale or redistribution and pocketing considerable fees in the process.
But in 2006, with the board's approval, it made three decisions.
It would take on more risk to make more profit, blowing past its own risk limits. It would concentrate that risk in commercial real estate. And it would take that risk on itself — on its own books — rather than as a broker.
Valukas interviewed all 11 board members, only one of whom, Chief Executive Richard Fuld, was an insider. They all bet the subprime mortgage crisis would be just that, a subprime crisis, and not infect everything else. Don't wag your finger at this before considering that Ben Bernanke, the Federal Reserve chairman, publicly shared that same view at the time.
As years passed, management told Lehman's board that the bank was passing its internal stress tests designed to predict what would happen should calamity strike. The problem, Valukas said, was that because Lehman's commercial real estate investments were so complex, it was difficult to design a stress test for them. So it didn't — until summer 2008, when it was too late.
By early 2008, Lehman wanted to reduce its leverage, but selling its assets at a fire sale would send a signal there was a problem, Valukas said. Lehman also didn't want to raise more money, because it would make existing shareholders' stock less valuable.
"So Lehman found a third way to lower its leverage," Valukas said. "It fudged the numbers."
This is what's known as Repo 105. And this is where the story becomes really complex.
"Three days before a quarterly reporting period, Lehman shipped tens of billions of dollars of assets from the U.S. and the U.K., where the Lehman U.K. subsidiary used the Repo 105 process to remove the assets from the balance sheet," Valukas said in the simplest terms possible. "Three days after the reporting period, the assets were shipped back to the U.S. and put back on the balance sheet. Lehman thus removed $50 billion from its balance sheet at the end of the first and second quarter."
And Lehman also included in its liquidity pool, which is supposed to contain stuff that can be easily converted to cash, billions of dollars that were, in fact, pledged to its banks. That meant the cushion was much smaller than the public had been told.
Now we come to the government.
"The (Securities and Exchange Commission) knew Lehman was blowing past its risk limits," Valukas said. "What did the SEC do about it? Not a thing. What did the SEC tell the investing public it was charged with protecting? Not a word."
Same goes for the liquidity problem, Valukas said.
The government also knew that "off-balance-sheet transactions" led to Enron's implosion — and Valukas accuses regulators of failing to scour Lehman's books for them or ask executives about it.
"It is far from clear that anyone or anything could have saved Lehman after it had committed itself to its countercyclical strategy," referring to its big commercial real estate bet, Valukas concluded in his remarks. "But had the government questioned rather than acquiesced and required disclosure, there might have been a softer landing — at least for the U.S. economy, if not for Lehman itself."
So how did Valukas find Repo 105 when no one else, including the government, did? Well, he had unprecedented cooperation. Only one person, a British regulator involved in blocking a last-ditch rescue effort for Lehman, declined an interview request for his report.
"The constant recurring point was that people wanted to say, 'It wasn't me. It wasn't our organization,'" Valukas said. "That's one of the reasons they were so forthcoming. They wanted to get their explanations out."
The second reason he found Repo 105 was that he listened to Jenner partner Matt Basil and then second-year associate Sofia Biller, now with law firm Ulmer & Berne. They were the ones who first heard of Repo 105 during an interview with a Lehman executive in the global balance sheet group, who had told Ernst & Young auditors about Repo 105. The day after the whistle-blower told the auditors about it, the auditors failed to pass that information on to Lehman's audit committee, according to the report.
"I was very, very skeptical about that," Valukas said. "So I pushed back very hard and said, 'Well, go poke around' (about Repo 105). … Then they started coming back with emails. And I started reading the emails, and I was like, 'Oh, my God. They really did do this.'"
Again, Valukas thought Enron had stamped out those behaviors.
"I thought I was going to run into everyone saying, 'Yes, I saw this coming. Yes, I understood this,'" Valukas said. "But you come away with the fact that no one understood what the hell was going on."
Valukas said he has "no opinions" on the lack of prosecutions that have resulted from his report. (I find this implausible, but I let it go.)
"Even if you had prosecutions, what would that bring you?" Valukas asked. "If there's anything I've learned, being both in the government as a prosecutor and on the civil side as a defense attorney, is that it's effective regulation that prevents it from happening in the first place, which is the critical part of the process."