Lawrence G. McDonald

THE FALL OF LEHMAN BROTHERS & FINANCIAL REFORM

Lehman Brothers’ Stock Chart

Lehman Brothers’ Chairman & CEORichard S. Fuld, Jr.

Lehman Brothers’ Board

Members

overseeing $750 billion of systemic risk

They had an average age of 70,

1) Abolish Chairman & CEO

2) Term Limits for CEOs & Board Members

3) Risk Committee Members On Board

4) Former CEOs As Board Members

Corporate Governance

Re-Vamping the Regulators, the Watchdogs Of Finance

1. Incentives for poorly paid regulators with TARP money.

2. Coordination Of Regulators; SEC, FDIC, FSA, Office Of Thrift Supervision, Comptroller of the Currency, Insurance Commissioner.

3. In 2007 there were 3,798 people working at the SEC. Only 24 people were assigned to regulate the ten largest investment and commercial banks.

America’s Banking System

*Sources, FDIC, Cleveland Fed & NCUA**Simon Johnson, professor, MIT's Sloan School of Management

1. 15 Years Ago, the Combined Assets of the Six Biggest Banks Totaled 17% of GDP*

• By 2006, that number was 55% • By 2009, it was 63%

2. Three U.S. banks have over 40 % of the global market for stock underwriting**

3. Five banks have over 95 percent of the market for over-the-counter derivatives**

4. The biggest four banks have half of the market for mortgages and two-thirds of the market for credit cards.**

The government created these mega-giants. Thanks in part to acquisitions of Countrywide Financial Corp. and Merrill Lynch., the assets of Bank of America have jumped 36 percent from before the financial crisis to $2.34 trillion. JPMorgan bought Bear Stearns Cos. and Washington Mutual Inc. and has assets of $2.14 trillion, up 37 percent. The top four banks now have 40 percent of the nation's deposits.

The Gramm-Leach-Bliley Act of 1999

Massive flaws STILL in our banking system

1. Regulatory Arbitrage

2. REPO 105 & Liquidity Pools

3. Poor Global Regulatory Coordination - Basel II & III

4. “Big four accounting firms are “too BIG to fail.”

Charlie Munger

Cause #2: A scary percentage of Lehman’s CDS / derivative trades were not settled, this was problem with all banks, key stroked by hand

Effect: Lynch Amendment: financial firms may not own more than 20% of an exchange.

Lincoln Amendment: Force banks to spin off their derivatives business or keep it in a subsidiary separate from the part of the company that may receive Federally-insured deposits.

Derivatives required to go onto a public exchange that would provide investors with details on the transactions.

Derivatives Language: Cause

Derivatives Language: Effect Inside the Dodd Frank Bill

• The $375 million lobby efforts spent by the street over the last 18 months have clearly paid off.

• Lincoln Language (Sec. 716): House Agriculture Committee Chairman Peterson (D-MN) successfully moved an amendment which weakened the original base Lincoln language.

• Credit Default Swaps will be allowed to be held in a separately capitalized Bank Holding Company within a big commercial bank. Originally this was expected to be a true spin off.  Of course no specifics on actual capitalization requirements yet, which means this was an active battleground.

• Modifications would allow banks to retain interest rate and foreign swaps, and cleared investment grade credit derivatives.

Derivatives Language: Effect

• What’s left of the Lincoln amendment has a two-year base phase-in, regulators are given some leeway to extend full implementation for three years.  Definition of Major Swap Participant: The SEC and CFTC are given broad leeway to define the definition of an MSP.

• - The Senate rejected the “Lynch Amendment” language governing limits on clearinghouse ownership. Instead, the final Bill adopted language which strengthened a regulatory initiative to set conflict of interest ownership guidelines through the regulatory process.

• End-User Exemption: End users are exempt from the exchange trading requirement and would include non-financial commercial entities who own, use, produce, process, manufacture, distribute, merchandise, or market goods, services, or commodities (including coal, natural gas, electricity, ethanol, crude oil, gasoline, propane, distillates, and other hydrocarbons) either individually or in a fiduciary capacity.

Cause #2: Lehman Gross Leverage reached 44xCause #3: One Trader at Morgan Stanley cost the Firm $8 billionCause #4: Lehman Brothers owned 7 Hedge Funds, leverage on leverage

Speier Amendment: 15:1 leverage limitation. Volcker Rule: Banks prohibited from proprietary trading except for transactions that benefit customers. Volcker Rule: This part of the bill included a prohibition for bank holding companies to engage in proprietary trading and certain relationships with hedge funds and private equity funds..

Risk Management: 1980s Drexel Burnham / S&L Crisis to 1990s Long Term Capital Management = 10x, LTCM to 2008 Lehman = 100x! : Cause

Cause #1: What is Proprietary Trading? 38% of Lehman Brothers Net Tangible Equity in 3 Investments: Suncal, Coeur Defense, Archstone Smith

Risk Management: Effect

- Volker Rule: modified from its initial form to include multiple exceptions for permitted activities, as well as “de minimus” allowances for investments in hedge funds and private equity. While proprietary trading was also more specifically defined based on what has been commonly referred to as the Merkley-Levin amendment, there is still a fair amount of regulatory discretion provided during the rulemaking phase.

- “De minimus” investments may be made in hedge funds and private equity funds, so long as the banking entity does not have more than 3 percent of total ownership of the fund and that investment does not represent more than 3 percent of its Tier 1 capital. There is a 2 year phase-in, with Federal Reserve approval for these investments.

- There is a study by the Financial Stability Oversight Council, due within 6 months of enactment that will make recommendations for implementing enhanced safety and soundness, as well as how to minimize risky activity.

Risk Management: Effect

- The Dodd Frank Bill states that rulemaking to implement the new restrictions must occur within 9 months of completion of the study listed above.

- Affected institutions will have 2 years to conform to the new restrictions, with the ability to appeal to the Federal Reserve for extensions each year, for up to 3 years. There is the potential for a maximum of a 5 year phase-in period, subject to Federal Reserve approval.

- For illiquid funds, the period can be extended by the Federal Reserve up to 5 years, from having a contractual obligation in effect on May 1, 2010.

- Firms can be asked to raise additional capital during the phase-in period, starting 15 months after the bill’s enactment.

- The bill calls for banks to hold more money as a cushion against risks, but it doesn't say how much.

- It also was mum on the amount of cash that firms dealing in derivatives need to set aside in case those bets sour.

Would create a freestanding Consumer Financial Protection Agency.

Allows the Comptroller of the Currency to pre-empt state consumer protection laws.

Prevents new consumer protection regulator from overseeing auto dealers.

Create a Bureau of Consumer Financial Protection as an independent division within the Federal Reserve.

Give more power to state attorneys general to make laws that are tougher than the Federal standard.

Durbin Amendment: Require Federal Reserve to limit debit card interchange fees and allows retailers to offer discounts to customers based on how they pay for their purchases.

Consumer Protection: Cause

Inside the Dodd Frank Bill’s Consumer Protection Agency

Cause #1: Lehman Brothers Originate to Distribute Machine. 2003: $500 to $600 million a month of subprime, Alt A mortgages. By Late 2006: $3 billion a month origination

Cause #2: 10,000 Lugheads at BNC and Aurora Loan Svs “some of the most despicable human beings on planet earth.”

Cause #3: 300+ Shadow Banks in 2007 don’t exist today

Cause #4: Ratings agencies actively gamed by Wall St.

Consumer Protection: Effect

• Durbin Amendment on Debit Card Interchange Fees ($20 billion interchange fee system): Durbin compromise language on debit card interchange fees remains intact. Federal Reserve itself, rather than the Consumer Financial Protection Agency (CFPB) will remain rule-writing and enforcement powers. The Fed would be allowed to consider monies spent fighting fraud when determining whether interchange fees are “reasonable and proportional.”

• Bureau within the Federal Reserve to regulate consumer financial products like mortgages and credit cards. The bureau would also oversee payday lenders and check cashing businesses. Auto dealers and pawnbrokers are exempt from the bureau's regulation even though the Department of Defense wanted auto dealers included because of past instances of exploiting members of the military. House members originally wanted this watchdog to be a freestanding agency.

• Lenders must verify that borrowers are able to repay the loans that they issue. Lenders would pay penalties for irresponsible lending.

Consumer Protection: Effect

• The Dodd Frank Bill would ensure that consumers benefit when refinancing a mortgage. It would eliminate fees -- known as "prepayment penalties" -- for paying off a mortgage early.

• Franken Amendment on Ratings Agencies: Two year SEC Study will be conducted, dead on arrival in the conference process. But the door was left open for the SEC to figure out a better way to match rating agencies with financial firms. But if it can't, the SEC is required to follow the original plan proposed by Sen. Al Franken...in two years.”

• There are 10 SEC-approved "Nationally Recognized Statistical Ratings Organizations," or rating agencies.

• Obviously, the three that are well-known are Moody's, Standard & Poor's and Fitch.

Allows GAO to audit balance sheets of the Fed and its regional banks.

Requires disclosure after 1 year

Requires a one-time GAO audit of Fed operations within one year

Requires Fed to disclose the names of recipients of emergency credit on its website by Dec. 1

FDIC and Federal Reserve Accountability: Cause

FDIC and Federal Reserve Accountability: Effect

• Financial Stability Oversight Council: The council. Headed by the Treasury Secretary would monitor systemic risk across the entire financial system and make recommendations to the Federal Reserve to alleviate that risk. The ten-member council would include the heads of the federal financial agencies.

• Fannie and Freddie Kick the Can Down the Road: New Bill does nothing to address the problems, and sustainability, of mortgage giants Fannie Mae and Freddie Mac and their $5 trillion mortgage portfolio.

• No Resolution Fund: The House wanted to create a $150 billion fund to pay for any future bailouts. The fund would be paid for by the banks. This provision was gutted. Conferees agreed that this could only be created after a massive collapse. This is the fund that Republicans successfully painted as a permanent bailout fund when Democrats in the Senate tried to include a similar, but only $50 billion, fund.

FDIC and Federal Reserve Accountability: Effect

• Government Accountability Office Study of the Federal Reserve: The GAO will be able to do a full audit of the Federal Reserve. This is still a major provision, but conferees did not accept the more strict language in the House bill that would require an audit every year.

• Too big to fail language still alive allowing the Federal Reserve to bail out a bank holding company in trouble with their derivatives book. Government protections for troubled swaps businesses are still under discussion. The Federal Reserve could use emergency powers in the event that a swap entity’s failure posed systemic risk.

Effect: Originally, Large institutions would be charged regular fees that would go into a $150B fund to cover any future failure.

FDIC would have authority to tap credit line at the Treasury to cover the costs of failure.

Miller-Moore amendment: Requires secured creditors of failing institutions to take losses up to 10% on claims before they could recoup losses

from restitution fund. Senator Breakfast: McConnell and Cornyn Prevents creditors from receiving payments in excess of what they would have won in U.S. Bankruptcy Court.

Resolution Authority: Cause

Cause #1: When they let Lehman fail this was a by product of a deadly game of Chicken between Treasury Secretary Hank Paulson and Lehman CEO Dick Fuld

Cause #1a: Lehman restructuring firm, Weil Gotshal called in much to late in the game as a threat?

Original docket: Judge Peck presented with 12 pages vs. 250 pages expected for a huge bankruptcy.

Prime Brokerage Clients saw their portfolios for sale in the street.

Bankruptcy bigger than Enron, Worldcom General Motors, Chrysler combined

Resolution Authority: Effect

• Special Assessment on financial companies with more than $50B and hedge funds with more than $10B consolidated assets under management

• This assessment of up to $19B will be levied on “financial companies” with more than $50B in assets and hedge funds with more than $10B in assets under management.

• Wall St. paying with their own blood. Assessment viewed as necessary to offset the estimated $20B in increased bureaucratic costs the legislation would impose and which would otherwise contribute to the national deficit.

• Financial Stability Oversight Council (FSOC) would collect and determine assessments on an annual basis (approximately $4B a year) working through the FDIC.

• First assessment would come due no later than September 30, 2012.

Resolution Authority: Effect

• Assessments would be required to be levied according to a “risk matrix” which FSOC and the FDIC would establish by rule and would vary based upon an individual firm’s “complexity of operations or organization, interconnectedness, size, direct or indirect activities…as well as the risk posed to the financial system.”

• Other Factors Determining Assessment: Extent of a company’s leverage, off-balance sheet exposures, Extent and nature of a company’s transactions and relationships with other financial firms, Company’s importance as a source of credit and liquidity; including for underserved and disadvantaged communities, Amount and nature of the company’s financial assets and liabilities, including the degree of reliance on short-term funding.

• Federal supervisory agencies will be empowered to make on-site inspections of a financial company’s books and records to carry out the assessments.

• The FDIC would have the authority to liquidate failing firms while the Treasury Department fronts the money to do so. There would also be a repayment plan so that taxpayers are guaranteed to get the money back.

SEC to define "venture capital funds.“

$150 million AUM threshold for SEC registration; state regulation for those under threshold.

Private funds required to disclose information needed to assess potential systemic risk to investors, counter-parties and creditors.

Investor Protection

Major Actions July / August 2010

• Good news for hedge funds, venture capital and private equity investors: Senate continued consideration of tax extenders legislation (HR 4213), but again were unable to garner the 60 votes needed to end debate on the measure. Majority Leader Reid (D-NV) had pulled the bill from the Senate floor as of late Thursday.

• Another black eye for the Obama Administration: Democratic leadership has spent considerable time wooing three “moderate” Senators – Sens. Snowe (R-ME), Collins (R-ME) and Ben Nelson (D-NE) – all of whom voted no on the motion to proceed.

• Expect separate new legislation on Fannie Freddie, Ratings Agencies, Securitization

• Consumer Protection Agency head likely to be chosen very soon. Larry Summer’s pal Elizabeth Warren is viewed by many in Washington as Borkable, look for a fight here.

Basil III Proposal