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Lehman Bankruptcy Report Illuminates Need for Derivatives Regulation

Although Sen. Chris Dodd (D-Conn.) is getting grief for all that he doesn’t plan on doing with his financial regulation reform bill, one thing that is in the bill is some regulation of over-the-counter derivatives that forces them onto exchanges. While Republicans like Sen. Richard Shelby (R-Ala.) are already arguing that the derivatives regulations in the bill go too far, last week’s report by the bankruptcy examiner on the Lehman Brothers failure shows exactly why derivatives trades should be done on an open exchange for the health of the companies using them.

Frank Partnoy at Naked Capitalism dug really, really far into the massive report, but, unlike most journalists who focused on the fictional balance sheets at Lehman, he looked at the section on valuation and found some conclusions he deems “utterly terrifying reading.” He discovered that Lehman’s own people had no way of determining the market value of their derivatives — the very thing putting derivatives on an exchange would do. Their lack of knowledge of the value — and therefore risk — of their securities was one major reason they weren’t able to balance their risk.

The report cites extensive evidence of valuation problems. Check out page 577, where the report concludes that Lehman’s high credit default swap valuations were reasonable because Citigroup’s marks were ONLY 8% lower than Lehman’s. 8%? And since when are Citigroup’s valuations the objective benchmark?Or page 547, where the report describes how Lehman’s so-called “Product Control Group” acted like Keystone Kops: the group used third-party prices for only 10% of Lehman’s CDO positions, and deferred to the traders’ models, saying “We’re not quants.”

Partnoy notes that the people in charge of leveraging the risk often didn’t understand, or accepted at face value, the pricing developed by the people who took on the risk in the first place. Sometimes, by the examiner’s pricing models, they were 30 times off the real market value. Again, were derivatives trading on an exchange, derivatives valuations would be as easy to asses as stock or futures prices.

Although the examiner said that Lehman’s derivatives valuation problems weren’t necessarily that bad, Partnoy finds fault with that conclusion.

Ultimately, the examiner concluded that these problems related to only a small portion of Lehman’s overall portfolio. But that conclusion was due in part to the fact that the examiner did not have the time or resources to examine many of Lehman’s positions in detail (Lehman had 900,000 derivative positions in 2008, and the examiner did not even try to value Lehman’s numerous corporate debt and equity holdings).

In other words, having found some problems, the examiner simply highlighted them and moved on.

Partnoy draws one major conclusion from the valuations report:

It shows that, even eighteen months after Lehman’s collapse, no one – not the bankruptcy examiner, not Lehman’s internal valuation experts, not Ernst and Young, and certainly not the regulators – could figure out what many of Lehman’s assets and liabilities were worth.

Although Shelby is unlikely to change his mind, as are the lobbyists who have his ear, Partnoy’s analysis of the Lehman report is a strong argument in favor of making derivatives trading far more public than Republicans want it to be.

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