SEC Didn’t Act on Lehman’s ‘Problematic’ Liquidity, Report Says

The U.S. Securities and Exchange Commission didn’t take action after determining in June 2008 that Lehman Brothers Holdings Inc. was exaggerating the liquid assets on its books, the bankruptcy examiner’s report shows.

Lehman counted a $2 billion deposit at Citigroup Inc. among cash-like assets available in an emergency, even though withdrawing the money could have impaired Lehman’s trading, according to last week’s report by Anton Valukas. SEC employees viewed the asset’s designation as “problematic,” yet didn’t intervene, his report said.

The findings highlight a gap between Lehman’s view of its so-called liquidity pool, used to pay bills in a pinch, and that of the SEC in the months before Lehman filed the biggest U.S. bankruptcy in September 2008. As the financial crisis gathered momentum, investors got only Lehman’s version.

“They were saying they didn’t have a problem,” said Peter Sorrentino, who helps oversee $13.8 billion at Huntington Asset Advisors in Cincinnati. “Well, they did. It just wasn’t being disclosed.”

The silence of regulators, who were focused on stability rather than honesty with investors, was invoked as a defense as Valukas quizzed more than 100 executives and other witnesses about the financial health and reporting at Lehman, based in New York.

No Government Objections

“A recurrent theme in their responses was that Lehman gave full and complete financial information to government agencies,” Valukas wrote. They told him that “the government never raised significant objections or directed that Lehman take any corrective action.”

Valukas didn’t draw conclusions about whether the SEC’s interactions with Lehman were appropriate. Mary Schapiro, who became SEC chairman in January 2009, has replaced most of the agency’s top officials. The SEC allows firms to determine how they disclose liquid assets, so long as they don’t deceive investors.

“We are looking closely at the examiner’s findings as part of our ongoing review of the accounting and disclosures of major financial institutions and their role in the financial crisis,” SEC spokesman John Nester said.

On June 16, 2008, Lehman finance chief Ian Lowitt told analysts on a conference call that Lehman’s $45 billion liquidity pool, composed of cash instruments, government and agency securities, and overnight loans, had “never been stronger.” Three months later, on a Sept. 10 call, Lowitt said the figure had slipped to $42 billion as the firm reduced outstanding commercial paper.

Five days after that, Lehman filed for bankruptcy.

24 Hours vs. Five Days

Behind the scenes, the SEC had been questioning how Lehman calculated its figures. The SEC deemed assets to be liquid only if they were convertible to cash within 24 hours. Lehman afforded itself five days.

In prior years, the SEC had periodically objected to assets included in the liquidity pool, prompting the firm to remove them. In 2008, though, the agency didn’t challenge the Citigroup deposit. The SEC told Lehman it preferred the shorter limit and never enforced it, according to the report.

“If the SEC feels that there is a real shortfall in the company’s liquidity, they’re not serving investors by suppressing that,” said John Coffee, a securities law professor at Columbia University. “The obligation is to disclose all material information.”

‘Really Big Problem’

The Federal Reserve Bank of New York learned Aug. 20 that Lehman had pledged $5 billion in additional collateral to JPMorgan Chase & Co., and didn’t pass the information to the SEC, Valukas said. The SEC learned of the pledge “late” that month, and was told by a Lehman executive that it wouldn’t affect the pool, the examiner said.

The SEC didn’t know that JPMorgan had demanded that Lehman post additional collateral during the week of Sept. 8, 2008. It wasn’t aware of any significant issues with Lehman’s liquidity pool until Sept. 12, when officials learned that a large portion of it had been allocated to clearing banks as collateral so that they would keep providing essential services.

In a Sept. 12 e-mail, one SEC employee wrote, “Lehman’s liquidity pool is almost totally locked up with clearing banks to cover intraday credit,” according to an e-mail cited by Valukas. “This is a really big problem.”

SEC ‘Got Compromised’

The SEC’s examiners at Lehman didn’t belong to the agency’s ranks of investigators and disclosure specialists. Instead, they were part of the Consolidated Supervised Entities program, set up in 2004 to guard against the collapse of systemically important bank holding companies including Goldman Sachs Group Inc., Morgan Stanley, Bear Stearns Cos. and Merrill Lynch & Co.

The unit primarily monitored Lehman for financial or operational weaknesses. The agency’s hallmark mandate is investor protection.

A week after Lehman’s collapse, then SEC-Chairman Christopher Cox testified to Congress that the CSE program was fundamentally flawed. No law authorized the voluntary program to prescribe a companywide liquidity level or enforce SEC leverage requirements, he said. The SEC announced Sept. 26, 2008, the program was ending.

“It looks like the SEC was behaving much like a bank regulator and trying to avoid public disclosure of information which could encourage either raids, short selling, or possibly a run on the bank,” Coffee said. “I think the SEC got itself compromised here.”