Is the SEC to Blame for Lehman's Failure?

Lehman Brothers bankruptcy examiner Anton Valukas blames the Securities and Exchange Commission for not cracking down on the risky behavior that led to the investment bank's demise in a hearing today on Capital Hill. His investigation will conclude that the regulatory framework was insufficient to keep Lehman's appetite for risk in check. As its leverage grew, the SEC sat by without forcing the firm the rein in its borrowing. Lehman's failure followed.

Valukas's findings can be summed up by the following short paragraph contained within his testimony (.pdf):

So the agencies were concerned. They gathered information. They monitored. But no agency regulated.

The SEC was Lehman's chief regulator through its Consolidated Supervised Entity (CSE) Program. In her testimony (.pdf), current Chairperson Mary Schapiro admits the program failed:

Under the CSE program, the SEC undertook for the first time the consolidated oversight of the five largest U.S. investment banks, whose operations were global in scope and extended well beyond the types of products and business lines typically found in a registered broker-dealer. Participation by the CSE firms in this regime was voluntary, and the consolidated oversight of these holding companies was more prudential in nature than the SEC's traditional rule-based approach for broker-dealer regulation. In brief, this program reflected a profoundly different approach to oversight and supervision for the Commission. Properly executing the program called for a correspondingly significant expansion in human, financial, managerial, technological and other resources devoted to the oversight and examination of CSE holding companies and their subsidiaries.

The SEC believed at the time that it was stepping in to address an existing gap in the oversight of these entities. Once, the agency took on that responsibility, however, it had to follow through effectively. Notwithstanding the hard work of its staff, in hindsight it is clear that the program lacked sufficient resources and staffing, was undermanaged, and at least in certain respects lacked a clear vision as to its scope and mandate.

The program was discontinued in 2008. One of the major problems with the program was that the SEC did not actually audit financial firms. Instead, it relied on third-party auditor reports. This is part of the reason why the SEC did not pick up on Lehman's now famous Repo 105 transactions, which hid some of the firm's leverage from regulators. Also from Schapiro's testimony:

As discussed in the Examiner's Report, regulators (including Commission staff), rating agencies and the Lehman Board, were unaware of Lehman's use of Repo 105 transactions. For purposes of the CSE program, the Commission did not perform an audit of Lehman's balance sheet. Instead, the Commission depended on the integrity of the balance sheet information provided by Lehman's management which was audited or, in the case of quarterly reports, reviewed, by Lehman's auditors. Lehman did not disclose in its audited financials that it was undertaking repos as sales - on the contrary, Lehman's disclosure would lead one to believe that it accounted for all of its repos as financings and that the repos were properly reported as such on the balance sheet.

So the problem wasn't only that the SEC failed to act -- the problem was also that the SEC didn't understand precisely what was going on in Lehman. Yet, Valukas somewhat disputes that. He found that the SEC certainly knew enough to act (his emphasis below):

The SEC knew that Lehman was reporting sums in its reported liquidity pool that the SEC did not believe were in fact liquid; the SEC knew that Lehman was exceeding its risk control limits; and the SEC should have known that Lehman was manipulating its balance sheet to make its leverage appear better than it was. Yet even in the face of actual knowledge of critical shortcomings, and after Bear Stearns' near collapse in March 2008 following a liquidity crisis, the SEC did not take decisive action.

This represents failures in both supervision and enforcement on the part of the SEC. Presumably, Congress' new systemic risk regulator to be created from financial reform would hope to do a better job. The Lehman bankruptcy examiner appears to provide evidence that a regulator must have enforcement authority and the will to act. Schapiro's testimony could be interpreted to assert that audit authority is necessary as well.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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