Stanford Law Review Online: Summe on Misconceptions About Lehman Brothers’ Bankruptcy

Over at the Stanford Law Review Online, Kimberly Summe has posted "Misconceptions About Lehman Brothers’ Bankruptcy and the Role Derivatives Played."  Here is an excerpt, but the entire piece is well worth a read:

Misconception #1: Derivatives Caused Lehman Brothers’ Failure ….

At the time of its bankruptcy, Lehman Brothers had an estimated $35 trillion notional derivatives portfolio. The 2,209 page autopsy report prepared by Lehman Brothers’ bankruptcy examiner, Anton Valukas, never mentions derivatives as a cause of the bank’s failure. Rather, poor management choices and a sharp lack of liquidity drove the narrative of Lehman Brothers’ bankruptcy…..

Misconception #2: Regulators Lacked Information About Lehman Brothers’ Financial Condition

The Valukas report was explicit that regulatory agencies sat on mountains of data but took no action to regulate Lehman Brothers’ conduct…..

Misconception #3: Derivatives Caused the Destruction of $75 Billion in Value ….

The allegation that derivatives destroyed value is flatly at odds with the fact that derivatives were the biggest contributor to boosting recoveries for Lehman’s creditors....

Misconception #4: Insufficient Collateralization

Policymakers focused on collateralization as a derivatives risk mitigation technique. Collateralization of derivatives, however, has existed for twenty years….

Misconception #5: The Bankruptcy Code Is Not Optimal for Systemically Important Bankruptcies ….

[U]nder the current settlement framework, Lehman Brothers’ bankruptcy will be resolved in just over three years—a remarkable timeframe given that Enron’s resolution took a decade.

Policymakers also focused on the wrong entities for failure. Banks, the most likely candidates for application of Dodd-Frank’s orderly resolution authority, have in fact been the least likely to experience failures due to derivatives losses, in part because of their efforts to hedge exposures. The largest derivatives failures to date involved non-bank entities such as Orange County, the hedge fund Long-Term Capital Management, and AIG Financial Products—entities with fewer risk management and legal resources than banks and which are less likely to hedge exposure. These types of entities are not covered by Dodd-Frank.

Conclusion

An alternative vision for policymakers in the aftermath of Lehman Brothers’ bankruptcy would have involved greater consideration of how liquidity can become constrained so quickly, as in the commercial paper and repo markets, and an effort to mandate the type and amount of collateral provided in these asset classes. In addition, a clarion call mentality among regulators with respect to critical issues such as the size and makeup of a bank’s liquidity pool and an insistence on adherence to banks’ self-established risk tolerances should be actionable. Instead, policymakers overlooked some of the principal causes of Lehman Brothers’ bankruptcy….

SJP