As part of his wide-ranging investigation into the collapse of Lehman Brothers Holdings, bankruptcy examiner Anton Valukas focused a lot attention on the business Lehman Brothers did with all the big banks. If the banks improperly obtained Lehman's assets, Lehman's creditors could try to get them back. However, after reviewing the firm's transactions with JP Morgan (JPM), Citigroup (C), HSBC (HBC), Bank of New York Mellon (BK), South Africa's Standard Bank and the Federal Reserve Bank of New York, Valukas takes no real issue with anything they -- or even Lehman -- did regarding certain transactions.

He does say a weak claim could be pursued against JP Morgan for making excessive collateral demands on Lehman in September 2008. But Valukas also says that to succeed, the judge or jury would have to decide that the collateral demands were unreasonable and that Lehman didn't waive the claim by providing the collateral as asked. It'll be interesting to see if anyone likes the odds enough to try to bring that claim.

Lehman's "Liquidity Pool" Wasn't So Deep

A key metric investors use to assess a financial institution's health is its "liquidity pool," that is, the amount of cash and assets (like Treasury bills) it holds that can be quickly converted to cash and thus be used to meet obligations at any moment. Liquidity, as the financial crisis taught, is the lifeblood of business, particularly financial firms. But as Lehman's financial condition worsened throughout 2007 and 2008, its liquidity pool became increasingly important to market analysts.

Lehman made many statements, as reported by Valukas, reassuring the markets and credit ratings agencies that its liquidity pool was robust. Those statements kept market analysts believing, right up to 48 hours before Lehman filed for bankruptcy, that the firm had a $41 billion unencumbered liquidity pool. This made the idea of a run on the bank or other funding crisis unlikely.

Indeed, on Sept. 10, 2008, CFO Lowitt held an earnings call in which he stressed the strength of Lehman's liquidity pool, reporting that as of the night before it stood at that $41 billion level.

However, starting in the summer of 2008, Valukas reports, Lehman included assets in its liquidity pool calculation that it likely shouldn't have because the firm's ability to turn them into cash on demand was very questionable. By the Sept. 10 earnings call, Lehman was including huge amounts of not-so-liquid assets in its liquidity pool. What Lehman didn't disclose on this call was that an internal memo said the firm had a "high" likelihood of easily monetizing only $25 billion of the $41 billion. It felt that a full $15 billion had "low" likelihood to be monetized.

Problematic Pledges

According to Valukas's report, the problem started relatively innocuously in June 2008 when Lehman gave $2 billion to Citigroup as extra collateral so that Citi would continue clearing Lehman's trades. Lehman counted the $2 billion in its liquidity pool, assuming it could take the money back at any time. But Citigroup was holding the funds to cover any losses it incurred as a result of clearing Lehman's trades. So, Lehman knew that if it took the money back, it would harm its ability to clear through Citigroup.

More problematic were the collateral deposits that followed. A week later, Lehman pledged $5 billion of additional collateral with JP Morgan. In August, it gave Bank of America (BAC) $500 million, complete with a security interest in the money. Also in August, it gave JP Morgan formal security interests in two accounts. On Sept. 2, it gave HSBC $1 billion in collateral secured by "cash deeds." And on Sept. 9-12, Lehman gave JP Morgan an additional $8 billion that was subject to security interests in favor of JP Morgan. Lehman counted most or all of these secured deposits in its liquidity pool despite the security interests.

Indeed, according to Valukas's report, in the negotiation with JP Morgan over the September $8 billion and the related security agreements, Lehman demanded that the agreement include Lehman's right to request the collateral back so that it could be kept in Lehman's liquidity pool. After much internal discussion, JP Morgan agreed because it believed the right to request the collateral back was meaningless: Just because Lehman asked, JP Morgan didn't have to give it back.

If Only the Ratings Agencies Knew...

Valukas also interviewed representatives from the three major credit rating agencies, Fitch, Standard & Poor's and Moody's, to determine whether they knew Lehman included encumbered securities in its liquidity pool, and if so, what they thought of it. All three denied knowing it and said they believed that it would have been important for them to know it. Both Fitch and S&P made clear that they would have excluded such assets in their calculations of Lehman's liquidity pool. Valukas doesn't report Moody's saying specifically how it would this information would have affected its view of Lehman's liquidity beyond that Moody's wanted to know about it.

Despite the repeated statements Lehman made to the market about its liquidity pool, including the Sept. 10 earnings call, Valukas says Lehman's officers did not breach their fiduciary duties in connection with the reporting of the pool. Valukas reached that conclusion mostly because no definitive standards exist for reporting a liquidity pool or what should or shouldn't be in it. Valukas also says he expresses no view on whether or not the liquidity pool disclosures might give rise to other causes of action.

Editor's Note: We'll be further reviewing the Valukas report and laying out its findings and their implications in follow-up stories.

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