Bloomberg: Lehman’s lessons

In the days before the Lehman Brothers collapse, uppermost in the minds of bankers and regulators was how to save the repo market from ruin.

Bloomberg News reporters Bob Ivry, Christine Harper and Mark Pittman published September 7, 2009, a detailed accounting of the days leading up to Lehman’s demise.  Read the whole thing.

From the Bloomberg story:

The bankers acknowledged that one of their favorite avenues for borrowing would be disrupted by Lehman’s collapse. Making sure the market wouldn’t freeze for short-term loans called bank repurchase agreements, or repos, was where the participants had their biggest success — and their bitterest disagreements.

In a repo arrangement, a lender sends cash to a borrower in return for collateral, often Treasury bills or notes, which the borrower agrees to repurchase as soon as the next day for the face value of the securities plus interest. When lenders perceived that Lehman might not pay repo loans or be able to post adequate collateral, they required more and higher quality assets from the firm.

The presentation prepared by Lehman employees, titled “Default Scenario: Liquidation Framework,” predicted, among other things, that a bankruptcy would trigger a freeze in the broader repo market.

“Repos default,” they wrote. “Financial institutions liquidate Lehman repo collateral. Repo defaults trigger default of a significant amount of holding company debt and cause the liquidation of hundreds of billions of dollars of securities.”

Repo collateral caused what might have been the tensest moment of the weekend, according to two participants.

While poring over Lehman’s mortgage portfolio on Saturday, former Goldman Sachs partner Peter S. Kraus, a Merrill Lynch vice president and now CEO of New York-based AllianceBernstein Holding LP, accused JPMorgan’s Dimon of being too aggressive in demanding more collateral and margin from other banks to cover declining values, according to two people who were there.

JPMorgan, as a so-called clearing bank, holds collateral for other banks in what are known as tri-party repo transactions. When the value of the collateral declines, JPMorgan can require a borrower bank to post more or higher quality assets so the lending bank is protected.

Dimon didn’t respond to Kraus, the participants said, and the confrontation died down. Both declined to comment.

The Fed was sufficiently anxious about a standstill in repo funding that on Sunday, Sept. 14, it temporarily modified Rule 23(a) of the Federal Reserve Act to allow banks to use customer deposits to fund securities they couldn’t finance in the repo market. That change, scheduled to expire in January, has since been extended through Oct. 30.

Monday Morning Calm

Also that day, the Fed announced that in exchange for loans it would take the same collateral that private repo counterparties accepted. Instead of demanding only investment- grade securities, the central bank would take the mortgage- backed bonds that had sparked the financial crisis.

The Fed arranged for Lehman’s broker-dealer unit to remain open after the bankruptcy filing to allow for repo deals to be resolved in an orderly way.

Monday morning dawned breezy and warm on Wall Street. It was already 79 degrees Fahrenheit when Thomas G. Wipf, Morgan Stanley’s white-bearded head of secured financing, arrived before 6 a.m. at his office in Times Square, four blocks from where the ball drops on New Year’s Eve and around the corner from Lehman’s headquarters. Wipf, who participated in the weekend meetings, had worked for three decades in the short-term financing market and was used to busy mornings as client companies renewed their loans. Instead, he said there was an eerie hush.

The phones were quiet.

No one was calling.

No one was lending.

The ice-nine was silently spreading.