Securities and Exchange Commission and Federal Reserve officials were warned by a leading Wall Street rival that Lehman Brothers was incorrectly calculating a key measure of its financial health months before its collapse in 2008, people familiar with the matter say.
Former Merrill Lynch officials said they contacted regulators about the way Lehman measured its liquidity position for competitive reasons.
The Merrill officials said they were coming under pressure from their trading partners and investors, who feared that Merrill was less liquid than Lehman.
The warnings take on a special significance after last week’s report by Anton Valukas, the Lehman bankruptcy court examiner, who found that Lehman had used questionable financing tools to flatter its balance sheet before its September 2008 collapse.
The findings raise questions over what federal regulators knew about Lehman’s accounting and when they knew it. In the account given by the Merrill officials, the SEC, the lead regulator, and the New York Federal Reserve were given warnings about Lehman’s balance sheet calculations as far back as March 2008.
Former and current Fed officials say even in the competitive world of Wall Street, it is unusual for rival bankers to relay such concerns to the Fed.
The former Merrill officials said they contacted the regulators after Lehman released an estimate of its liquidity position in the first quarter of 2008.
Lehman touted its results to its counterparties and its investors as proof that it was sounder than some of its rivals, including Merrill, these people said.
Lehman’s management told its board at the time that it had “the strongest liquidity position of the brokers”, according to the report by Lehman’s examiner.
“We started getting calls from our counterparties and investors in our debt. Since we didn’t believe the Lehman numbers and thought their calculations were aggressive, we called the regulators,” says one former Merrill banker, now at another big bank.
In response, Merrill debated changing the way it calculated its liquidity. “Lehman was telling the world that it had excess liquidity and we knew they couldn’t be better than we were,” one said.
Definitions of liquidity broadly involve keeping enough cash and marketable securities on hand to repay obligations for a year without raising additional funds in the markets. But there are no strict standards on the amounts or the definitions.
Merrill officials said their calculations led them to believe that Lehman included what is known as regulatory capital in its calculation of excess liquidity. Executives at other banks say that is improper.
The SEC declined to comment beyond saying that the senior people at the unit that oversaw Lehman had left the regulator.
The New York Fed said it were unable to verify that the conversation with Merrill Lynch bankers took place.
Mr Valukas said in his report that the banks interacting with Lehman may have suspected Lehman was incorrectly calculating its liquidity. In September 2008, days before it collapsed, Lehman maintained that it had about $50 billion in readily accessible funds, though at the end it had nothing like that amount.
Lehman’s measure of its liquidity included cash and collateral that was locked up with other banks, the report said.