Why a Bank Might Like Owning a Hedge Fund, Lehman & R3 Capital Division

David Dayen reports Last Chance for Lobbyists as FinReg Conference Concludes:

This actually isn’t entirely new. Certain promises around asset management companies in Massachusetts were promised to Brown in exchange for his cloture vote on the Senate bill. But there’s absolutely no need to do anything for the sole benefit of Scott Brown at this point. Lawmakers in the Senate have probably already picked up one vote in the form of Maria Cantwell, if they close the enforcement loophole to the derivatives title (which they expect to do). Russ Feingold then becomes a consequential figure, and his support for the bill would more than cancel out Brown flipping to No.

On the policy, this would be a disaster. The biggest banks already own asset management companies and private equity firms, and some own insurance companies too (or would certainly be incentivized to buy one so they could keep trading). This rips out the heart of what the Volcker rule seeks to accomplish.

So Scott Brown is also a problem on the Volcker Rule. Like some House Democrats, he is seeking to weaken reform by allowing commercial banks to have stakes in hedge funds and private equity firms.

Now besides using their charter to leech value from taxpayers as well as take bets in a manner that doesn’t benefit their clients, why else would a bank want to own a hedge fund? I got a reason: How about massaging the books?

Hopping into the blog time machine, let’s go back to June 2008, Yves Smith at nakedcapitalism, Bloomberg: Lehman Sold $5 Billion of Assets to Investee Hedge Fund:

Lehman did indeed sell $5 billion of assets to a fund in which the investment bank has an economic interest, R3 Capital Partners, and its founder was indeed the former head of Lehman’s principal investing group. The disparity with our report was that the amount alleged to have been sold was much greater, $55 billion versus the $5 billion in the Bloomberg story. However, this $5 billion is material relative to the $70 billion of net asset sales Lehman reported for the last quarter and begs the question of whether it should have been disclosed in the supplemental information provided at the same time as the earnings press release. We hope that the 10-Q filing, which will contain the balance sheet and footnores, will be more forthcoming.

Which was following a bad case scenario that turned out to be true, So How Did Lehman Delever? A Not-Very-Pretty Possibility, with an anonymous email:

Curious whether, to your knowledge, they’ve given much detail around the reduction in gross & net leverage they achieved in the May qtr. My understanding is that the vast majority of the reduction came from spinning out two large businesses into independent entities: the mortgage trading business (now called “One William St Capital”) and the principal investing business (now called “R3 Capital”). R3 Capital is starting life with assets of around $55 billion.

From friends both inside & outside LEH, I understand that LEH is keeping a 45% stake in each business…The main driver, unsurprisingly, was to allow LEH to maintain as much econ interest as possible, consistent with meeting accounting standards to get the biz’s off LEH’s balance sheet.

I haven’t spoken to anyone who has had much to say either way about whether (& to what extent) LEH would face contingent liabilities in the event the new entities were counterparties to losses…but it’s not that hard to imagine a situation where either of these two entities faced losses from derivatives contracts that exceeded (by a wide margin) the capitalization of the newco’s. Will the counterparties, in those cases, look to LEH as a backstop? How could they not?

(Ah, summer 2008.)

We now know, from the Jenner Report, there was even more manipulation of earnings from the mechanisms of Repo 105. Letting banks take ownership in hedge funds is inviting this kind of dual-book keeping, the activity of hiding the actual balance sheet from actual investors through funneling it into hedge funds that the bank has ownership over.

There’s no reason people can’t start hedge funds, but creating conditions where banks are encouraged to take what we’ve recently learned from Lehman and apply it across the financial sector is asking for trouble. It’s sad to see Scott Brown not get the lesson from State Street or this lesson from Lehman.

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One Response to Why a Bank Might Like Owning a Hedge Fund, Lehman & R3 Capital Division

  1. Pingback: FT Alphaville » Further reading

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