February 22nd, 2011
Mary Schapiro
Chairman
Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549
Cc: Luis Aguilar, Commissioner
Cc: Kathleen Casey, Commissioner
Cc: Troy Paredes, Commissioner
Cc: Elisse Walter, Commissioner
Cc: Elizabeth M. Murphy, Secretary
Re: File No. S7-22-10 – Short Term Borrowings Disclosure
Dear Ms. Schapiro:
Americans for Financial Reform is an unprecedented coalition of over 250 national, state and local groups who have come together to reform the financial industry. Members of our coalition include consumer, civil rights, investor, retiree, community, labor, religious and business groups as well as Nobel Prize-winning economists.
We are writing to express our support for the SEC proposal to require increased disclosure of intraperiod short-term borrowings for financial firms. Although we realize that this letter is being sent after the comment deadline, we have been encouraged to express our views by recent statements that the Commission would consider comments submitted after the deadline has passed.
While the financial crisis of 2008 had many dimensions, it was to a significant degree a liquidity crisis. Banks that were heavily dependent on short-term funding through the wholesale markets found their sources of liquidity evaporating, as lenders in the commercial paper and repo market withdrew their support.1 In some cases this run on short-term funding contributed to the collapse of major institutions, such as Lehman Brothers and Bear Stearns. In others, it led to a need for government support and a withdrawal of credit supply to bank customers.
It is precisely this issue that is targeted by the SEC’s disclosure proposal. The relationship between these forms of short-term leverage and a historic financial crisis shows the importance of full disclosure to investors of real borrowing levels at financial institutions.
Unfortunately, we now know that this full disclosure was lacking prior to and during the financial crisis. Misrepresentation of leverage and borrowing levels was endemic among major Wall Street financial institutions, including those supervised by the SEC. The most well-known case is the so-called “Repo 105” transactions at Lehman Brothers, in which tens of billions of dollars of repo borrowing was misrepresented as securities sales. The resulting funds were used to pay down liabilities just before end-of-quarter financial reports were made public, thus misrepresenting to investors the true level of borrowing at Lehman. Lehman’s own accountants described these transactions internally as an “accounting gimmick” used to “reduce the balance sheet at quarter end”.2
These kinds of “accounting gimmicks” were not limited to Lehman. Other investment banks – notably Bank of America and Citigroup – have admitted to the SEC that they too misrepresented repo transactions in a similar manner.3 As in the Lehman case, these transactions were timed to temporarily remove debt from the balance sheet just prior to end-of-quarter financial reports to investors.
These cases show that the current requirement to disclose debt levels to investors only at quarter-end or year-end are not sufficient. Companies can manipulate their reported end-of-quarter debt levels, but investors and regulators cannot assume that creditor or liquidity pressure on a company will be neatly timed to coincide with the end of the quarter. Full disclosure therefore requires that financial companies make clear their maximum levels of short-term debt, at whatever time during the year those borrowings occur.
The SEC’s new proposed rule would accomplish this goal by requiring companies to report their average and maximum debt levels over the entire quarter, not just at the end of the quarter. This common-sense provision will provide critical information to investors without an excessive burden on financial companies. Indeed, good internal risk management practices should lead managers to carefully track their debt levels in any case. Given the capacity of modern information technology and the operational need for risk managers to be aware of maximum short-term borrowing levels, we believe that compliance with the SEC proposal is practical for financial institutions.
Investor protection and full disclosure is at the heart of the SEC’s mandate and mission. The financial crisis revealed a significant failure by the agency to perform this mission in the area of controlling and disclosing borrowing levels at major financial institutions. This failure had profound consequences for investors and for the economy as a whole. The current proposed rule on short-term borrowing disclosures represents one important step in addressing this failure. We hope that the final rule will reflect the SEC’s commitment to fix the problem.
Thank you for the opportunity to share our views on the proposed rule.
Sincerely,
Americans for Financial Reform