Definition from Wikipedia:
Check kiting is the illegal act of taking advantage of the float to make use of non-existent funds in a checking or other bank account. It is commonly defined as writing a check from one bank knowingly with non-sufficient funds, then writing a check to another bank, also with non-sufficient funds, in order to cover the absence. The purpose of check kiting is to falsely inflate the balance of a checking account in order to allow checks that have been written that would otherwise bounce to clear.
From July 2004 through September 2008, Lawrence G. McDonald was a Vice President of Distressed Debt and Convertible Securities Trading at Lehman Brothers (OTC:LEHMQ). He is now a Managing Director at Pangea Capital Management LP. Lawrence is most famous as author of the best selling book "A Colossal Failure of Common Sense: the Inside Story of the Collapse of Lehman Brothers".
MacDonald, in an article at The Huffington Post entitled "The Geithner Deception", lays major blame for the financial collapse of 2008 at the feet of now Treasury Secretary Timothy Geithner. Geithner was President of the Federal Reserve Bank of New York from 2003 through 2008 as the credit bubble expanded and exploded into crisis.
Unsettled Derivatives Trades
McDonald's premise is that a major reason for the collapse of Lehman and, very quickly, the world's financial structure, was unsettled derivative trades. The most notorious of these were known as CDS (credit default swaps) which amounted to guarantees by a seller to make payment to the buyer should there be a credit default by a third party. We'll come back to discuss CDSs further in the next section.
But first, let's complete the picture so well laid out by Lawrence McDonald. He compares the operation of CDS trades to those in a regulated market, such as the stock exchanges or regulated derivative markets such as the CBOE (The Chicago Board of Options Exchange). When trades are made in those markets, the buyer must deliver payment by the settlement date or the trade is cancelled. In the case of stocks, settlement is required within three days.
McDonald says the problem became blatantly evident to Geithner in 2005:
When spectacular problems in the Credit Default Swaps (CDS) markets came to his attention following the bankruptcies of Delta and Northwest Airlines in 2005, he allowed the industry to continue to self-regulate its trading activities.
Every day billions of dollars of CDS contracts had been trading between banks, brokers and hedge funds, but contract execution to settle these transactions was often delayed by months. Literally hundreds of billions of dollars of outstanding derivative contract risk was floating off the balance sheets of the major financial institutions. This strategy allowed the derivative traders to engage in the equivalent of "check kiting" on a grand scale.
Geithner had come to a fork in the road and he didn't take the path less traveled. He could have taken action right then and there to seek to require an exchange clearing process for CDS similar to those for stocks and regulated options. But he didn't make that choice.
Geithner chose the other well cronied path, that was bathed in the soothing light of self-regulation and easy money through a process equivalent to "check kiting".
The Nature of CDS
Let's make the description as simple as possible. Company A accepts a fee from company B for entering an agreement to compensate company B should a specified company C fail.
If B holds a financial interest in C, the CDS is similar to an insurance policy issued by A to protect B's interest. If B holds no financial interest in C, the CDS is similar to a naked put. A naked put is a casino bet that C will fail. After placing such a bet it is possible for B to take actions that increase the likelihood that C will fail. A common analogy is that buying a naked CDS and then shorting the stock of the same company is like buying a fire insurance policy on someone else's house and then committing arson.
As mentioned earlier, there was no process for settlement of CDS deals and some were not closed (settled) until months after the transaction was made. In the meantime, all parties involved in such transactions just went on signing more CDS deals. And again and again. Before the first CDS deal was settled (money paid), both sides could have entered into multiple other deals. The A parties would be using money that they had not yet received and the B parties would be using money that they had yet to pay to A parties.
This kiting process for each deal could have "the check in the mail" for months. This is how the total notional value of all CDSs grew to hundreds of trillions of dollars, many multiples of the "insured" risks and many multiples of the actual total assets of the "kiters".
Some firms were able to engage in this CDS kiting with newly authorized high levels of leverage. Five large broker dealers sought from the SEC and obtained expansion of leverage to a maximum allowed ratio of 40:1 in 2004. Only two of them are still standing: Goldman Sachs (GS) and Morgan Stanley (MS). The other three (Bear Stearns, Merrill Lynch and Lehman Brothers) were essentially vaporized. For more details, see a report by Julie Satow in the New York Sun.
Lehman Brothers: The Final Straw
Bear Stearns collapsed first, but Lehman was the straw that broke the camel's back. We know more about the Lehman situation because they have gone through bankruptcy examination and all other failures have not had such transparency. Lehman had such egregious defective practices that no other firms were willing to do back room deals, as in the case of Bear Stearns and Merrill Lynch. The result was bankruptcy.
The panic that ensued resulted in large part because of the CDS "kiting". There were months of deals in limbo between signing the contracts and paying for them. No one knew exactly what anybody would actually have on the books once all deals settled. The perception was that there might be lurking a smoke monster, as in the series "Lost".
It turned out that Lehman had a rather modest CDS exposure, about 4 billion, if I remember correctly. But no one knew that at the time and no one knew what might be hidden off the books, tied to a "kite" string. So Lehman went bankrupt, unnecessarily in the grand scheme of things, simply because of lack of transparency.
Yes, there were major systemic problems. But if the expanded leverage had not been authorized, then problems would have been less. If all derivatives were forced to observe a rigorous deal and settlement schedule with transactions occurring through a regulated exchange, problems would have been less. But if Lehman (or anybody else) came to the same point of failure under those circumstances, the nature of any takeover deal would have been much clearer. A merger deal without bankruptcy would likely have occurred and a world wide panic would have been avoided.
The Last Days Before the End
The development of the seeds of the financial crisis go back as much as 30 years. But the final days started in 2003 and 2004 when the expansion of leverage was sought and obtained from the SEC at a time when there was an ill advised extension of accommodative Fed policy. The nuclear bomb came into view in 2005 with the two airline defaults mentioned at the beginning of this article. The one person at the decision switch at the time was Geithner, the head of the New York Fed. He didn't push for a resolution of the unsecured nuclear bomb problem. Instead he worked out of the public eye to encourage the banks to improve the time cycle from deal to settlement. Just how much of this was ineffectual pussyfooting is described in the McDonald article.
The kites were kept aloft and eventually a lightening strike came down the strings and fried the kiters. Some were resuscitated at the emergency room and survive today. But with the free (to them) medical care they received, they are still capable of kiting again.
Note to new readers: I have been a strong "break up the oligarchs" advocate for almost a year and a half now. In reading this, do not come to the conclusion that I am an apologist for super sizing financial institutions. What I have tried to explain here is some of the most important processes that created the final explosion. Even at the end (2005-07) there were plenty of opportunities missed to avoid a global collapse. We need to recognize that. We need to remember it is almost never too late.
Disclosure: No positions.