The Lehman report
By Chris ClairIf you’re looking for the actual report, beyond the reporting on it in the media and on the blogs, it’s here:
I’m wading through it, and the reporting on it, and will have something later today. In the meantime, here’s what we’ve got for now: Lehman Insolvent Weeks before Bankruptcy: Examiner.
March 17th, 2010 at 11:52 am
Chris,
thanks for the link.
The introduction of the Examiner is in my opinion a wonderful piece of narrative: clear, concise and effective. Wish all journalists could write so well.
One can sense and understand both the hubris and greed of the subject examined and yet there is no use of derogatory, populist adjectives.
I find his choice of defining ” colorable” the actions which are to be prosecuted a final subtle touch of moderation.I think that this piece should be read in all high schools so that young people can understand what went on and is probably still going on. But the people at large should be able to read it.
I took the liberty of deleting the notes for the sake of fluency.
Sincerely
INTRODUCTION
On January 29, 2008, Lehman Brothers Holdings Inc. (“LBHI”1) reported record
revenues of nearly $60 billion and record earnings in excess of $4 billion for its fiscal
year ending November 30, 2007. During January 2008, Lehman’s stock traded as high
as $65.73 per share and averaged in the high to mid‐fifties,3 implying a market
capitalization of over $30 billion. Less than eight months later, on September 12, 2008,
Lehman’s stock closed under $4, a decline of nearly 95% from its January 2008 value.
On September 15, 2008, LBHI sought Chapter 11 protection, in the largest bankruptcy
proceeding ever filed.
There are many reasons Lehman failed, and the responsibility is shared. Lehman
was more the consequence than the cause of a deteriorating economic climate.
Lehman’s financial plight, and the consequences to Lehman’s creditors and
shareholders, was exacerbated by Lehman executives, whose conduct ranged from
serious but non‐culpable errors of business judgment to actionable balance sheet
manipulation; by the investment bank business model, which rewarded excessive risk
taking and leverage; and by Government agencies, who by their own admission might
better have anticipated or mitigated the outcome.
Lehman’s business model was not unique; all of the major investment banks that
existed at the time followed some variation of a high‐risk, high‐leverage model that
required the confidence of counterparties to sustain. Lehman maintained
approximately $700 billion of assets, and corresponding liabilities, on capital of
approximately $25 billion.8 But the assets were predominantly long‐term, while the
liabilities were largely short‐term. Lehman funded itself through the short‐term repo
markets and had to borrow tens or hundreds of billions of dollars in those markets each
day from counterparties to be able to open for business. Confidence was critical. The
moment that repo counterparties were to lose confidence in Lehman and decline to roll
over its daily funding, Lehman would be unable to fund itself and continue to operate.
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So too with the other investment banks, had they continued business as usual. It is no
coincidence that no major investment bank still exists with that model.
In 2006, Lehman made the deliberate decision to embark upon an aggressive
growth strategy, to take on significantly greater risk, and to substantially increase
leverage on its capital. In 2007, as the sub‐prime residential mortgage business
progressed from problem to crisis, Lehman was slow to recognize the developing storm
and its spillover effect upon commercial real estate and other business lines. Rather
than pull back, Lehman made the conscious decision to “double down,” hoping to
profit from a counter‐cyclical strategy. As it did so, Lehman significantly and
repeatedly exceeded its own internal risk limits and controls.
With the implosion and near collapse of Bear Stearns in March 2008, it became
clear that Lehman’s growth strategy had been flawed, so much so that its very survival
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was in jeopardy. The markets were shaken by Bear’s demise, and Lehman was widely
considered to be the next bank that might fail. Confidence was eroding. Lehman
pursued a number of strategies to avoid demise.
But to buy itself more time, to maintain that critical confidence, Lehman painted
a misleading picture of its financial condition.
Lehman required favorable ratings from the principal rating agencies to maintain
investor and counterparty confidence; and while the rating agencies looked at many
things in arriving at their conclusions, it was clear – and clear to Lehman – that its net
leverage and liquidity numbers were of critical importance. Indeed, Lehman’s CEO
Richard S. Fuld, Jr., told the Examiner that the rating agencies were particularly focused
on net leverage;18 Lehman knew it had to report favorable net leverage numbers to
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maintain its ratings and confidence. So at the end of the second quarter of 2008, as
Lehman was forced to announce a quarterly loss of $2.8 billion – resulting from a
combination of write‐downs on assets, sales of assets at losses, decreasing revenues, and
losses on hedges – it sought to cushion the bad news by trumpeting that it had
significantly reduced its net leverage ratio to less than 12.5, that it had reduced the net
assets on its balance sheet by $60 billion, and that it had a strong and robust liquidity
pool.
Lehman did not disclose, however, that it had been using an accounting device
(known within Lehman as “Repo 105”) to manage its balance sheet – by temporarily
removing approximately $50 billion of assets from the balance sheet at the end of the
first and second quarters of 2008. In an ordinary repo, Lehman raised cash by selling
assets with a simultaneous obligation to repurchase them the next day or several days
later; such transactions were accounted for as financings, and the assets remained on
Lehman’s balance sheet. In a Repo 105 transaction, Lehman did exactly the same thing,
but because the assets were 105% or more of the cash received, accounting rules
permitted the transactions to be treated as sales rather than financings, so that the assets
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could be removed from the balance sheet. With Repo 105 transactions, Lehman’s
reported net leverage was 12.1 at the end of the second quarter of 2008; but if Lehman
had used ordinary repos, net leverage would have to have been reported at 13.9.
Contemporaneous Lehman e‐mails describe the “function called repo 105
whereby you can repo a position for a week and it is regarded as a true sale to get rid of
net balance sheet.” Lehman used Repo 105 for no articulated business purpose except
“to reduce balance sheet at the quarter‐end.” Rather than sell assets at a loss, “[a]
Repo 105 increase would help avoid this without negatively impacting our leverage
ratios.” Lehman’s Global Financial Controller confirmed that “the only purpose or
motive for [Repo 105] transactions was reduction in the balance sheet” and that “there
was no substance to the transactions.”
Lehman did not disclose its use – or the significant magnitude of its use – of
Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board
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of Directors. Lehman’s auditors, Ernst & Young, were aware of but did not question
Lehman’s use and nondisclosure of the Repo 105 accounting transactions.
In mid‐March 2008, after the Bear Stearns near collapse, teams of Government
monitors from the Securities and Exchange Commission (“SEC”) and the Federal
Reserve Bank of New York (“FRBNY”) were dispatched to and took up residence at
Lehman, to monitor Lehman’s financial condition with particular focus on liquidity.
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Lehman publicly asserted throughout 2008 that it had a liquidity pool sufficient to
weather any foreseeable economic downturn.
But Lehman did not publicly disclose that by June 2008 significant components
of its reported liquidity pool had become difficult to monetize. As late as September
10, 2008, Lehman publicly announced that its liquidity pool was approximately $40
billion; but a substantial portion of that total was in fact encumbered or otherwise
illiquid. From June on, Lehman continued to include in its reported liquidity
substantial amounts of cash and securities it had placed as “comfort” deposits with
various clearing banks; Lehman had a technical right to recall those deposits, but its
ability to continue its usual clearing business with those banks had it done so was far
from clear. By August, substantial amounts of “comfort” deposits had become actual
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pledges. By September 12, two days after it publicly reported a $41 billion liquidity
pool, the pool actually contained less than $2 billion of readily monetizable assets.
Months earlier, on June 9, 2008, Lehman pre‐announced its second quarter
results and reported a loss of $2.8 billion, its first ever loss since going public in 1994.
Despite that announcement, Lehman was able to raise $6 billion of new capital in a
public offering on June 12, 2008. But Lehman knew that new capital was not enough.
Treasury Secretary Henry M. Paulson, Jr., privately told Fuld that if Lehman was forced
to report further losses in the third quarter without having a buyer or a definitive
survival plan in place, Lehman’s existence would be in jeopardy.
On September 10, 2008, Lehman announced that it was projecting a $3.9 billion
loss for the third quarter of 2008. Although Lehman had explored options over the
summer, it had no buyer in place; its only announced survival plan was to spin off
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troubled assets into a separate entity. Secretary Paulson’s prediction turned out to be
right – it was not enough.
By the close of trading on September 12, 2008, Lehman’s stock price had declined
to $3.65 per share, a 94% drop from the $62.19 January 2, 2008 price.
$62.19
$31.75
$27.50
$20.96
$7.79 $7.25
$3.65
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
2-Jan-08 17-Mar-08 10-Jun-08 1-Jul-08 9-Sep-08 10-Sep-08 12-Sep-08
Landmark Dates
Lehman Stock Price
Over the weekend of September 12‐14, an intensive series of meetings was
conducted by and among Treasury Secretary Paulson, FRBNY President Timothy F.
Geithner, SEC Chairman Christopher Cox, and the chief executives of leading financial
institutions. Secretary Paulson began the meetings by stating the Government was
there to do all it could – but that it could not fund a solution. The Government’s
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analysis was that it did not have the legal authority to make a direct capital investment
in Lehman, and Lehman’s assets were insufficient to support a loan large enough to
avoid Lehman’s collapse.
It appeared by early September 14 that a deal had been reached with Barclays
which would save Lehman from collapse. But later that day, the deal fell apart when
the parties learned that the Financial Services Authority (“FSA”), the United Kingdom’s
bank regulator, refused to waive U.K. shareholder‐approval requirements.
Lehman no longer had sufficient liquidity to fund its daily operations. On the
evening of September 14, SEC Chairman Cox phoned the Lehman Board and conveyed
the Government’s strong suggestion that Lehman act before the markets opened in
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Asia. On September 15, 2008, at 1:45 a.m., LBHI filed for Chapter 11 bankruptcy
protection.
Sorting out whether and the extent to which the financial upheaval that followed
was the direct result of the Lehman bankruptcy filing is beyond the scope of the
Examiner’s investigation. But those events help put into context the significance of the
Lehman filing. The Dow Jones index plunged 504 points on September 15. On
September 16, AIG was on the verge of collapse; the Government intervened with a
financial bailout package that ultimately cost about $182 billion. On September 16,
2008, the Primary Fund, a $62 billion money market fund, announced that – because of
the loss it suffered on its exposure to Lehman – it had “broken the buck,” i.e., its share
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price had fallen to less than $1 per share. On October 3, 2008, Congress passed a $700
billion Troubled Asset Relief Program (“TARP”) rescue package.
In his recent reconfirmation hearings, Federal Reserve Chairman Ben Bernanke,
speaking of the overall economic crisis, candidly conceded that “there were mistakes
made all around” and “we should have done more.” Lehman should have done more,
done better. Some of these failings were simply errors of judgment which do not give
rise to colorable causes of action; some go beyond and are indeed colorable.
* * *