The bankruptcy of Lehman Bros. in September 2008 is widely seen as the event that kicked the financial meltdown into high gear.
So it makes sense that the report released last week by Lehman’s bankruptcy examiner should stand as the one indispensable analysis of how Wall Street almost brought the U.S. economy crashing down.
The uncompromising report should put to rest the self-serving claims by Lehman’s ex-Chairman Richard S. Fuld that the firm was destroyed by rumors, short selling, stock manipulation and an unwarranted loss of confidence by clients and trading partners. In 2,200 pages, the examiner, Anton R. Valukas, lays out the truth in all its ugly glory: Lehman’s fall was 100% its own fault.
Not that there weren’t accessories to the crime. Every institution tasked with overseeing Lehman’s management and performance got hoodwinked. Credit rating firms, outside auditors, board members and Fuld’s cheerleaders at CNBC all bought into a corporate strategy animated by greed and stupidity. In March 2008, the Securities and Exchange Commission and the Federal Reserve placed full-time teams at Lehman to keep an eye on its financial condition; yet they missed what was bubbling under the surface.
The examination by Valukas, a former federal prosecutor, expert in white-collar crime and chairman of the Chicago law firm Jenner & Block, was ordered by the Bankruptcy Court to determine whether there was any fraud or other wrongdoing before Lehman’s bankruptcy filing and whether there’s any money to be recovered from its executives or business partners.
Valukas found not much of the latter and plenty of the former. He also determined that a government rescue of Lehman, a la Bear Stearns or AIG, was never in the cards -- the firm couldn’t find a willing buyer as Bear Stearns had, and unlike AIG it lacked the assets and collateral needed to fund a government bailout loan.
His report points to the necessity of meaningful oversight of big financial institutions by the federal government, something that needs to be preserved in the regulatory reform bill introduced by Sen. Christopher J. Dodd (D-Conn.).
Let’s take a quick tour of the Lehman inferno, with Valukas in the role of Dante. We’ll leave aside, for the moment, his disclosure of how Lehman used a clever accounting device to conceal its true fiscal condition. The broader story is its mistimed bet on high-risk lending.
Lehman was not alone on Wall Street in deciding in 2006 to shift out of its old business model of making loans for sale to other investors and into making investments for its own books -- a change Valukas describes as going from the “moving” to the “storage” business. But it was acquiring exactly the sort of assets that would be hard to unload in a downturn, such as low-quality mortgages, commercial real estate investments and loans to overleveraged companies.
The downturn arrived in 2007. The spread of the subprime virus prompted other investment banks to flee those assets, but Lehman’s brass doubled down, telling the board that with everyone else rushing for the exits, Lehman was poised to reap “substantial opportunities.”
Just as business was shrinking, Lehman’s net assets soared to about $400 billion, an increase of nearly 50% from the beginning of 2006 through the first quarter of 2008. This gives the lie to the argument that Lehman’s officers and directors are being blamed unfairly for overlooking problems visible only in hindsight: They saw the train coming but chose not to get out of the way. As Valukas tells the tale, directors’ most common explanation boils down to this: It seemed like a good idea at the time.
Lehman had rules and procedures to ensure that it did not take on more risk than it could safely manage. These included limits on the size of individual deals and on total holdings of certain assets. But when the constraints threatened to dampen the party, Lehman simply rolled over them.
The firm subjected its portfolio to regular stress testing, which means calculating its potential losses from a range of bad-case scenarios; but it excluded its riskiest real estate and private equity investments from the tests. When the level of its risky holdings exceeded its risk limits, it simply raised the limits. This resembles trying to lose weight by counting calories but leaving cupcakes and ice cream out of the calculation, and fitting into your wardrobe by buying bigger clothes.
Of course, it defeats the purpose of having any risk limits at all. As Lehman found itself stuck with a unmarketably toxic portfolio during the credit freeze of 2007, an executive lectured a colleague in an e-mail reproduced in the report: “In case we ever forget; this is why one has concentration limits and overall portfolio limits. Markets do seize up.” When the reckoning arrived, Lehman resorted to sleight of hand. Pressured by investors and regulators to sharply reduce its leverage -- that is, the size of its (very risky) investment portfolio compared with its capital -- the firm became addicted to a form of repurchase agreement known as Repo 105.
Repurchase agreements, or repos, are common enough on Wall Street as a device for short-term financing. You borrow against an asset, subject to an agreement to repay the money, plus interest and a fee, and take the asset back from the lender a few days hence. But the asset remains on your balance sheet.
Repo 105 was different. Lehman booked these deals as sales. This enabled it to take the assets off its balance sheet, making it look smaller and sharply reducing its reported leverage.
In 2007 and 2008, Lehman executives sharply escalated their use of Repo 105, especially near the end of each quarter when the heat was on to show reduced leverage. A few days after quarter’s end, of course, the assets were back on its books.
Insiders knew that Repo 105 had no economic purpose but was used solely for window dressing: “It is another drug we r on [sic],” an executive complained in an internal e-mail. A whistle-blower told Lehman’s auditing firm, Ernst & Young, about the extraordinary popularity of Repo 105, but the auditors didn’t look into the claim, which Valukas believes may constitute “professional malpractice.” (E&Y says it did its auditing properly.)
Dick Fuld crowed to Wall Street about Lehman’s success in reducing leverage, as if it had done so by selling hard-to-market assets as investors and regulators wanted. He and other top executives told Valukas that they weren’t aware how Repo 105 was used. Valukas makes it quite clear that he thinks they’re lying, but says the truth is up to a court to decide.
His report points to several important lessons. One is the folly of relying on self-discipline and self-regulation in the financial markets. The credit-rating firms were utterly useless in appraising Lehman’s true condition. Ernst & Young’s dereliction seems so extreme that it deserves harsh punishment, maybe even extinction (“to obliterate, to punish and to discourage others,” John le Carre wrote in another context).
And I’d love to hear an argument for allowing any of Lehman’s independent directors, who seem seldom to have asked a penetrating question, ever to serve on a corporate board again.
As I write, those 10 directors, who pulled down better than $100,000 cash a year to sit jointly in the driver’s seat for Lehman’s race to disaster, still boast at least 15 company directorships among them. Does this make you confident that corporate America is in good hands? Me neither.