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Lbex-Docid 2125011 Foia Confidential Treatment Lehman Brothers Consolidated Supervised Entity Market and Credit Risk Review SECURITIES AND EXCHANGE COMMISSION Division of Market Regulation Office of Prudential Supervision and Risk Analysis 100 F Street NE Mail Stop 6628 Washington, DC 20549 CONFIDENTIAL – FOR SEC USE ONLY FOIA CONFIDENTIAL TREATMENT REQUESTED BY LBEX-DOCID 2125011 LEHMAN BROTHERS HOLDINGS INC. Table of Contents Acronyms Scope and Methodology of Review......................................................................... 1 I. Risk Management Infrastructure.......................................................................... 3 a. Formal Governance Structure ................................................................ 3 b. Risk Appetite Framework ....................................................................... 4 c. Aggregate Risk Limits............................................................................. 6 II. Market Risk Management ................................................................................... 7 a. Structure of Market Risk Management................................................... 8 b. Models and Methodologies for Measuring Risk ..................................... 10 i. Introduction to VaR ...................................................................... 11 ii. Revaluation ................................................................................. 11 iii. Mapping .................................................................................13 iv. Historical time series.................................................................. 13 c. Businesses Generating Significant Market Risk..................................... 14 i. Interest Rate Products and Liquid Markets Proprietary ............... 14 ii. Credit Businesses ....................................................................... 16 iii. Mortgage trading ........................................................................ 18 iv. Municipals ................................................................................. 21 v. Equity Volatility (Equity Derivatives) ........................................... 23 vi. Global Real Estate Group ......................................................... 24 vii. Risk Arbitrage ........................................................................... 26 d. Control Processes ................................................................................. 27 i. Price Verification ......................................................................... 27 ii. Profit and Loss Attribution Process............................................. 28 iii. Model Control ............................................................................ 30 III. Credit Risk Management................................................................................. 32 a. Overview of Businesses Generating Credit Risk ................................... 32 b. Tools ................................................................................. 33 i. Potential Exposure Modeling ....................................................... 33 Fixed Income and Foreign Exchange Derivatives ............... 35 Equity Derivatives ................................................................ 36 Credit Derivatives ................................................................ 37 Fixed Income and Equity Financing..................................... 38 Prime Brokerage.................................................................. 38 Revaluation Techniques ...................................................... 38 PE Validation ....................................................................... 39 ii. Internal Credit Ratings ................................................................ 40 c. Limits and Permissioning................................................................. 41 d. Technology Systems....................................................................... 43 i. Credit Work Station...................................................................... 43 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LBEX-DOCID 2125011 LEHMAN BROTHERS HOLDINGS INC. ii. MPE System .............................................................................. 43 iii. Credit Approval System (CAS)................................................... 44 iv. Credit Risk Reporting Applications ............................................ 44 v. Risk Rating Scorecard Application ............................................. 44 vi. Future Enhancements ............................................................... 44 e. Specific Business Areas......................................................................... 45 i. Lending Activities......................................................................... 45 Leveraged Finance .............................................................. 45 Relationship Lending ........................................................... 49 Warehouse Lending............................................................. 49 ii. OTC Derivatives/Securities Lending/Repos............................... 51 iii. Prime Brokerage ........................................................................ 55 IV. Risk Appetite……………................................................................................... 58 a. Risk Appetite Components..................................................................... 58 b. Aggregation Process.............................................................................. 60 c. Risk Appetite Limitations ........................................................................ 61 V. Areas of Focus….. ……….................................................................................. 62 a. Energy Trading….. ................................................................................. 62 b. Risk Appetite…….. ................................................................................. 62 c. Scenario Analysis................................................................................... 63 d. PE Modeling Changes............................................................................ 64 e. VaR Backtesting and PE Validation ....................................................... 64 f. Changes to Credit Limit Structure ........................................................... 65 g. Internal Facility Ratings .......................................................................... 65 h. Prime Brokerage…................................................................................. 65 i. Model Control…….. ................................................................................. 65 VI. Conclusion………………. ................................................................................. 66 Appendix A: CSE review work papers Appendix B: Lehman staff consulted during CSE review FOIA CONFIDENTIAL TREATMENT REQUESTED BY LBEX-DOCID 2125011 LEHMAN BROTHERS HOLDINGS INC. Acronyms in Lehman Consolidated Supervised Entity Market and Credit Risk Review ABS Asset Backed Securities ALS Aurora Loan Service ARM Adjustable-Rate Mortgages BMA Bond Market Association CAO Chief Administrative Officer CAS Credit Approval System CDO Collateralized Debt Obligation CDS Credit Default Swaps CE Current Exposure CEO Chief Executive Officer CFO Chief Financial Officer CLO Collateralized Loan Obligations CMBS Commercial Mortgage Backed Securties CMO Collateralized Mortgage Obligations CRM Credit Risk Management CRO Chief Risk Officer CSA Collateral Support Agreements CSE Consolidated Supervised Entity CVA Credit Valuation Adjustment CWS Credit Work Station DQCG Data Quality Control Group EAD Exposure At Default EE Expected Exposure ELP Estimated Loss Potential EMG/HF Emerging Market Firms And Hedge Funds EPE Effective Potential Exposure EPPE Effective Peak Potential Exposure FX Foreign Exchange GCS Global Clearing Services GMG Global Margin Group GREG Global Real Estate Group HistSim Historical Simulation HYCC High Yield Commitment Committee IB Investment Banking ICR Internal Credit Rating IO Interest-Only LBO Leveraged Buy-Outs LGD Loss Given Default LTV Loan-to-Value MACs Material Adverse Clauses MIS Capital Markets Technology Group MMD Municipal Market Data MPE Maximum Potential Exposure FOIA CONFIDENTIAL TREATMENT REQUESTED BY LBEX-DOCID 2125011 LEHMAN BROTHERS HOLDINGS INC. MRA Marginal Risk Appetite MRM Market Risk Management NAV Net Asset Values NIM Net Interest Margin NPC New Products Committee NPE Net Potential Exposure OAS Option-Adjusted Spread OEC Operating Exposures Committee OPSRA Office Of Prudential Supervision And Risk Analysis P&L Profit And Loss PC Product Control PD Probabilities Of Default PE Potential Exposure PPE Peak Potential Exposure PTG Principal Transaction Group QR Quantitative Research QRM Quantitative Risk Management RA Risk Appetite RMD Risk Management Department ROTE Return On Tangible Equity TBA To-Be-Announced Market TMG Transaction Management Group VaR Value-At-Risk VCV Variance-Covariance VoD Value-On-Default WLT Whole Loan Tracking System FOIA CONFIDENTIAL TREATMENT REQUESTED BY LBEX-DOCID 2125011 LEHMAN BROTHERS HOLDINGS INC. Scope and Methodology of Review Pursuant to Lehman Brothers’ (Lehman) application to become a Consolidated Supervised Entity (CSE), staff of the Office of Prudential Supervision and Risk Analysis (OPSRA)1 reviewed the independent risk management function at Lehman. We met with members of the Risk Management Department (RMD), trading desk heads, financial controllers, model research heads, and others.2 The
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