L e h m a n B r o t h e r s A Crisis of Value i ii Lehman Brothers A Crisis of Value O o n a g h M c D o n a l d Manchester University Press iii Copyright © Oonagh McDonald 2016 The right of Oonagh McDonald to be identifi ed as the author of this work has been asserted by her in accordance with the Copyright, Designs and Patents Act 1988. Published by Manchester University Press Altrincham Street, Manchester M1 7JA www.manchesteruniversitypress.co.uk This work is published subject to a Creative Commons Attribution Non-commercial No Derivatives Licence. You may share this work for non-commercial purposes only, provided you give attribution to the copyright holder and the publisher. For permission to publish commercial versions please contact Manchester University Press. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data applied for ISBN 978 1 7849 93405 hardback ISBN 978 1 5261 00580 open access First published 2016 The publisher has no responsibility for the persistence or accuracy of URLs for any external or third-party internet websites referred to in this book, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate. Typeset by Refi neCatch Limited, Bungay, Suffolk iv C o n t e n t s Preface vi Acknowledgements viii Abbreviations ix 1 From Cotton Trader to Investment Banker: 1844–2008 1 2 From Hubris to Nemesis: January to September 2008 15 3 Th e Fateful Weekend 41 4 Regulating the ‘Big Five’ 73 5 Th e Largest Bankruptcy in American History 89 6 Th e Destruction of Value 113 7 Lehman’s Valuation of Its Assets 133 8 Measuring Value 159 9 Monitoring Value 179 10 Chasing a Chimera? 203 Appendix 1 Th e Lehman Brothers Board of Directors in 2007 223 Appendix 2 Th e Lehman Brothers Corporate Structure 227 Notes 229 Bibliography 251 Index 263 v P r e f a c e Th e purpose of this book is to explain the fundamental causes of the bank’s failure, including the inadequacy of the regulatory and supervisory framework. For some, it was the repeal of the Glass-Steagall Act that was the overriding cause, not just of the collapse of Lehman Brothers, but of the fi nancial crisis as a whole. Th e argument of this book is that the cause is partly to be found both in weak and ineff ective regulation and also in a programme of regulation and supervision that was simply not fi t for the purpose. Lehman Brothers certainly contributed to its own demise. When the company pursued its more aggressive policies to increase its profi ts and its market share, it moved away from purchasing residential real estate loans, even when these were subprime, and packaging them into mortgage backed securities, which were then sold on. From 2006 onwards, its more aggressive strategy focused on commercial real estate, leveraged loans and private equity. Its move into commercial real estate increased the levels of risk for the company, with increasingly illiquid assets. Dick Fuld, the chairman and CEO , and his senior management, ignored the increased risks, choosing to rely on over- valuations of the fi rm’s assets. One of the continuing puzzles is why Lehman Brothers was allowed to fail. Th e main players in that decision, Henry Paulson, Timothy Geithner and Chairman Bernanke, have generally claimed that the Federal Reserve did not have the legal powers to rescue Lehman Brothers in the absence of a buyer for the company. Th is explanation was always diffi cult to reconcile with the decision to bail out AIG two days later. Th at is not the only issue to be considered. Th e failure of Lehman Brothers has many facets, and each of those is examined in the second part of the book. Much has been said about the ‘destruction of value’ in the fi nancial press and academic analyses. Trillions of dollars ‘disappeared’ through plummeting asset prices and, as some would argue, the crisis entailed not the destruction of ‘real’ value but the exposure of fi ctitious or virtual capital and artifi cial value. Th e appointed examiner for the bankruptcy proceedings stated that ‘valuation is central to the question of Lehman’s solvency’. Th at was the conclusion of his Report, which is over 2,200 pages, based on collecting over fi ve million documents. An analysis of some of the key elements in the Report, as well vi Preface vii as other documents and reports, leads to the conclusion that this is indeed the case. However, this opens up the questions about what is meant by value when it comes to valuing assets and how that value is to be measured and explained. In Chapter 7 it is argued that the valuation of Lehman’s real estate assets was problematic to say the least, as the regulators did not require the investment banks to adopt a recognized methodology of valuation, and that Lehman’s own methods were fl awed. Chapter 8 spells out the recognized methodologies and procedures for valuation that were available at the time and which, in eff ect, Lehman chose to either ignore or not apply in any rigorous way. Fuld and his team ignored the risks involved; his board was not in a position to monitor the risks involved in his aggressive ‘real estate’ programme and did not do so. Th e underlying question is: what is meant by value in the context of a market? A brief look at contemporary theories of value suggests that they provide an inadequate explanation of the way in which assets are priced by the market, and especially the role of trust. Th e collapse of Lehman Brothers destroyed confi dence, which is why the markets froze. Th ere is no intrinsic or enduring value in any asset. Its value, and hence its price, is simply what the market will pay at any one time. Th is is the second in my series of books on the fi nancial crisis. Th e fi rst was Fannie Mae and Freddie Mac: Turning the American Dream into a Nightmare. Th e distinctiveness of my approach is to describe the role of the major institutions in the events leading up to the crisis. Lehman Brothers has a specifi c role in that. It was the collapse of Lehman Brothers which, though not the sole cause of the crisis, was the trigger for it. Th e next book will examine the role of leading fi nancial institutions and the regulators in the fi nancial crisis and its aft ermath. A c k n o w l e d g e m e n t s I have benefi tted from discussions with Professor Kevin Keasey, Director of the International Institute of Banking and Financial Services, University of Leeds, and Professor Robert Hudson, Professor of Finance at Hull University School of Business. I would especially like to thank Robert Stowe England, fi nancial journalist and author of ‘Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance’ for his assistance and Lord Desai, Emeritus Professor of Economics at London School of Economics, for reading the manuscript in draft and for all his constructive comments. Any errors and misconceptions are mine. Dr Oonagh McDonald CBE viii A b b r e v i a t i o n s AIG American International Group BHC Bank Holding Company BIS Bank for International Settlements BoA Bank of America CAE Chief Audit Executive CalPERS California Public Employees Retirement System CCC Carlyle Capital Corporation CDO Collateralized Debt Obligation CDS Credit Default Swaps CEO Chief Executive Offi cer CFO Chief Financial Offi cer CLO Collateralized Loan Obligation CMBS Commercial Mortgage-Backed Securities CRE Commercial Real Estate CRO Chief Risk Offi cer CSE Consolidated Supervised Entities DCF Discounted Cash Flow DTCC Depository Trust and Clearing Corporation EESA Emergency Economic Stabilization Act EMH Effi cient Market Hypothesis FCIC Financial Crisis Inquiry Commission FDIC Federal Deposit Insurance Corporation FHC Financial Holding Company FOMC Federal Open Market Committee FRB Federal Reserve Bank FRBNY Federal Reserve Bank of New York FSA Financial Services Authority ( UK ) GAAP Generally Accepted Accounting Principles GLBA Gramm-Leach-Bliley Act GREG Global Real Estate Group ISDA International Swaps and Derivatives Association LBIE Lehman Brothers International (Europe) ix x Abbreviations LBSF Lehman Brothers Special Financing Inc LTCM Long Term Capital Management MBS Mortgage-Backed Security MIS Management Information System MMF Money Market Funds NYSE New York Stock Exchange O C C O ffi ce of the Comptroller of the Currency OLA Orderly Liquidation Authority OTC Over- the-Counter OTCFX Over- the-Counter Forex O T S O ffi ce of Th rift Supervision OTTI Other Th an Temporary Impairments PDCF Primary Dealer Credit Facility RMBS s Residential Mortgage- Backed Securities SEC Securities and Exchange Commission SIFI s Systemically Important Financial Institutions TSLF Term Securities Lending Facility USPAP Uniform Standards of Professional Appraisal Practices VaR Value at Risk 1 From Cotton Trader to Investment Banker: 1844–2008 A brief history On 29 January 2008, Lehman Brothers Holdings Inc reported record revenues of nearly $60bn and record earnings of over $4bn for its fi scal year ending 30 November 2007. Just eight months later, on 15 September 2008, Lehman Brothers sought Chapter 11 protection in the largest bankruptcy ever fi led. Its collapse sent shock waves around the world. Everyone remembers the name, Lehman Brothers. Many regard its collapse as the cause of 2008’s fi nancial crisis.