Sunday, June 29, 2014

Lehman Valukas Report

While poking around on the internet in connection with the Valukas report to GM I was surprised to find that Anton Valukas was also the Examiner in the Lehman Brothers bankruptcy and had produced a long report about the firm's demise.  Since this is a subject of interest to me I went through the report.  I don't recommend this, the report is over 2000 pages long, full of legalese, sometimes repetitive and rather narrowly focused on who if anybody could the bankruptcy estate sue to try to recover some of Lehman's losses.  Still I felt it gave me a better idea of what had happened. 

Based on the report, the root cause of Lehman's failure was a disastrous 2006 decision by its CEO, Richard Fuld.  At a time when cracks were appearing  in the financial world, especially with regard to residential real estate, and other financial institutions were getting nervous, Fuld decided to vastly increase Lehman's exposure in the areas that were starting to appear shaky.  This involved making a lot of risky, illiquid investments.  (An illiquid investment is one which is expensive to sell, they tend to have the nasty habit of becoming especially illiquid (expensive to sell) at exactly the times you are most likely to need the money.)  Just the sort of poison a highly leveraged firm like Lehman doesn't need on its balance sheet in bad times.  The report calls this course of action a countercyclical strategy which appears to be an euphemism for a reckless gamble.  Of course as the report points out Lehman was in the business of taking risks.  However managing a firm like Lehman is all about limiting risk, trying to ensure that a little bit of bad luck or a single bad decision isn't catastrophic.   So Fuld's decision was bad in two ways, he misjudged the severity of the coming problems and less excusably he risked far too much on his judgment being correct endangering the firm.

Of course the initial decision wasn't fatal in itself, Fuld could have changed his mind and reversed course the next day and little harm would have been done.  But as the decision was implemented in 2006 and 2007 the risk to Lehman mounted. Eventually Lehman stopped adding to its exposure but didn't take any effective steps to reduce it.  When the markets moved against Lehman in 2008 bankruptcy (absent a government bailout) became inevitable.  It is unclear when the point of no return was passed.  Perhaps the Lehman could have survived (albeit severely damaged) if suitably decisive action had been taken early in 2008.  But this would have required Fuld to face up to the fact that he had made a horrendous blunder which seems to have been beyond him.  So instead Fuld seems to have tried to keep up appearances as long as possible while hoping for a market turn in Lehman's favor or a government bailout neither of which was forthcoming.

When Lehman did go bankrupt and its assets were liquidated there turned out to be a big gap between the value of the assets as recorded in Lehman's books and what they could actually be sold for resulting in large losses for Lehman's creditors.  I had been of the general opinion that this indicated some sort of huge fraud had taken place.  But according to the report this may be wrong.  There are several other potential explanations.  First fair market value for accounting purposes is defined as the price a willing buyer and willing seller would agree on.  It is not intended to reflect the price that could be obtained in a distress sale.  Nor does it reflect sales expenses.  This is fine if the asset holder intends (and has the financial capacity) to hold the asset indefinitely but means for illiquid assets there is likely to be a big gap between the value in the accounts and what can be realized in a forced sale.  That said it also appears that near the end when potential buyers were given access to Lehman's books they were not pleased with what they found although it is a little unclear whether this was just because they found Lehman's assets hard to value rather than definitely over valued.  It is inherently difficult to value illiquid assets with few comparable recent sales.   The report does acknowledge a few instances where Lehman's marks (values assigned to Lehman's assets in the accounts) were definitely inflated (outside even the wide range of possible good faith values for illiquid assets).  But this seems to have mostly reflected a failure to keep up with rapidly deteriorating market conditions rather than conscious deliberate fraud.

The rapidly deteriorating market also meant considerable loss of value could occur between the appraisal valuation dates reflected in Lehman's books and the dates Lehman's assets were liquidated.  Of course a substantial part of this loss of value was caused by Lehman's bankruptcy itself.

Another issue was winding up Lehman's derivative contracts.  A derivative contract is basically a bet between two parties about future events.  The parties post collateral to guarantee payment.  When one party goes bankrupt the other party is generally allowed to terminate the contract early and claim the current contract value.  This value can be hard to assess objectively so the initial claim will often be on the high side so as to establish a negotiating position.  This seems to have been the case with Lehman's contracts with the Lehman estate ultimately able to obtain more favorable settlement values than initially offered by its counterparties.  It seems possible there was still some loss of value though, the rules are not set up to favor defaulting parties.  

Finally Lehman as a going concern was an intricate web of relationships (with for example many legally distinct corporate entities some operating under foreign law).  Sorting out the mess when it all came crashing down was unavoidably expensive requiring millions in fees to be paid to people like Valukas, his law firm and the financial advisors he hired to help compile his report.

So perhaps the gap between the value of Lehman's assets in Lehman's books and what they realized when sold was not generally due to fraudulent books.  Still I would like to see somewhere a detailed explanation of how the gap arose.  This is not to be found in this report or anywhere else that I am aware of.

As the report explains under the business judgment rule the courts generally don't second guess business decisions even stupid ones which work out badly.  So the government couldn't prosecute Fuld for being an idiot.  But according to the report during 2008 Lehman attempted to make use of an accounting loophole to disguise how leveraged they were.  By performing a series of transactions (with no economic purpose) they could avoid listing some their debt on their balance sheet reducing the amount Lehman appeared to be leveraged.  It is unclear whether Lehman actually managed to satisfy the conditions of the accounting rule they were attempting to exploit but as the report points out it doesn't really matter, there is a general accounting rule that you can't report materially misleading accounts even if you are arguably in technical compliance with the more specific rules.  So it appears that high Lehman officials (including Fuld) could have been prosecuted for fraud (for deliberately reporting materially misleading results) if the government had chosen to do so.  But for political reasons I have never really understood the Obama administration gave Fuld (along with most everybody else) a pass for potentially criminal behavior in the lead up to the financial crisis. 

However this bad behavior wasn't a major cause of Lehman's collapse, it occurred after Lehman was already in big trouble.  Perhaps you can argue it was a contributing factor in that it was a form of denial without which Lehman might have been more likely to take the drastic painful steps needed to give it a chance to survive.   This seems pretty speculative however.  The misleading public statements did of course hurt anyone who relied on them to invest in Lehman which is all you need to prosecute.

In short this report fills in some of the details regarding Lehman's collapse but it is not a good big picture account for the interested layman.  As far as I know no such account has yet been written.

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