As we mark the two-year anniversary of the collapse of Bear Stearns and its subsequent purchase by JPMorgan Chase (NYSE: JPM), the examiner in the Lehman bankruptcy -- an even larger fiasco – has just published a 2,000+ page report that includes an analysis of the events that led up to the bankruptcy filing. It's not all dry reading, either; among the nuggets: An account of Lehman's attempt to reach out to Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) CEO Warren Buffett as a potential investor. Ultimately, Buffett passed on Lehman, but he went on to make a $5 billion investment in another investment bank, Goldman Sachs (NYSE: GS). What made the difference?

I invest if you invest
During their initial phone call on Friday, March 28, 2008, Buffett told Lehman CEO Dick Fuld that, as a condition for any investment, he wanted Lehman executives to invest under the same terms. Fuld balked at this commitment on the basis that Lehman executives already received a substantial part of their compensation in Lehman shares. Buffett saw Fuld's hesitancy as a first red light.

It's not about the short-sellers
Second, Buffett was not impressed when Fuld complained about short-sellers. To Buffett, this suggested that Fuld was unwilling or unable to analyze his own failures; either way, this didn't speak well to his leadership abilities.

The letter is ready to go, Mr. Chairman
Furthermore, Buffett found it odd that Lehman had prepared a draft letter to Lehman employees announcing a deal -- complete with deal size and price -- the day before he and Fuld had even spoken over the phone. Odder still, Fuld didn't know the genesis of the letter, and it appears that he never even saw the draft.

Why mention a $100 million trifle?
Following the phone call, Buffett spent the rest of Friday reviewing and analyzing Lehman's 10-K report, during which time he identified multiple areas of concern, including Lehman's real estate and high yield investments, its derivatives exposure and its securitization activity -- all areas at the heart of the credit crisis. On Saturday, Buffett learned that Lehman had a $100 million problem in Japan which Fuld hadn't mentioned during their phone call. Both sets of issues sealed Buffett's decision not to invest in Lehman.

Who's rejecting whom here?
Ironically, after discussing the matter with members of his Executive Committee and his Board, Fuld decided that, despite the fact that a Buffett investment would contain a "stamp of approval," he could not offer better terms to Buffett than those on offer to other investors in a separate capital raising that was concluded in April 2008. Fuld called Buffett the following Monday to tell him that Lehman could not go forward on the basis of Buffett's terms! This saved Buffett the trouble of a call to reject Fuld -- something he had already made up his mind to do.

The lessons for investors are several-fold:

  • Look for companies run by executives that "eat their own cooking" much like Buffett and his partner, Charlie Munger, do at Berkshire. There is no substitute for properly aligned interests between a company's executive management and its shareholders. Perhaps it's no coincidence that (Nasdaq: AMZN), Best Buy (Nasdaq: BBY), and Microsoft (Nasdaq: MSFT) -- all well-run businesses -- have significant insider ownership. Of course, this isn't a sufficient condition for investing; Lehman Brothers' insider ownership levels were higher than at each of these companies.

Investors can learn a lot more by assessing whether executives have internalized the following habits (which Mr. Fuld hadn't).

  • Accept your errors and admit them openly. It's impossible to begin repairing a problem if you are unable to recognize you have a significant responsibility in the matter. Short-sellers did not cause Lehman's demise; the firm collapsed for a very simple reason -- it was insolvent. If Dick Fuld had recognized that Lehman's problems were self-inflicted (excessive leverage, headlong jump into real estate, etc.) instead of trying to find scapegoats, he would surely have been more proactive -- and more realistic -- in trying to find a solution.

(Officials from Greece and other European nations would do well to heed this lesson instead of blaming their woes on credit default swap traders.)

  • Be forthright and comprehensive in your disclosures -- particularly when you're looking for a partner. We can't know why Dick Fuld didn't mention Lehman's $100 million exposure in Japan. However, other revelations from the examiner's report concerning the now-infamous "Repo 105" accounting sleight of hand suggest Lehman may have developed a culture in which it was acceptable to conceal the extent of the firm's problems to its stakeholders. This is anathema to Buffett, who has always made it a point of being on the up-and-up with his partners.

Quantitative and qualitative analysis for the win!
The interaction between Lehman and Buffett provides a fascinating case study of the way in which Buffett applies quantitative and qualitative analysis to investment decisions. Although Buffett made his assessment of the firm's financial and managerial weaknesses nearly six months prior to its bankruptcy, he was ultimately proved correct -- spectacularly so.

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