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It's been more than 18 months since Lehman Brothers filed for bankruptcy. But the official autopsy was just released a few weeks ago, when a team of lawyers produced a 2,200-page report examining the events leading up to Lehman's demise -- the largest bankruptcy in history.
The depth of analysis in this report is mind-blowing. Consider this quote from the introduction: "The available universe of Lehman email and other electronically stored documents is estimated at three petabytes of data -- roughly the equivalent of 350 billion pages." From this heap, "the Examiner collected in excess of five million documents, estimated to comprise more than 40,000,000 pages."
I spent a good part of the past week reading this report. (You can download it here.) Fortunately, it reads more like a John Grisham novel than a lawyerly dissertation. The pages are entirely readable, and filled with some great quotes that really describe why Lehman failed, and how Wall Street works. Here are the top 10 of those quotes.
1. On compensation madness:
"Lehman's compensation policy was designed, in theory, to penalize excessive risk taking ... But in practice, Lehman rewarded its employees based upon revenue with minimal attention to risk factors in setting compensation. [No] risk-related adjustments [were] applied rigorously or consistently ... To calculate revenue for its compensation pool, Lehman included revenue not yet recognized but recorded based on mark-to-market positions. In theory, therefore, traders and business units were incented to enter into transactions for short-term profits, even if those transactions created long-term risks for the firm."
This isn't unique to Lehman. Every other bank -- Goldman Sachs (NYSE: GS ) , Morgan Stanley (NYSE: MS ) , Citigroup (NYSE: C ) , Bank of America (NYSE: BAC ) , and JPMorgan Chase (NYSE: JPM ) -- compensated bankers and traders based on revenue that could go up in smoke.
2. On fooling itself:
"Although Lehman conducted stress tests on a monthly basis and reported the results of these stress tests periodically to regulators and to its Board of Directors, the stress tests excluded Lehman's commercial real estate investments, its private equity investments, and, for a time, its leveraged loan commitments. Thus, Lehman's management did not have a regular and systematic means of analyzing the amount of catastrophic loss that the firm could suffer from these increasingly large and illiquid investments."
Talk about denial. This is like weighing only your legs, concluding you're a healthy weight, and giving yourself permission to eat more CornNuts.
3. On lack of self-control:
"Lehman's management decided to exceed risk limits with respect to Lehman's principal investments, namely, the "concentration limits" on Lehman's leveraged loan and commercial real estate businesses, including the "single transaction limits" on the leveraged loans. These limits were designed to ensure that Lehman's investments were properly limited and diversified by business line and by counterparty. Lehman took highly concentrated risks in these two business lines, and, partly as a result of market conditions, ultimately exceeded its risk limits by margins of 70% as to commercial real estate and by 100% as to leveraged loans."
Another good example of management fooling itself. Lehman had fairly strict internal limits on how much risk it could take. Management just ignored them.
4. On excessive self-confidence:
"Lehman's senior managers were confident making business judgments based on their understanding of the markets, and did not feel constrained by the quantitative metrics generated by Lehman's risk management system."
5. On balance sheet trickery:
"Lehman did not disclose its use -- or the significant magnitude of its use -- of Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board of Directors. Lehman's auditors, Ernst & Young, were aware of but did not question Lehman's use and nondisclosure of the Repo 105 accounting transactions."
Repo 105 is accounting wizardry that masks the true state of a bank's balance sheet by hiding assets when it reports to investors.
6. On hoodwinking investors with repo 105:
"[U]nbeknownst to the investing public, rating agencies, Government regulators, and Lehman's Board of Directors, Lehman reverse engineered the firm's net leverage ratio for public consumption. Notably, during Lehman's 2008 earnings calls in which it touted its leverage reduction, analysts frequently inquired about the means by which Lehman was reducing its leverage. Although CFO Callan told analysts that Lehman was 'trying to give the group a great amount of transparency on the balance sheet,' she reported that Lehman was reducing its leverage through the sale of less liquid asset categories but said nothing about the firm's use of Repo 105 transactions."
This, Fools, is why you should still avoid banks like the plague.
7. On stressless stress tests:
"After March 2008 ... The [Federal Reserve] developed two new stress scenarios: 'Bear Stearns' and 'Bear Stearns Light.' Lehman failed both tests. The [Fed] then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed. However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed. It does not appear that any agency required any action of Lehman in response to the results of the stress testing."
Heckuva job, guys.
8. On asking the Federal Reserve for help:
[Tim] Geithner also spoke with [Lehman CEO Dick] Fuld about Fuld's proposal that Lehman become a bank holding company. Geithner viewed that as 'gimmicky:' 'You can't solve a liquidity/capital problem by becoming a bank holding company.'"
Funny: Just months later, Goldman Sachs, Morgan Stanley, American Express (NYSE: AXP ) , and GMAC all became bank holding companies with the Fed's blessing in order to solve their liquidity problems. And it worked.
9. On the Fed blindsided by the collapse:
"[Fed chairman Ben] Bernanke told the Examiner: 'I speak for myself, and I think I can speak for others, that at no time did we say, 'We could save Lehman, but we won't.' Our concern was about the financial system, and we knew the implications for the greater financial system would be catastrophic, and it was.' According to Bernanke, a 'range of views existed about the likely effect of Lehman's failure on the economy. If the effect was measured on a scale of 0 to 100, some thought a Lehman failure would be a 'minor disruption' -- in the 1-15 range. Bernanke's own view was in the 90-95 range. However, the actual effect turned out to be 'maybe 140.' 'It was worse than almost anybody expected.'"
This is a pretty common view. Very few people, if anyone, could foresee exactly how much trauma Lehman's collapse would create.
10. On why the government couldn't save Lehman:
"[Treasury secretary Hank]Paulson believed that the Government lacked authority to inject capital into Lehman Brothers. The Federal Reserve's willingness to provide financial help to Bear Stearns (toward the JPMorgan purchase) and AIG was not, in his view, inconsistent with the Federal Reserve's decision to deny aid to Lehman. With Bear Stearns, the Federal Reserve had a willing buyer (JPMorgan); Lehman did not. With AIG, AIG had valuable insurance subsidiaries to use as collateral; again, Lehman had nothing comparable."
Oh, well. Better luck next time.
What do you think about Lehman's collapse? Fire away in the comments section below.