By Frank Partnoy, Professor of Law and Finance University of San Diego School of Law and author of Fiasco, Infectious Greed, and The Match King
The buzz on the Lehman bankruptcy examiner's report has focused on Repo 105, for good reason. That scheme is one powerful example of how the balance sheets of major Wall Street banks are fiction. It also shows why Congress must include real accounting reform in its financial legislation, or risk another collapse. (If you have 8 minutes to kill, here is my recent talk on the off-balance sheet problem, from the Roosevelt Institute financial conference.)
But an even more troubling section of the Lehman report is not Volume 3 on Repo 105. It is Volume 2, on Valuation. The Valuation section is 500 pages of utterly terrifying reading. It shows that, even eighteen months after Lehman's collapse, no one "“ not the bankruptcy examiner, not Lehman's internal valuation experts, not Ernst and Young, and certainly not the regulators "“ could figure out what many of Lehman's assets and liabilities were worth. It shows Lehman was too complex to do anything but fail.
The report cites extensive evidence of valuation problems. Check out page 577, where the report concludes that Lehman's high credit default swap valuations were reasonable because Citigroup's marks were ONLY 8% lower than Lehman's. 8%? And since when are Citigroup's valuations the objective benchmark?
Or page 547, where the report describes how Lehman's so-called "Product Control Group" acted like Keystone Kops: the group used third-party prices for only 10% of Lehman's CDO positions, and deferred to the traders' models, saying "We're not quants." Here are two money quotes:
While the function of the Product Control Group was to serve as a check on the desk marks set by Lehman's traders, the CDO product controllers were hampered in two respects. First, the Product Control Group did not appear to have sufficient resources to price test Lehman's CDO positions comprehensively. Second, while the CDO product controllers were able to effectively verify the prices of many positions using trade data and third"party prices, they did not have the same level of quantitative sophistication as many of the desk personnel who developed models to price CDOs. (page 547)
Or this one:
However, approximately a quarter of Lehman's CDO positions were not affirmatively priced by the Product Control Group, but simply noted as "?OK' because the desk had already written down the position significantly. (page 548)
My favorite section describes the valuation of Ceago, Lehman's largest CDO position. My corporate finance students at the University of San Diego School of Law understand that you should use higher discount rates for riskier projects. But the Valuation section of the report found that with respect to Ceago, Lehman used LOWER discount rates for the riskier tranches than for the safer ones:
The discount rates used by Lehman's Product Controllers were significantly understated. As stated, swap rates were used for the discount rate on the Ceago subordinate tranches. However, the resulting rates (approximately 3% to 4%) were significantly lower than the approximately 9% discount rate used to value the more senior S tranche. It is inappropriate to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche. (page 556)
It's one thing to have product controllers who aren't "quants"; it's quite another to have people in crucial risk management roles who don't understand present value.
When the examiner compared Lehman's marks on these lower tranches to more reliable valuation estimates, it found that "the prices estimated for the C and D tranches of Ceago securities are approximately one"thirtieth of the price reported by Lehman. (pages 560-61) One thirtieth? These valuations weren't even close.
Ultimately, the examiner concluded that these problems related to only a small portion of Lehman's overall portfolio. But that conclusion was due in part to the fact that the examiner did not have the time or resources to examine many of Lehman's positions in detail (Lehman had 900,000 derivative positions in 2008, and the examiner did not even try to value Lehman's numerous corporate debt and equity holdings).
The bankruptcy examiner didn't see enough to bring lawsuits. But the valuation section of the report raises some hot-button issues for private parties and prosecutors. As the report put it, there are issues that "may warrant further review by parties in interest."
For example, parties in interest might want to look at the report's section on Archstone, a publicly traded REIT Lehman acquired in October 2007. Much ink has been spilled criticizing the valuation of Archstone. Here is the Report's finding (at page 361):
"¦ there is sufficient evidence to support a finding that Lehman's valuations for its Archstone equity positions were unreasonable beginning as of the end of the first quarter of 2008, and continuing through the end of the third quarter of 2008.
And Archstone is just one of many examples.
The Repo 105 section of the Lehman report shows that Lehman's balance sheet was fiction. That was bad. The Valuation section shows that Lehman's approach to valuing assets and liabilities was seriously flawed. That is worse. For a levered trading firm, to not understand your economic position is to sign your own death warrant.
Oddly, your post left me more sympathetic to Lehman. I fully expected systematic efforts to distort valuation. Your report instead states that there were isolated egregious mispricing, periodic incompetence and large doses of deference from the auditors. I would have expected much of this in a small and simple company, much less a large scale financial conglomerate.
Bob,
Really? Not being able to value positions is monstrous incompetence in a financial institution.
The point of the post is that other commentors are making more of what the report said re valuation than they ought to. Bluntly, this is not Jenner & Block’s area of expertise (not for instruments and exposures this complex, anyhow). All they can do is highlight where they saw things that looked sus. But NOT finding something sus does NOT mean that that area/activity was necessarily in the free and clear.
"Really? Not being able to value positions is monstrous incompetence in a financial institution."
In the court of public opinion, which is always in session, "monstrous incompetence", on valuations, is vastly different than the, "deliberately and falsely tarted up", Repo 105 balance sheets.
Most people always feel some sympathy for the poor bumbling fools, and of course by extension, Slicky Dicky Fuld benefits. They were his people that "lacked sophistication" after all. The report (and Uncle Billy Cunctator makes a good point in his comment below with the past business relationship of Tony and Slicky Dicky) is some thorns of deceit ("by half") wrapped in ‘roses of incompetence’ which will ultimately become the focus in the corporate media.
The good professor Frank moves the ploy along with his post by focusing on the incompetence — witness Bob's comments — and worse, he opens his post with this, "It also shows why Congress must include real accounting reform in its financial legislation, or risk another collapse." Sheeesh … what an expression of lame ignorance, ask the foxes to not be foxes. If I were one of his students I would demand my tuition back immediately.
Deception is the strongest political force on the planet.
i on the ball,
You need to read Sarbox. The CEO certifies that internal controls are adequate. This is a clear Sarbox violation.
And if you are not in trading markets, you do not recognize the seriousness of the remark. “Monstrous incompetence” = certain death.
That's like telling an atheist he needs to read the bible. Sorry, but sarbox never restored my confidence in "?capital markets' or accounting firms. Maybe if Fuld does some serious jail time I'll become a believer.
I stand by my comments. The public thinks, "Monstrous incompetence" = just another dumb ass and I can really relate positively to that poor slob.
Deception is the strongest political force on the planet.
i on the ball,
I beg to differ. No ordinary person is going to identify with people who paid themselves millions (in the case of Fuld, hundreds of millions) and were abject screwups.
This is tantamount to monstrous incompetence in running a nuclear plant. People in the business get the consequences of incompetence in operations that have to run within fine tolerances in order not to destroy themselves. And those outside can and do understand that the claims as to why these guy deserved such extortionate pay were lies, pure and simple.
Au contraire …. Lots of ordinary people identify with abject screw ups, and the wealthier and more powerful they are the better. All they have to do is say I'm sorry and scamericans lap it up. This monstrous incompetent ran more than a nuclear plant, and it took years to get a slippery and evasive apology out of him …
http://www.zpub.com/un/un-bc-sp1.html
Deception is the strongest political force on the planet.
My point was not clear, for which I appologize. I believe in my heart that Lehman was a criminal enterprise, and downloaded the 2200 page report, and am reading all these posts. I am trying to avoid intellectual laziness and not assume that all smoke is fire. I agree that misvaluation would be critical to the charade, but find the evidence was as easily interpreted as ommission than commission. The repo evidence, however seems pretty clearcut to me as strategic deception.
Bob,
Partnoy is saying something a bit different. Some commentors are trying to say, “See, the problem at Lehman wasn’t the derivatives” or whatever based on the valuation section.
The point here is to stress the limits of the report so people do not go off half baked. It did an exemplary job in some areas, but even as comprehenisve a report as this DID NOT get to the bottom of valuation. All it did was look for obvious red flags in the records plus a wee bit of sampling.
Nice posting. I am glad some are pawing through the report and sharing their findings.
Since it seems that no one is ever going to go to prison for this ongoing rape of the world financial system via our “elected” government. I wonder if it possible that our military can be counted on to have grasp on global history and the downside effects of our current corporatist/political system. Maybe 8 years of Bush purged the military of the remaining moral military leaders but one can only hope there is some way back from our current brink.
Our downfall may be served to us by the rest of the developed world by finally shunning our dollar and agreeing to a less manipulable currency exchange process and international financial crisis agreements. The longer other countries wait to confront America’s financial criminality the more they will suffer.
The examiner has a name. Why don’t you use it?
“Lehman examiner, Anton “Tony” Valukas”
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