Financial Training Partners

Last post, we argued that Lehman’s Repo 105 balance-sheet-management tactic was not the worst thing Lehman Brothers did on its way to extinction. Volume 8 of Anton Vakulas’s Bankruptcy Examiner’s report details a bunch of blunders with far more serious consequences.

Here are a few of our favorites:

• Although management was aware of the growing problems in the mortgage markets as early as 2006, Lehman decided to take on more risk “to pick up ground and improve its competitive position.”
• It chose to do that by “making ‘principal’ investments – committing its own capital in commercial real estate, leveraged lending, and private equity investments.”
• And it sacrificed liquidity along the way, so that “less liquid assets more than doubled during the same time from $86.9 billion at the end of the fourth quarter of 2006 to $174.6 billion at the end of the first quarter of 2008.”

But in our view, Lehman’s biggest missteps were in risk management. Lehman’s opportunistic push for growth changed into an aggressive push to offset declines in its commercial mortgage business late in 2007 and early in 2008, and that led the company to ignore its own risk controls.

This chart from the Examiner’s Report shows how Lehman’s risk appetite grew through 2007 and into 2008. Risk appetite was Lehman’s estimate of the amount it could lose without jeopardizing employee compensation or shareholder returns.

The chart also shows how in the last two quarters of 2007 the firm exceeded its own risk appetite limit with hardly any restraint, and then in the first quarter of 2008 solved the problem not by reducing risk but by raising the limit.

There are plenty of other instances of management’s undisciplined approach to risk management:

• Management played games with key risk measures and “omitted some of the largest risks from its risk usage calculation” until June 2008 and “did not revise its stress testing to address its evolving business strategy.”
• “Lehman rewarded its employees based upon revenue with minimal attention to risk factors in setting compensation,” in spite of the fact that managers were supposed to “use risk-weighted metrics such as return on risk equity…to determine compensation.”
• After she resisted an increase in the firm’s risk appetite in 2007, Lehman replaced its highly regarded Chief Risk Officer, Madelyn Antoncic, in the third quarter of 2007 with the Chief Financial Officer, Rick O’Meara, who had no risk management experience.

Lehman did not see risk management as a crucial discipline or as a vital safeguard for a company operating with little capital and limited liquidity in troubled markets. For Lehman, risk management was a public relations tool.

It was a show put on to reassure clients, regulators, lenders, and the rating agencies but with no substance or bite. And that misuse of risk management was far more misleading and much more damaging than Repo 105.