Lehman's dance with the Devil

[MarketNeutral]

At the dances and other introductory inter-gender socializations sponsored by the small Catholic High School from which my wife graduated, care was always made that the young dancers did not dance so close as to not "leave room for the Holy Ghost"; supposedly, the friction generated by the mere contact of the boys' itchy wool pants with the girls' polyester skirts was enough to produce an infernal conflagration so powerful as to call forth Beelzebub himself right out of the infernal regions.

Maybe it would - maybe it wouldn't. One thing we now know is clear, and it has been clear since the beginning of time, up to the dark nights under the gibbet in Salem Massachusetts and beyond. In stressing the supposedly evil power of the front of the



thighs, while overlooking the pure, devil drawing antenna in the pants back pocket, what we so innocuously call a "wallet", tinhorn moralists and their fellow travelers go a long way in demonstrating their true misunderstanding of the nature of evil, and what must be done to banish it from polite society.

Moving forward in time from the basketball court converted to the dance floor to the adult courts of law to the floors of stock exchanges, one can see how easily Americans still get it wrong.

Seventeen months past the financial markets freeway pileup and disintegration in September 2008, we still have to go back to the collapse of Lehman Brothers to fully understand how we all got here, lying at the side of the road after having been ejected from the smoking hulks of our nitro-powered financial turbospeedsters.

In one sense, the fall of Lehman could be seen as the capitalist world's passage across the Styx River, from the world of lightness into the dark, with Lehman CEO Dick Fuld as the ferryman. Some will say that the actual day of its collapse, September 15, 2008, was like a repeat of those two other American mornings, Honolulu on December 7, 1941, and New York City, on September 11, 2001. As the Hawaiian housewives hung out laundry and Manhattan commuters emerged from out of the subway, they looked around and realized that their lives would never be the same again.

As more time passes, and as the economies of Asia regain their footing long in advance of those in Europe or North America, Lehman's fall might yet come to be associated with June 28, 1914, when the bullets of Sarajevo opened what was termed World War I, but what in actuality was a 31-year European civil war, after which world power no longer resided in Europe (see Silences say it all, Asia Times Online, September 16, 2008).

But for all we now know of what Lehman did, we still know precious little of what Lehman was, especially what it was like on the inside. No author with the stature of Michael Lewis, say, and his esteemed 1989 work on the bond trading culture at what was then Salomon Brothers, Liar's Poker, has yet allowed us a deep look into the devil's lair.

Perhaps until now. Two important pieces of the Lehman puzzle are now seeing the clarifying light of day. One describes the base human experience of living with Lehman, another what we now call the infamous "Repo 105".

This month's Vanity Fair carries excerpts from The Devil's Casino: Friendship, Betrayal, and the High Stakes Games Played Inside Lehman Brothers, by Vicky Ward, The environment described within seems to been one set by CEO Dick Fuld, who seemed always to want the world to see a Lehman where the Holy Ghost was in obvious display.

The book makes abundantly clear the importance Fuld placed on his top executives being married, and staying married - preferably happily so. And those spouses were expected to follow unwritten rules about the clothes they wore, the charities they supported, and the hikes they took at the company's Sun Valley retreats.

Ward quotes one senior executive at a corporate dinner "Now, look at this! Every single person here is with their original spouse. That is why we are successful. Because our word is our honor. We succeed in business because people can trust us."

Fuld was concerned just as much about the appearance of his executives as he did the appearances of the wives on their arms. He dressed immaculately, and expected colleagues to do likewise. "Sloppy dress, sloppy thinking," went his motto.
Lehman was the last of the Wall Street firms to go casual on Fridays. In the late 1990s, Fuld reluctantly called the operating committee together for a vote on whether they wanted it, and to his dismay they all did. He lamented, "I don't know what this means." He reinforced the point: "You know what? This democratic bullshit has gone on for long enough." Joe Gregory chimed in, "Oh, I don't want this, either, Dick. We are a different generation. We don't believe in it, but we have to do this for the younger people." Fuld compromised by letting the firm go casual on Fridays - except for the 10th (executive) floor.
Any marketing consultant can tell you exactly what Fuld was trying to do - implant with potential customers or business partners the impression that Lehman was as immaculate in its business dealings as it was in personal appearance and family morality; Bear Stearns might have been known as being populated by ketchup stained high school dropouts flailing about with the sharpest elbows on the street, a reputation it paid for when the firm had to be bailed out in March of 2008, but Fuld wanted you to know that Lehman believed in things, in non-negotiable standards and in rules, and it showed.

It's amazing how much of Wall Street got conned by something that watchers of late night infomercials learn almost instinctively. There really aren't nubile, lonely things just waiting by their phone for someone like you to call, or, to put it simply, not all advertisements contain only boundless truth. The proof of that was Repo 105.

Lehman in September 2008 filed the largest corporate bankruptcy in United States history; in January 2009, the United States Bankruptcy Court for Southern New York decided that it really had to know what had gone on. It appointed Anton R Valukas, a partner in the law firm of Jenner and Block and a former United States Attorney, to conduct a thorough examination and write a report on what happened to Lehman. At 2,200 pages, one certainly can't say that Valukas' report gave short shrift to the will of the court.

Around 2005, Fuld, perhaps taking after his middle-class American breadwinner template Clark W Griswold from 1983's National Lampoon's Vacation, decided that it was time for him to just "go for it". However, Fuld's folly would not be with Christie Brinkley and her red Ferrari. No, he would follow down the same road to perdition that so many others of his kind were then traversing - with collateralized mortgage obligations derived from subprime mortgage securities.

But by then, there was substantial evidence that the party was winding down. Real-estate prices had been skyrocketing ever since America came out of the 2000-01 recession, and most observers at least believed that by then the best part of the gains had occurred.

[MarketNeutral]

That made little difference to Fuld. He fully believed that he could make up for his late arrival to the markets just by running faster, through the siren song of leverage. A 2004 Securities and Exchange Commission ruling allowed much higher leverage ratios for investment banks like Lehman, and, as Citigroup CEO Chuck Prince said around that time, "As long as the music is playing, you've got to get up and dance". Fuld, like the rest of the street, then proceeded to dance the subprime Lambada with passion and abandon, with just about the same results.

So came the blowoff part of the great real-estate bubble, from 2004 to early 2007. By 2008, it was all being thrown into reverse at a frightening clip. First to go was highly leveraged Bear




Stearns. Then, careful observers looked past all the crisply pressed shirts and highly shined shoes to see that Lehman's business model contained just as much, or more, leverage than had Bear's. Yesterday's virtue - a firm drowning in debt - was now today's vice.

This was especially problematical for Lehman, an affirmed aficionado of the wholesale banking model, which called upon it to raise hundreds of millions if not billions in the overnight capital markets every day. If that funding suddenly disappeared, so would Lehman.

According to Valukas:
Lehman maintained approximately $700 billion of assets, and corresponding liabilities, on capital of approximately $25 billion. But the assets were predominantly long term, while the liabilities were largely short term. Lehman funded itself through the short term repo markets and had to borrow tens or hundreds of billions of dollars in those markets each day from counterparties to be able to open for business. Confidence was critical. The moment that repo counterparties were to lose confidence in Lehman and decline to roll over its daily funding, Lehman would be unable to fund itself and continue to operate. So too with the other investment banks, had they continued business as usual. It is no coincidence that no major investment bank still exists with that model.
The cash/assets profile described above represented 28 to 1 leverage, unheard of for a major investment bank in previous times. However, if the assets involved had suddenly become non-performing mortgage assets, their presence on Lehman's balance sheets immediately became daggers pointed at Lehman's heart. They had to go - and fast. The standard method then would have called for the assets' sales, but there was just one problem with that.

With many of the assets now deemed to be "illiquid", that is, with wide or non-existent bid/ask spreads between market buy and sell prices, Lehman still wanted to keep the assets. They still believed that eventually their value would return. Therefore, it had to come up with a financing stratagem that would placate the wholesale funders, but was still clever enough to keep the assets on Lehman's books - in other words, Repo 105.

One of the most common tools in the corporate treasurer's toolbox is the so called repurchase agreement, or repo. Corporate Party A needs some short-term cash, so, for a time period of perhaps just one day, it sells some securities, some assets, from its portfolios, to Corporate Party B, agreeing to buy them back, with a small premium, at the end of the auction.

But Lehman gave the repo agreement a precious little twist. Yes, it agreed to sell securities, thus reducing its leverage ratio and hopefully placating its wholesale funders; but it kept the buyback section of the deal secret. This it would do by agreeing to price the securities to be repurchased at 105% of their original repo price - way above the mandatory reportable and standard repo rate - thus, Repo 105.

How would Lehman get the extra 5% repurchase price? Borrowing. More leverage. Thus, a duplicitously fugacious strategy to save the company in the short term (perhaps to give Lehman's board time to don their golden parachutes, while the general public held onto the stock until worthlessness) actually weakened it long term. The executives' shiny white shirts couldn't hide the mephitic, atramentous rot spreading underneath.

As described by Valukas:
In 2007-08, Lehman knew that net leverage numbers were critical to the rating agencies and to counterparty confidence. Its ability to deleverage by selling assets was severely limited by the illiquidity and depressed prices of the assets it had accumulated.

Against this backdrop, Lehman turned to Repo 105 transactions to temporarily remove $50 billion of assets from its balance sheet at first- and second-quarter ends in 2008 so that it could report significantly lower net leverage numbers than reality. Lehman did so despite its understanding that none of its peers used similar accounting at that time to arrive at their leverage numbers, to which Lehman would be compared.

Lehman defined materiality, for purposes of reopening a closed balance sheet, as "any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion)". Lehman's use of Repo 105 moved net leverage not by tenths but by whole points: Lehman's failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those "low" leverage numbers to investors as positive news, created a misleading portrayal of Lehman's true financial health.

Colorable claims [ie plausible legal claims] exist against the senior officers who were responsible for balance sheet management and financial disclosure, who signed and certified Lehman's financial statements and who failed to disclose Lehman's use and extent of Repo 105 transactions to manage its balance sheet.
Also evident in Lehman's use of Repo 105 was how little respect or fear it had for the potential bite of the regulatory agencies such as the Securities and Exchange Commission, as well as just how little authority the SEC believed it should have, back then in the glory days of the great market fetishist boom. By getting the SEC to accept Repo 105, in essence, the structured finance version of "the dog ate my homework", one can understand how so much was allowed to go on for so long.

But by September 2008, the greatest of the greater fools had been played, and 'ol Scratch came to collect on his contract with Fuld. Not Dan'l Webster, nor his modern day surrogates, the then Treasury secretary, Henry Paulson, or Federal Reserve chairman Ben Bernanke, could save him. Now, from the Valukas report, comes the bad news to be given to creditors when they try and ultimately fail to collect on their debts - when Lehman danced, very little room was left for the Holy Ghost. Indeed, there was little room for any theological or philosophical abstractions other than the greed for money and the lies told to get it.

It's a cautionary analysis, as well. Next time you find some brokerage that looks like it analyzes stocks less on the basis of legendary conservative investors Benjamin Graham and David LeFevre Dodd and more in the style of TV-show host and former jailbird Martha Stewart, no matter what they say about their word being true to their honor, go find a sturdy little nun to hide behind, and hope she is true to hers.
http://www.atimes.com/atimes/printN.html