Frank Partnoy: Lehman Examiner Punted on Valuation

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.

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  1. Bob goodwin

    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.

    1. Yves Smith Post author


      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.

      1. i on the ball patriot

        “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.

        1. Yves Smith Post author

          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.

          1. i on the ball patriot

            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.

          2. Yves Smith Post author

            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.

          3. i on the ball patriot

            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 …


            Deception is the strongest political force on the planet.

      2. Bob goodwin

        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.

        1. Yves Smith Post author


          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.

    2. Alexandra Hamilton

      “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.””
      First, 90% of the stuff was mispriced (in their favor) and you think that is not systematic?
      Second, we have the best and brightest here, they are getting huge bonuses for that. The “I didn’t understand” defense is thus laughable.
      Third, by signing, the CEO and the CFO are both at risk because of this:—-000-.html

      For § 1350(c)(1) no intent is required, knowledge is enough.

  2. psychohistorian

    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.

  3. Uncle Billy Cunctator

    The examiner has a name. Why don’t you use it?

    “Lehman examiner, Anton “Tony” Valukas”

    And again, what is the true role of the examiner here. He digs out some dirt, but not enough, by half. Is there any discussion of the role of Barclays? Any talk of “Ice-9”?

    Reposted from previous thread:

    A guy from Jenner and Block assigns his teams each to write about 100 pages of report. That would require over 20 teams. Did Jenner and Block actually write it? If not, who did.

    It’s fascinating that they would choose the guy who runs Jenner and Block to do this work. This was their big early client:

    Got that? Construction and materials in Chicago? Worked hand in hand with Daily? Kept himself out of the clutches of the squid in Chicago? Are people stupid? Jenner was their go-to lawyer. *That* is what Jenner & Block is built on. Still HQ’d in Chicago, with offices in D.C. and NY… you think this company is squeaky clean? The geniuses directing this play probably understand that people are really not *that* stupid and will be able to make the connections from Jenner & Block and Anton to all sorts of terrible things. So why use them? To cover things up really well with a 2,000 page report? It can’t possibly be just a massive PR move. “Look at the heroic Jenner & Block,” they will say. “They have exposed all the filth at Lehman!” “They are beyond reproach!” “Anton should be on the Supreme Court!” What is it, PR, or sophisticated coverup via massive report?


    Try to look at the larger game being played. Is this limited hangout, intensive PR? If we’ve got the bad guys investigating the bad guys and no one even bothers to mention this, it seems to be working pretty well. Why is no one talking about what’s *really* going on? Afraid for their livelihoods and/or lives? We need some high-level whistle-blowers, and we need them now.

  4. John Moore

    How goes the saying, “It takes a thief to catch a thief”? The FBI hires crooks to catch other crooks if they aren’t expert enough themselves. That’s one way to investigate crime. There are others, but the forensics and law enforcement people who think like the crooks have some insight into their methods. If you have a lawful or morally rigid mindset and never think out of the box, then you may miss the tricks others use to deceive and steal from you. This applies to lawyers as well as magicians of all sorts. Many people are socialized to not question authority figures or experts or “successful CEOs/ministers/” even if those people turn out to be frauds. TV programming makes this sort propagandizing or cult worship even worse.

  5. anon

    The Valuation section adds more value to your case for OBS Transparency than it adds to an understanding of the problems unique to Lehman.

    The examiners report provides a good example of general industry standard practice for price verification procedures, so its worth highlighting that the statement,

    “… 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.

    applies to every institution that trades in the products Lehman did.

    Are they all “too complex to do anything but fail?”.

    I’d argue Lehman’s failure has less to do with it’s complexity relative to it’s peers than it does to it’s horrible management and unsustainable leverage.

    The examiners report highlights some of the errors made by Lehman’s Product Controllers (by the way, the “so-called” bit is bound to offend, Lehman’s PCs may be worst of breed, but PC is a legitimate specialist group).


    “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?

    This isn’t as damning as it sounds, when its reread in context. The CITI benchmark is relevant when the benchmark is the counterparty to the transaction. In that case it connects collateral to the reported valuation and improves the mutual accuracy of the reported valuations (or exposes the common error of both). The examiner makes this distinction pretty clearly in the report.

    Ironically, that discussion about dervatives deals done under CRAs implies that derivatives valuation reporting for the banks are likely to be consistent(ish), which is something I’ve been concerned about. In AIGs case their reported valuations didn’t agree with the values their counterparties were reporting. I’d be more concerned that 8% is an acceptable tolerance, more than that the counterparty is CITI in this case.

    The most damning bit re Lehman, is they fudged the non complex illiquid stuff, were less bad on the complex valuations.


    ‘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)’

    This is a longstanding issue. What most firms do is require that the models used for valuation be vetted by a Models control group before it is okd for use in reporting, then locked in a secure library. The models are documented and subject to review and change controls procedures that are audited. The report indicates Lehman had a similar procedure. Far from perfect, but good to know if you want to make a judgement about it.

  6. Dr. Economic Value

    The oft maligned Office of Thrift Supervision (OTS) has been after best-of-breed fair-value (“market valuation”) methodologies since the early 1990’s. In fact, their internal NPV model, which relies on broad-based assumptions, uses an OAS methodology that is most likely more sophisticated than 80-90% of the banks that do business in the United States. In fact, some of the larger banks aren’t even required to put reasonable marks on their banking books; they are permitted to only simulate net interest income. The only time they are required to place a “proxy” mark on balance sheet items is x1 per year under FAS-107 fair value disclosure requirements. FAS 157 and 159, as we already know, have been totally diluted. Banks, and more broadly all systemically important FIs, should be required to produce fair-value balance sheets on a regular (monthly) basis. The system isn’t going to get safer by beating down the doors of FASB or the captured regulators. It will be made safer when there is much, MUCH more granular and frequent disclosure. Disclosure we the people can then analyze and make judgment calls around. My disclosure I am not talking about “paper”, but streaming data. This is why Senate Bill S.3005 is so critical (and I bet 99% of the people reading this have no clue what S.3005 even recommends). Given the blinders that many have on, perhaps we get what we deserve – no transparency and pathetic reporting. Get behind S.3005. Make these firms stream data to the NIF on a daily basis; NIF anonymizes and provides to the masses. Once the atomistic data of the FIs are “known”, there will be market discipline and perhaps – over a long period of time – more confidence in the market. See also: for a paper OTS issued on fair value.

  7. Siggy

    The report rendered by Jenner & Block is a road map for litigation. See it for what it is, a road map.

    The target of the road map is not Lehman Bros. alone. Look to the potential for malfeaseance on the part of regulators and the counterparties as well.

    Consider the false profits implicit in the report, that is the basis of a claw back of a fraudulent conveyance as occurred in the instance of bonus payments.

    For those who think the Examiner’s Report is a coverup I suggest you return to the document and read in a less litteral manner. Reflect on implication. Moreover, be sensitive to the fact the issue is fraud and that it is very difficult to prove and that there is a liable defense available. Now, that defense may not hold but it is there.

    Finally, use the Report to understand that the parties to the fraud are multiple and that what has occured is a conspiracy by default. What should now begin to occur is that we should see indictments and/or investigations being mounted and anounced by the Justice Department.

    There is the real rub of Report, the fact that it is the bankruptcy that is bringing to issue the fraud that has occurred.

  8. Hugh

    I am not sure what the issue is here. We all know that under mark to market/fair evaluation all banks are insolvent. The difference between Lehman and the rest is that it is being wound up while the others are being let to operate as if solvent.

    If you wanted a guesstimate of Lehman’s worth. I would suggest discounting its ABS by 40-50% and treating the rest of its paper as worthless. I mean what’s going to happen to it? It will get sold to some other insolvent bank or institution and we will just have to deal with it again later. It is like passing around a hot potato except the only hands involved ultimately are those of the taxpayer.

  9. jerry denim

    The valuation problems revealed in the Lehman examiner’s report were disturbing but not at all surprising. Disturbing because I imagine what was going on inside Lehman is pretty much the same story all across town.

    Critics of complex OTC derivatives who speak from knowledge of what goes on inside Wall Street have warned of these valuation problems for years.

    How do you arrive at a fair price for a highly illiquid deliberately byzantine OTC derivative where your firm may be the only buyer/seller? If there are only two or three other buyers/sellers who are all watching each other is that any better? And of course let’s not forget that post Gramm-Leach-Bliley you have multiple parties inside of one-stop-shop financial firms with their own narrow and competing interests. Parties who had every motivation to misrepresent the value of trades and activities even within their own firm.

    What did anyone expect?

  10. Alexandra Hamilton

    Thanks for bringing that up. I had the impression that with all the attention to repo 105, the reason why they thad to do those repos 105 in the first place, did not get enough attention.
    They were short of money because the valuation of the products on their balance sheet was simply wrong. With the repo 105 they simply tried to make up for that.

  11. james c

    It is probably a mistake to assume that the valuation guys were incompetent.It is much more likely that they were coming up with the numbers that management wanted and got paid well for doing so.

    1. Yves Smith Post author


      This is risk control types v. line managers. The line managers will come up with flattering #s. Even if the supposed minders are in cahoots, they need to be CREDIBLY in cahoots.

      And you have to understand: not having realistic marks on trading positions in a levered firm is fatal. The word incompetence, even if accurate, does not convey how serious a failing this is. There is other evidence of sheer incompetence: something like 100 different systems that didn’t talk to each other for their derivatives. This is like trying to fly to the moon with only a sextant as your navigation tool.

  12. fresno dan

    If this type of investigation was done for all the wall street financial institutions, not just the ones without a chair when th music stopped, wouldn’t the result be the same?
    If not, which wall street bank has sound finances, prudent managent, and honest accounting (assuming accounting can be “honest” – the more I read of this stuff, it seems it is all premised on a realitor’s view that real estate only goes up)?

  13. Willis Heinl

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