“Summer” Rerun: So Where, Exactly, Did Lehman’s $130 Billion Go?

Dear readers,

We reinstituting a Naked Capitalism feature, the summer rerun. The last time we reprised an archival NC post (aside from a few more recent ones by Matt Stoller) was a July 9, 2009 post that we published again on December 29, 2011.

Interestingly, picking up again from 2009 serves as a reminder of issues that were hot in the aftermath of the crisis that were not addressed adequately, if at all. Here, we discuss the mystery of the magnitude of Lehman’s losses. We pointed out that they are so large and impossible to explain that there had to be accounting fraud, but the bankruptcy overseer had its own reasons not go to there.

Note that this post was published eights months before Anton Valukus released his report on the Lehman bankruptcy, which described the Repo 105 ruse that allowed Lehman to hide over $50 billion of dodgy assets at quarter end and thus not include them in its financial reports. As we wrote in March 2010:

Quite a few observers, including this blogger, have been stunned and frustrated at the refusal to investigate what was almost certain accounting fraud at Lehman. Despite the bankruptcy administrator’s effort to blame the gaping hole in Lehman’s balance sheet on its disorderly collapse, the idea that the firm, which was by its own accounts solvent, would suddenly spring a roughly $130+ billion hole in its $660 balance sheet, is simply implausible on its face. Indeed, it was such common knowledge in the Lehman flailing about period that Lehman’s accounts were sus that Hank Paulson’s recent book mentions repeatedly that Lehman’s valuations were phony as if it were no big deal.

Well, it is folks, as a newly-released examiner’s report by Anton Valukas in connection with the Lehman bankruptcy makes clear. The unraveling isn’t merely implicating Fuld and his recent succession of CFOs, or its accounting firm, Ernst & Young, as might be expected. It also emerges that the NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations.

As we now know, the fact that so many well-placed people might be implicated if financial fraud at Lehman had been investigated meant it would never go further than the Valkas report. That analysis was generally regarded as taking the view that “this stuff might look stinky but it wasn’t actually fraud” given that the Repo 105 chicanery in particular had the blessing of a UK law firm, Linklaters. We argued that there was enough smoke that a deeper investigation was warranted. Oh, and for reference, we kept tabs on the Lehman black hole and it got bigger than as of the date of the post below.

This post first ran on July 10, 2009

The Lehman demise refuses to go away.

It has come out that the losses appear likely to be $130 billion on what was a roughly $660 billion balance sheet. That is an insanely high level.

What has caught my attention from the get-go is that blame was very quickly pinned on the disorderly bankruptcy. While I am sure that is a major factor, it is now being played up in the press as if it was the sole cause. I find it curious that Bryan Marsal, the president of Lehman and more important, co-chief executive officer of Alvarez & Marsal, the restructuring consultant for US bankruptcy, is taking the time to tell this story, per the CNBC clip below. There happens to be a piece in the Financial Times: tonight on Lehman (hat tip reader Don B) as well as this video from last week via reader Hubert, which says there might be a bit of a PR effort afoot.

Blogger was rejecting the CNBC embed code, and I fixed the supposed broken link, but if you have trouble, try here.

Marsal sticks with the “disorderly bankruptcy” message, and invokes Public Enemy Number Two: derivatives (Number One is credit default swaps). And he maintains that the bank was felled by a liquidity, not a solvency problem.

Why is this all a tad convenient? Raising the issue of dubious accounting now, which is fraud, opens up a whole new can of worms. That would seem to be enough of a reason.

But it seems pretty likely that dubious asset valuations played a role. Remember, David Einhorn was very critical of the Lehman’s accounting; it was very highly levered. Not much would have to be wrong for the bank to be bust. An ex-Lehman employe also has doubts:

I’ve always thought the fixed income portfolio was a much more promising source to look for the shortfall…they took no writedowns whatsoever on the portfolio through the fall/winter, despite a larger (relative to size) mix of mortgage and other toxic waste (leveraged finance, bridge to nowhere loans) than MER, C, etc. The Level 3 bucket grew substantially, until investors began to catch on & focus on that metric…at which time they moved a bunch of the Level 3 stuff off balance sheet (through setting up JV’s like One William, R3, etc)…all to avoid marks that would have created a bigger capital hole than they felt they could fill.

Another indicator that things might not be what they seem: the UK administrator says that there were 100 companies in that operation, and was stunned by its complexity. In a separate development described in the FT, Alvaraz & Marsal is trying to come up with a global plan, which seems peculiar given the national nature of bankruptcy regimes. And the UK administrator, which is overseeing the biggest non-US piece (and may also have a bone of contention, given how $8 billion was drained by the parent from the UK at the 11th hour) is having none of it:

Now, however, the liquidator to the parent company, Lehman Brothers Holdings Incorporated, is trying to change this mentality among the affiliates. Alvarez & Marsal, US restructuring experts, want to recreate some ghost version of the deceased bank through the global protocol, which aims to encourage each affiliate to focus on maximising the size of the overall pie rather than focusing only on their slice.

To that end, they have drawn up an agreement with seven administrators representing 27 Lehman companies – with more expected to sign. This promises much closer co-operation, the development of a single system for adjudicating internal claims and more sharing of data….

Crucially, however, not all the administrators are on board. PwC, in charge of Lehman’s main London-based European operations, known as Lehman Brothers International (Europe) and the most pivotal operation outside the US, has flatly refused to sign up.

Tony Lomas, head of the PwC team, is a veteran of cross-border corporate collapses from Robert Maxwell’s media empire to failed carmaker MG Rover and the European arm of Enron, the energy company. “My experience tells me [the protocol] is aspirational and lacks practicality,” he says. “It is sometimes not even practical to reduce an agreement between just two insolvency practitioners in different estates to writing.”

Back to the main plot, the $130 billion that went poof.

Lehman had $6 trillion of derivatives. But if they included credit default swaps, they were presumably hedged with offsetting positions, so the notional amount would way overstate real exposures. And another portion was probably plain vanilla stuff like interest rate swaps, which would not have a lot of latitude for pricing disputes.

If Lehman was done in by adverse market conditions and dirty tricks by the rest of the banking industry to the tune of $130 billion, wouldn’t the counterparties to Lehman’s losing positions be showing gains?

Where this might come back is via the repos used to fund derivative positions. I will confess to not haivng tracked down Lehman’s final 10-Q, but a normal I-Bank is funded roughly 50% by repos, so say $330 billion. Let us make generous assumptions, that Lehman was using 40% structured credits as collateral. And remember, thanks to the 2005 bankruptcy laws, the counterparties can grab collateral. They don’t have to go into the bankruptcy queue.

Collateral haircuts went through the roof when Lehman went down:

But even with a 20% spike in repo haircuts, we get only to $26 billionish. Even if the Lehman counterparties were jerks and upped the haircuts by 30%, it still only gets you to around $40 billion.

The reason I am particularly suspicious of Alvarez & Marsal is their role is badly conflicted. If you listen to the recording, Marsal argues that Lehman was not handled properly, and stresses that the board was shockec by the result. They had assumed an “ordelry transiotn” meaning a sale, or bailout like Fannie.

The problem is that Alvarez & Marsal was advising the Lehman board before the bankruptcy. So Marsal’s statement is tantamount to an admission that his firm advised the board badly.

And even more peculiarly, in January A&M issued a report for the board in December contending that the “chaotic” bankruptcy was the cause (by implication the sole cause) of the big losses. But then they pegged the damage resulting from the disorder at only $50 to $75 billion. No wonder they are out doing the PR circuit. They want everyone to forget that earlier $50 to $75 billion range.

Here is a section from a December Wall Street Journal article:

As much as $75 billion of Lehman Brothers Holdings Inc. value was destroyed by the unplanned and chaotic form of the firm’s bankruptcy filing in September, according to an internal analysis by the company’s restructuring advisers.

A less-hurried Chapter 11 bankruptcy filing likely would have preserved tens of billions of dollars of value…An orderly filing would have enabled Lehman to sell some assets outside of federal bankruptcy-court protection, and would have given it time to try to unwind its derivatives portfolio in a way that might have preserved value, the study says.

We now have the interesting question, :”If the board was told as much as $75 billion was due to the chaos, pray tell where did the other $55 billion go?” And the assertion that Chapter 11 would have produced a vastly better outcome is questionable. As we pointed out then:

Here is where readers are encouraged to correct me if I have something wrong or a bit askew. I was under the very strong impression that securities firms do not decay in an orderly fashion, but instead collapse rapidly once certain triggers are breached, making it well-nigh impossible to contain the unwind. In fact, you’d need pretty substantial changes in both bankruptcy law and the way that trading counterparties deal with each other to have the sort of managed process that the A&M reports argues should have taken place.


1. Once a firm is downgraded beyond a certain threshold, any counterparties that trade with it will be downgraded due to their exposures. And when other firms stop being willing to enter into repos (which do involve a credit exposure) a securities firm is toast. Liquidity is the life blood of a trading firm. And a bankruptcy filing has the same effect. From Jim Bianco:

If Lehman does file, Moody’s has to downgrade their counter-party rating to junk. This forces everyone to stop doing business with Lehman. If you do business with a junk counter-party, you risk your rating falling to junk as well (you are only as good as your shakiest counter-party). Most buy-side accounts have fiduciary rules that bar them from doing business with a junk rated counter-party. Recall that this was the trigger that buried Bear.

No way that Moody’s will agree to keep a bankrupt broker with an investment grade counter-party risk rating.

2. The A&M report appears to have ignored the 2005 bankruptcy law changes that rendered the claim made above, that Lehman could have blocked the unwind of its derivatives book via a Chapter 11 filing, incorrect. From the Financial Times:

Wall Street unwittingly created one of the catalysts for the collapse of Bear Stearns, Lehman Brothers and American International Group by backing new bankruptcy rules that were aimed at insulating banks from the failure of a big client, lawyers and bankers say.

The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.

The new rules were intended to insulate financial companies from the collapse of a large counterparty, such as a hedge fund, by making it easier for them to unwind trades and retrieve collateral.

However, experts say the new rules might have accelerated the demise of Bear, Lehman and AIG by removing legal obstacles for banks and hedge funds that wanted to close positions and demand extra collateral from the three companies.

“The changes were introduced to promote the orderly unwinding of transactions but they ended up speeding up the bankruptcy process,” said William Goldman, a partner at DLA Piper, the law firm. “They wanted to protect the likes of Lehman and Bear Stearns from the domino effect that would have ensued had a counterparty gone under. They never thought the ones to go under would have been Lehman and Bear.”…

The changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG….

Lawyers said the 2005 exemptions also could apply to non-financial companies, potentially complicating the bankruptcy process of any company that uses derivatives. Stephen Lubben, professor at Seton Hall University School of Law, said: “These provisions affect a non-financial firm, such as a car company or an airline, because they also engage in derivatives trading.”.

Now perhaps the Wall Street Journal summary does the A&M report a disservice, and they did correctly parse out any that might have been spared the 2005 bankruptcy law changes. But the FT article gives the impression these changes included most if not all derivatives.

And there is another issue. Chapter 11 filings require debtor-in-possession financing (you need to keep paying bills while holding the creditors at the time of filing at bay). Lehman would have been a very big DIP. The financial community is a really small pond. Word of Lehman attempting to line up a big enough DIP would have lead to an immediate run on the firm. No counterparty wants to risk having trading assets frozen for months, perhaps longer.

So if the logic above is correct, the A&M report looks like a costly ass-covering exercise to protect the board from lawsuits. And the Journal did the board a favor by giving it reasonably prominent placement.

We were not alone in our skepticism. From Independent Accountant:

How interesting. A&M was hired before LEH’s bankruptcy. What if anything did A&M tell LEH before filing? Is A&M’s report designed to protect A&M from a malpractice suit for failure to warn LEH’s board of this at least, reasonably possible result? If A&M did not anticipate this $50+ billion disaster, why listen to A&M now? What does “value was destroyed” mean? Did an “Act of God” cause it? Aren’t derivatives a “zero-sum” game? If so, counterparties gained at LEH’s expense! Should LEH’s bankruptcy estate sue them? Or is A&M protecting these counterparties by saying value “destruction”, not transfer? Has LEH preference payments or fraudulent transfers to pursue? Does A&M recognize LEH’s counterparties may give it future referrals with nothing more to gain from LEH, a “repeat player advantage”? A better title for the WSJ article, “Lehman’s Chaotic Bankruptcy filing Destroyed Billions in Value”, would have been “Lehman’s Consultant Claims … “. The WSJ accepted A&M’s claims at face value. “Preserved value” or cost counterparties more? “This also terminated contracts”. Did the “Three Musketeers”, Henry Paulson (HP), Zimbabwe Ben (ZB) and Chris Cox (CC) know this on the night of 14 September?…

No matter, LEH’s board should not have filed on 15 September if it was not in the interest of LEH’s shareholders and creditors. PERIOD! Did Marsal discuss these “fundamental rules” with LEH’s board on the night of 14 September? If not, why not? Where was Harvey Miller (HM), LEH’s bankruptcy counsel on the night of 14 September? Should LEH sue HM for malpractice? The WSJ headline is revealing. Creating chaos may conceal bankruptcy fraud so intentional acts appear to result from oversight or mistake. Did that happen here? Is the SDNY US Attorney’s Office looking into this? The WSJ might have used this title, “Lehman Counterparties Screw Unsecured Creditors Out Of $50 Billion”.

Zero Hedge and Independent Accountant have also criticized A&M for incurring charges in the BK that look hard to justify, yet also taking the easy way out and skipping steps that would have increased recoveries for creditors.

Another example: in the video, Marsal mentions that his firm hired some 400 ex Lehman staffers to help unwind the trades, and threw out a $500,000 salary and a $500,000 bonus if recovery targets were met as a representative figure.

The world happens to be awash in unemployed structured credit types these days, I would bet at least 300 of those 400 jobs could have been filled at much lower cost. But Alvarez & Marsal has no incentive to do that. Paying more makes it easier to hire people, and also makes their fees look more reasonable. And say “derivatives” and a BK judge will buy in, even if the skills required may not be all that high level. In the LTCM bankruptcy, Myron Scholes worked for a mere $250,000 a year, which in today’s dollars is about $330,000. Am I to believe in that there is good reason to pay more than the equivalent of $500,000 all in for a successful job? Well, sadly yes, pay escalated with perilous little justification, since most of the money supposedly made turned out to be smoke and mirrors, but those high water marks are still holding.

If readers have any idea where the $130 billion went, we’d be very curious to know. Please comment or ping us at yves@nakedcapitalism.com.

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  1. John Zelnicker

    Yves, I’m delighted to see these reruns. I only started reading NC in August, 2011, so I missed a lot of your incisive analysis of the GFC, its causes and the ensuing events.

  2. Chauncey Gardiner

    Article poses interesting question. The sums are staggering, and obviously some individuals do know. With this administration’s publicly stated policy to “look forward and not backwards” from the get-go, and little meaningful congressional oversight, it is quite likely that this matter, as with some others, will never be resolved (and that those who fail to learn from history are doomed to repeat it).

    Thought Lehman’s ownership of Indian Ocean Tuna in the Seychelles was a fishy 2006 acquisition by an NYC mega-bank, albeit “only $200 million”… Sometimes relatively modest-sized transactions provide a fractal from which one can derive a bigger picture. Don’t know if that is the case in this instance, but it is interesting to consider where the Seychelles are located geographically.

  3. fresno dan

    crooks all the way down (or is it all the way up…)
    what is so dispiriting is that the authorities obviously don’t want to know…

  4. Jay M

    When I saw “Summer” rerun I imagined Larry Summers being thrown under the bus, with the bus then smoothly put in reverse gear, rerun, right?
    Seriously, being simple minded, I never got how after the Enron collapse TPTB thought it was acceptable to Enronize the entire financial structure. I guess it had already happened, Enron was the crack in the windshield that eventually disintegrated while we were gaily sailing down the capitalist highway. The fact that some of the Enron geniuses were prosecuted is another marker that makes the current incumbent look bent even compared to Bush 2. Thanks for the memories.

  5. James Cole

    Just looking at the repos alone, I think you answer your own question: if repos on structured products accounts for $132mm of assets, the precipitous drop in value to the tune of 50-70% of those assets = $60-90mm of losses. In your analysis above, you’re only looking at the rise in haircuts, which are themselves discounts from market value but don’t take into account the drop in market value itself. So you could have a CMO drop from $100mm market value to $30mm market value and go from counting $97mm of that as good collateral to only $12mm ($30mm x 40% haircut) as “good” collateral.

    Also, I don’t know why you assume that all CDS written by Lehman were hedged; clearly, the practice at the time was to write as much protection as the laser printer could spit out. That’s what did AIG in.

    Between naked CDS writing and repos on structured products, I don’t even think you need the “disorderly bankruptcy” theory very much at all.

    1. Yves Smith Post author

      Repos aren’t as asset. They are a liability from Lehman’s perspective. The rise in haircuts explains why there was no liquidity when Lehman collapsed. They could not roll their repos and had a funding gap. But it does not explain the value of assets in bankruptcy after the Fed has goosed asset prices stabilized the market. And as we went on the Lehman black hole intermittent posts, the size of the black hole got MUCH bigger.

      Unlike many other banks, Lehman wasn’t a big CDO player. CDOs did go pretty much to zero but other structured credit products didn’t.

  6. Chauncey Gardiner

    Great article, thank you for running it. Finally had time to watch the related video this evening.

    Re: … “Creating chaos may conceal bankruptcy fraud so intentional acts appear to result from oversight or mistake. Did that happen here?”

    Don’t know, but in retrospect it would h/b a good idea to bring in some very competent forensic accountants to look at valuation and timing issues, among other aspects.

    An aspect of Lehman’s bankruptcy that I don’t believe has received a lot of public attention is the extent to which their BK might have affected the amounts of the U.S. Treasury and Fed bailouts of other entities. Based on the related video, it seems to me that an argument can be made that Lehman was deliberately cannibalized by its rivals, and that cannibalization may in turn have reduced the ultimate amounts of the public’s bailouts of Lehman’s competitors.

    If Lehman’s bankruptcy was largely attributable to illiquidity due to the withdrawal of short term credit facilities by their competitors, possibly in concert with the NY Fed (which it appears may have aligned itself with one or more of those competitors in the demise of the bankrupt), and if Lehman’s assets were applied to reduce losses and liquidity issues at their rivals, then why is Lehman’s BK and the internecine warfare that led to it, including the possibility of preference payments and fraudulent transfers, of continuing public interest?

    As an ordinary citizen, it seems to me that the causes of the Lehman, Bear Stearns and MF Global BKs were of a fundamentally different nature from the problems that led to the enormous bailout of AIG, although the underlying intent in that instance may have been similar to the others.

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