The first question to ask is, how did this [financial crisis] happen? The answer is that the investment banks outmaneuvered the watchdogs, as I will explain in detail in a moment. As a result, with no one watching, the management teams at the investment banks did exactly what they were incentivized to do: maximize employee compensation. Investment banks pay out 50% of revenues as compensation. So, more leverage means more revenues, which means more compensation.
The second question is, how do the investment banks justify such thin capitalization ratios? And the answer is, in part, by relying on flawed risk models, most notably value at risk (VaR). VaR is an interesting concept. The idea is to tell how much a portfolio stands to make or lose 95% of the days or 99% of the days or what have you. Of course, if you are a risk manager, you should not be particularly concerned how much is at risk 95% or 99% of the time. You don’t need to have a lot of advanced math to know that the answer will always be a manageable amount that will not jeopardize the bank.
A risk manager’s job is to worry about whether the bank is putting itself at risk in the unusual times — or, in statistical terms, in the tails of distribution. Yet, VaR ignores what happens in the tails. It specifically cuts them off. A 99% VaR calculation does not evaluate what happens in the last 1%. This, in my view, makes VaR relatively useless as a risk management tool and potentially catastrophic when its use creates a false sense of security among senior managers and watchdogs. This is like an airbag that works all the time, except when you have a car accident.
By ignoring the tails, VaR creates an incentive to take excessive but remote risks. Consider an investment in a coin-flip. If you bet $100 on tails at even money, your VaR to a 99% threshold is $100, as you will lose that amount 50% of the time, which obviously is within the threshold. In this case, the VaR will equal the maximum loss.
Compare that to a bet where you offer 127 to 1 odds on $100 that heads won’t come up seven times in a row. You will win more than 99.2% of the time, which exceeds the 99% threshold. As a result, your 99% VaR is zero, even though you are exposed to a possible $12,700 loss. In other words, an investment bank wouldn’t have to put up any capital to make this bet. The math whizzes will say it is more complicated than that, but this is the basic idea.
Now we understand why investment banks held enormous portfolios of “super-senior triple A-rated” whatever. These securities had very small returns. However, the risk models said they had trivial VaR, because the possibility of credit loss was calculated to be beyond the VaR threshold. This meant that holding them required only a trivial amount of capital, and a small return over a trivial amount of capital can generate an almost infinite revenue-to-equity ratio. VaR-driven risk management encouraged accepting a lot of bets that amounted to accepting the risk that heads wouldn’t come up seven times in a row.
In the current crisis, it has turned out that the unlucky outcome was far more likely than the backtested models predicted. What is worse, the various supposedly remote risks that required trivial capital are highly correlated; you don’t just lose on one bad bet in this environment, you lose on many of them for the same reason. This is why in recent periods the investment banks had quarterly write-downs that were many times the firmwide modelled VaR.
Lehman’s management is charismatic and has almost cult-like status. It gets tremendously favorable press for everything from handling the 1998 crisis to supposedly hedging in this crisis to not playing bridge while the franchise implodes.
From a balance sheet and business mix perspective, Lehman is not that materially different from Bear Stearns. Lehman entered the crisis with a huge reliance on US fixed income, particularly mortgage origination and securitization. It is different from Bear in that it has greater exposure to commercial real estate and its asset management franchise did not blow up. Incidentally, neither Bear nor Lehman had enormous on-balance-sheet exposure to CDOs. At the end of November 2007, Lehman had Level 3 assets and total assets of about 2.4 times and 40 times its tangible common equity, respectively. Even so, at the end of January 2008, Lehman increased its dividend and authorized the repurchase of 19% of its shares. In the quarter ended in February, Lehman spent over $750 million on share repurchases, while growing assets by another $90 billion. I estimate Lehman’s ratio of assets to tangible common equity to have reached 44 times.
There is good reason to question Lehman’s fair value calculations. It has been particularly aggressive in transferring mortgage assets into Level 3. Last year, Lehman reported its Level 3 assets actually had $400 million of realized and unrealized gains. Lehman has more than 20% of its tangible common equity tied up in the debt and equity of a single private equity transaction — Archstone-Smith, a real estate investment trust (REIT) purchased at a high price at the end of the cycle. Lehman does not provide disclosure about its valuation, though most of the comparable company trading prices have fallen 20-30% since the deal was announced. The high leverage in the privatized Archstone-Smith would suggest the need for a multibillion-dollar write-down.
Lehman has additional large exposures to Alt-A mortgages, CMBS and below-investment-grade corporate debt. Our analysis of market transactions and how debt indices performed in the February quarter would suggest Lehman could have taken many billions more in write-downs than it did. Lehman has large exposure to commercial real estate. Lehman has potential legal liability for selling auction-rate securities to risk-averse investors as near cash equivalents.
What’s more, Lehman does not provide enough transparency for us even to hazard a guess as to how they have accounted for these items. It responds to requests for improved transparency grudgingly, and I suspect that greater transparency on these valuations would not inspire market confidence. Instead of addressing questions about its accounting and valuations, Lehman wants to shift the debate to where it is on stronger ground. It wants the market to focus on its liquidity. However, in my opinion, the proper debate should be about Lehman’s asset values, future earning capabilities and capital sufficiency.
In early April, Lehman raised $4 billion of new capital from investors, thereby spreading the eventual problems over a larger capital pool. Given the crisis, the regulators seem willing to turn a blind eye toward efforts to raise capital before recognizing large losses; this holds for a number of other troubled financial institutions. The problem with 44 times leverage is that if your assets fall by only a percent, you lose almost half the equity. Suddenly, 44 times leverage becomes 80 times leverage and confidence is lost. It is more practical to raise the new equity before showing the loss. Hopefully, the new investors understand what they are buying into, even though there probably isn’t much discussion of this dynamic in the offering memos. Some of the sovereign wealth funds that made these types of investment last year have come to regret them.
Lehman wants to concentrate on long investors; in fact, it went to great lengths to tell the market that it sold all of its recent convert issue to long-only investors. Putting aside the fact that some of the clearing firms have told us that this wasn’t entirely true, companies that fight short sellers in this manner have poor records. The same goes for companies that publicly ask the SEC to investigate short selling, as Lehman has done. There is good academic research to support my view on this point. As I have studied Lehman for each of the last three quarters, I have seen the company take smaller write-downs than one might expect. Each time, Lehman reported a modest profit and slightly exceeded analyst estimates that each time had been reduced just before the public announcement of the results. That Lehman has not reported a loss smells of performance smoothing. Given that Lehman hasn’t reported a loss to date, there is little reason to expect that it will any time soon. Even so, I believe that the outlook for Lehman’s stock is dim. Any deferred losses will likely create an earnings headwind going forward. As a result, in any forthcoming recovery, Lehman might underearn compared to peers that have been more aggressive in recognizing losses.
Further, I do expect the authorities to require the brokerdealers to de-lever. In my judgment, a back-of-the-envelope calculation of prudent reform would require 50-100% capital for no ready market investments; 8-12% capital for what the investment banks call “net assets”; 2% capital for the other assets on the balance sheet; and an additional charge that I don’t know how to quantify for derivative exposures and contingent commitments. Only tangible equity, not subordinated debt, should count as capital. On that basis, assuming that Level 3 assets are a good proxy for no ready market investments — assigning no charge for the derivative exposure or contingent commitments and assuming its asset valuations are fairly stated — Lehman, based on its November balance sheet, would need $55-$89 billion of tangible equity, which would be a three- to-five-fold increase.
Risk Part 1: Issues
Risk Part 2: The Mess
Risk Part 3: Case Study - How Poor Risk Management Caused the Crisis
Risk Part 4: Regulatory Revision
Risk Part 5: Capitalism 2.0
Risk Part 6: Moral Hazard
Risk Part 7: Some Basic Accounting Problems