According to bankruptcy examiner Anton Valukas, the seeds of Lehman's Sept. 15, 2008, bankruptcy were sown in 2006, aggressively fertilized throughout 2007 and 2008's first two quarters, and harvested in the summer of 2008. Valukas concludes that although Lehman used its so-called Repo 105 to cook its books, what ultimately brought the firm down was bad business judgment.

Lehman had traditionally pursued a relatively low-risk brokerage model, in which it originated or purchased assets primarily to sell them to the markets, rather than investing its own capital and adding the assets to its balance sheet as part of a higher-risk banking model. Valukas reports that after Lehman watched its competitors make strong profits by using their balance sheets for proprietary investments, in 2006 Lehman decided to aggressively adopt the same strategy.

David Goldfarb, a former Lehman executive, explained in a 2006 Lehman document cited by Valukas, that Lehman sought "13% annual growth" in revenues, supported by "an even faster increase in the firm's balance sheet, total capital base and risk appetite."

Lehman pursued three major types of investments: Commercial real estate, leveraged loans and private equity. While all three would lead Lehman to abandon its traditional risk controls, as Valukas has documented, bad commercial real estate investments ultimately brought Lehman down.

Lehman's Stress Tests Didn't Measure Its New Risks

Many of Lehman's new investments were illiquid, which made them particularly risky for a firm with such high leverage and low equity base, according to Valukas. Having large volumes of illiquid investments complicated Lehman's business in three fundamental ways: They cannot be sold quickly to raise cash, unless sold for far below face value. They cannot be sold easily, at any speed, so selling them isn't an effective strategy to reduce leverage. And they cannot be easily hedged -- indeed, Lehman didn't hedge many of them, according to Valukas.

Despite the risks posed by Lehman's dramatic ramping up of its illiquid investment portfolio, the firm's own stress tests excluded illiquid assets. When Lehman began stress testing, this exclusion made sense because illiquid assets represented an insignificant amount of Lehman's investments. But continuing to exclude them after the business strategy changed meant that the firm's risk profile was allowed to shift dramatically without it showing up in the test results. According to Valukas, experimental stress tests conducted in 2008 showed that excluded assets represented as much as two-thirds of the losses predicted by the tests.

In addition to stress tests, Lehman managed its risks by setting risk limits, both in the aggregate and for individual transactions. As Lehman pursued its growth strategy, Valukas reports, Lehman kept raising and exceeding both types of limits.

Up the Staircase of Rising Risk


For fiscal year 2007, Lehman raised its firmwide risk limit from $2.3 billion to $3.3 billion. To justify the increase, Lehman modified the way it calculated the amount of risk it could support, Valukas reports, resulting in an additional several hundred million dollars in acceptable risk. In September 2007, Lehman upped the firmwide limit again, to $3.5 billion. For fiscal year 2008, Valukas notes, Lehman again raised it, to $4 billion, but only by significantly changing the way it calculated how much risk it could handle. Valukas asserts that if the same assumptions used for the 2007 calculation had been used for 2008, the resulting risk limit would have been $2.5 billion.

Lehman similarly changed how it approached its risk limits for individual transactions. Starting in 2006, Valukas reports, Lehman's management decided to stop enforcing a single transaction limit for leveraged loans because the limit had cost Lehman too much business, and it refused to apply the limit to commercial real estate loans.

Valukas cites an April 2007 memo by Lehman executive Kentaro Umezaki to illustrate Lehman's attitude toward risk-taking. Umezaki questioned if Lehman even had a limit on its high-yield risk and noted that at a recent firmwide meeting, CEO Richard Fuld (pictured) had encouraged growth despite the fact that Lehman was near its risk limits. As a result, Umezaki said, "the majority of the trading business's focus is on revenues, with balance sheet, risk limit, capital or cost implications being a secondary concern."

A Countercyclical Growth Opportunity?

The subprime crisis began to blow up in the second half of 2006, and it was in full force by spring, 2007. Lehman experienced the meltdown first hand because it was forced to hold much more of the mortgage-backed securities it originated than it had intended to. By January 2007, Lehman's securitization revenue -- the money it made by packaging and selling mortgages -- had plunged.

Even so, Valukas notes, Lehman kept issuing significant volumes of so-called Alternative-A mortgages (or Alt-A, those just one step above subprime) until August 2007. Indeed, Valukas says, Lehman management saw the subprime crisis as a countercyclical growth opportunity, believing the damage wouldn't spread to other economic sectors.

Lehman continued to expand its investments in leveraged loans, commercial real estate and other areas throughout the first two quarters of 2007. Even as the financial crisis began to spread in May 2007, Lehman completed leveraged loan deals and started new ones until August, and it kept doing real estate deals even later into 2007.

With leveraged loans, in the first half of 2007 Lehman was "the most aggressive lender per dollar of shareholder equity," according to Valukas.

The Final Straw

The capstone of the commercial real estate investments was the Archstone deal. In May 2007, Lehman got involved in the $22 billion acquisition of Archstone, a massive real estate investment trust (REIT). According to Valukas, Lehman management didn't do quantitative analysis of the risks Archstone entailed or on their impact on Lehman, even though it was clear from the outset that it would cause the firm to exceed its risk limits.

Despite a shutdown in the securitization market that in previous times would have allowed Lehman to offload some of its Archstone risk, Lehman went ahead and closed on Archstone on Oct. 5, 2007. Lehman faced $6 billion in exposure to Archstone, of which $2.4 billion was in the riskiest parts of the deal, according to Valukas.

Incidentally, the out-to-lunch Securities and Exchange Commission told Valukas that it perceived nothing wrong with the Archstone deal because it "did not second-guess Lehman's business decisions so long as the limit excesses were properly escalated within Lehman's management." By contrast, the Treasury's Office of Thrift Supervision, which performed annual reviews of Lehman and other banks, was sharply critical of the deal. Indeed, when then-Treasury Secretary Henry Paulson learned of the Archstone closing, he told Valukas, he questioned the wisdom of the decision and the direction Lehman was heading.

In part because of Archstone, Lehman's cash capital went from its traditional $2 billion surplus to a negative number. Lehman's total capital ratio was also harmed. The SEC required a minimum 10% total capital ratio, and for six months of 2007-08, Lehman was at or near 10%, according to Valukas. Despite this situation, Lehman didn't embark on asset sales or capital-raising. In the first quarter of 2008, Valukas reports that CEO Fuld had decided not to raise equity unless he could do so at a premium.

Lehman's Accelerating Death Spiral

Throughout Lehman's explosive growth period, some in the firm tried to limit its risk-taking but had a hard time getting traction, according to Valukas. Even as various risky businesses were shut down or scaled back in 2007, Lehman's balance sheet continued to grow. Not until Bear Stearns fell in March 2008 was CFO Erin Callan able to get balance-sheet reduction on the
executive committee's agenda, Valukas reports, and even then progress at reducing the balance sheet was slow. It didn't begin to decline until the end of 2008's second quarter.

As the summer of 2008 progressed, the market perceived Lehman to be in deep trouble. On June 9, the firm announced its first-ever quarterly loss -- $2.8 billion -- since going public 14 years earlier. Treasury Secretary Paulson reported to Valukas that he told CEO Fuld that if Lehman reported a third-quarter loss without a strategic buyer in place or a definite survival plan, Lehman could go under.

Valukas cites a June 13, 2008, email from Federal Reserve Vice Chairman Donald Kohn to Fed Chairman Ben Bernanke reporting that he and some institutional investors believed the only question was when Lehman would fail, not if. In July 2008, Valukas reports, global rumors were saying "Lehman was 'done & dusted' with no forthcoming Bernanke bailout."

A Clean Lehman and a Dirty Lehman

From June 2008 to Lehman's bankruptcy in mid-September, Valukas notes that Lehman pursued two visions of survival: It would sell itself to another institution, or it would put all of its bad real estate assets into a "SpinCo" and line up investors for the "clean Lehman" that remained.

The SpinCo approach faced several hurdles, according to Valukas. Lehman would have to value its illiquid, rapidly deteriorating real estate holdings and give SpinCo enough cash to support the real estate assets. That would leave Lehman facing an "equity hole" in its own capital structure while it looked for investors for SpinCo and tried to get the SEC to remove significant accounting obstacles.

The challenges to the SpinCo approach were so great, Valukas reported, that Paulson told Fuld to abandon the plan. CEO Jamie Dimon of JPMorgan Chase (JPM) thought the plan was too leveraged, complex and real-estate-laden to work, and Warren Buffett also dismissed it. When Lehman announced the SpinCo idea on its Sept. 10, 2008, earnings call, analysts immediately focused on the equity hole. Ultimately, Lehman couldn't get SpinCo done before it went bankrupt.

No Deals, No Buyers -- Just Bankruptcy

As for strategic partners, Lehman had on-and-off discussions with Korea Development Bank that ultimately foundered in early September. Lehman also reached out to MetLife (MET), but it refused to do a deal after its August due diligence turned up too many problems with Lehman's commercial real estate and residential mortgages, according to Valukas. As September began, Lehman tried to get the Investment Corp. of Dubai to invest in SpinCo, but it ultimately refused.

Also at the start of September, Secretary Paulson urged Bank of America (BAC) to do a deal with Lehman, according to Valukas, but after due dilligence BofA concluded that Lehman's real estate valuations were too high, and there were approximately $65 billion in assets that it didn't want "at any price." Barclays (BCS) was Lehman's last hope, but those negotiations ultimately foundered, too. On Sept. 15, Lehman entered bankruptcy -- and the global financial crisis was underway.

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