A hard look at how Lehman masked the horrors of its balance sheet. Words of wisdom from Seth Klarman.
HOCUS-POCUS. THAT, IT EMERGES, SANK LEHMAN
Brothers and damn near the entire financial system, to say nothing of the economy as a whole. So charged a court-appointed examiner named Anton Valukas, may his tribe increase, in a 2,200-page bombshell of a report made public on Thursday by U.S. Bankruptcy Judge James Peck.
Lehman, in case you were too busy dumping stocks at the time to notice, went belly-up in September 2008, and in one fell swan dive earned the unenviable distinction of being the biggest bankruptcy in our republic’s long and glorious history. It took Mr. Valukas, of the New York law firm Jenner & Block, 14 months and $38 million to perform the autopsy, and it has proved time and money very well spent.
Let us confess right up front that we haven’t read the entire 2,200 pages of the tome. But we have perused juicy excerpts and plumbed the accounts of sources we’ve found reliable to get a pretty good picture of why Lehman went belly-up and who the likely villains were. It’s an ugly picture and leads inexorably to the conclusion that if what some of the principals did so sneakily to hide the firm’s dangerously wretched financial condition in the long months preceding its collapse isn’t illegal, it should be.
The list of suspects begins, inevitably, with the boss man, Dick Fuld, on whose watch Lehman went under. Mr. Fuld, who if the allegations in the report are right might need to change his name to Mr. Fudge, denies knowledge of the accounting trickery employed to mask Lehman’s seriously deteriorating finances and keep all interested parties, emphatically including its own shareholders, blissfully in the dark. Na¿f that we are, we’ve always had the silly idea that the shareholders were the true owners of a company.
Other members of the top brass also appear deserving of notice as at least contributing to Lehman’s downfall by their yeoman-like labors in aiding and abetting the fetid deception. Certain lenders cited in the report, among them Chase and Citi, were in a sense complicit, deliberately or not, in the firm’s collapse. And, as usual, the so-called independent accountants seem to have been out to lunch when the stealthy mischief was being wrought.
The key to Lehman’s ledgerdemain (forgive us, it was too sweet a pun to resist) was Repo 105, a form of repurchase agreement between banks that briefly swap loans for assets the borrower is obliged to buy back. As Mr. Valukas reveals, the real purpose of these transactions undertaken by Lehman, which conveniently spiked at the end of the quarter, was “balance sheet manipulation.”
The sums involved in this hanky-panky, moreover, weren’t exactly chump change: $38.6 billion at year end ’07, $49 billion in the first quarter of ’08 and $50 billion the following quarter. But, then, Lehman had more than its quota of punk assets to hide.
Dick Fuld, as duly noted, has claimed he was unaware of these shenanigans. It’s possible, of course, that Mr. Fuld’s memory is a bit fuzzy on this subject since, as Lehman’s leader, he had a lot to worry about. Who among us hasn’t experienced such a lapse in trying to recall a trivial matter, especially something as dull as accounting?
But, as related by Mr. Valukas, one of Mr. Fuld’s trusty subordinates, Bart McDade, claims to have briefed his chief specifically on the firm’s use of Repo 105 and the need to reduce it in June of 2008. And, in any case, Mr. Fuld assured the examiner that he had “many conversations with his executives” about cutting back on leverage.
For their part, Lehman’s accountants, Ernst & Young, seemingly were reluctant, perhaps out of sheer politeness, to be too nosy about what the Examiner calls Lehman’s reverse financial engineering. The report notes that Ernst & Young knew that Lehman was using Repo 105 but neglected to question it, much less raise a fuss about it.
Which would appear to affirm the opinion of our old friend, treasured Barron’s contributor and accounting icon Abe Briloff, that the big accounting firms are not all that accountable. In Abe’s extremely learned view, they have too often and undeservedly escaped opprobrium for their critical role in the decline and fall of the financial system during the great recession.
In short, to coin a cliché, there’s more than enough blame to go around — and we haven’t exhausted the roster of culprits, by a long shot — for Lehman’s demise and all the horrors that issued from it.
SETH KLARMAN IS THE MAIN man at the Baupost Group, a Boston-based money-management firm that has compiled a splendid record stretching back over some 18 years. Although Baupost to the untutored eye may look like a hedge fund, it’s rather a different animal. For one thing it eschews leverage; for another, while it does short stocks from time to time, bearish positions typically are an insignificant presence in its portfolios.
Although just about everybody calls himself a value investor, Seth is that rare bird who really is a value investor. And like Seth himself his investment approach is unostentatious, smart, serious and painstaking. His year-end letters to his limited partners are always a joy to read and, unlike so much of the genre, enlivened by insightfulness, wit and that most uncommon ingredient — common sense.
In his latest commentary on 2009, he reflects with more than a dollop of wryness on the effects of that mother of all rallies (which, we would be derelict and ill-mannered were we to fail to mention, last week celebrated its one-year anniversary). Seth writes that the monster move has been taken as “an all-clear signal.” It even, he says a tad wondrously, has rescued from the purgatory where moldy old Street sayings end up the notion that we’re in a Goldilocks world for investors, one that’s not too hot and not too cold.
Gentleman and scholar that he is, he submits a delicate demur to this vision of “financial utopia,” pointing out that its components are inarguably a tad repulsive, encompassing as they do unyielding reduction by Uncle Sam of short-term interest rates to just this side of zero, the printing presses running all-out, all the time, and the dead hand of government cropping up everywhere — in the financial markets, in accounting standards, in the economy.
Maybe, he suggests, the sure and simple way to reach this wonderful state of nirvana is by simply engineering “a near-total collapse of the system” every few years. Gosh knows, we might interject, there’s no lack of experienced hands in Wall Street and Washington capable of doing the job.
We don’t want to give you the impression that Seth is a sour cynic. Far from it. He laments that “one might expect that the near-death experience of most investors would generate valuable lessons for the future” instead of gaily resuming what he calls their “shockingly speculative behavior.”
Our point is that someone as seasoned as he is in the ways and whims of Wall Street can still be shocked by anything investors do or fail to do is the quintessential opposite of a cynic. And to prove it, in his latest epistle, Seth offers 20 critical lessons investors should have taken away from the market catastrophe they so recently suffered through.
A few of our favorites:
— Beware leverage in all its forms.
— Steer clear of financial risk models. Reality is always too complex to be accurately modeled. Markets are governed by behavioral science, not physical science.
— Rating agencies are highly conflicted, unimaginative dupes, not to be trusted.
Virtually all of Seth’s cautions as well as the several we’ve mentioned have relevance to Lehman and its lugubrious fate. Frankly, we were surprised that release of the Examiner’s report and the unpleasant disclosures it contained had so little effect on Friday’s market. Perhaps it was merely further demonstration of why Seth sees an increasingly speculative thrust to trading.
AT THAT, THE MARKET in its final session backed and filled languorously before edging higher at the close. And while the trend has been up the past couple of weeks, the gains continue to lack much zest. Doubt obviously still hangs heavy on individual investors and the latest decline in consumer sentiment is partly a reflection of this wariness.
So, too, manifestly is the stubborn refusal of employment to show more than a modicum of improvement. On this latter score, the latest piece of bad news is that Larry Summers now predicts a significant upturn is right around the corner.
Barron’s Roundtable stalwart and proprietor of The High-Tech Strategist Fred Hickey has been right as rain this year on the stock market. Which means, of course, his portfolio has prospered. In his latest missive, Fred opines that “my hunch is that this market might roll over and suffer at least a 10% correction,” something he points out we haven’t had since stocks took off a year ago.
He hazards that if the Fed really decides to ring down the curtain on quantitative easing that could trigger fears of rising rates, or, even worse, a chain reaction of rising rates that might unnerve investors, force Mr. Bernanke to speed up the printing presses again and cream the dollar.
In some ways, Fred’s talking his book, since he’s loaded with gold, to which such a sequence would add fresh glister. As for tech, although he has enjoyed some profitable trades, he now believes that, with a few exceptions, like Microsoft, Verizon, Cadence Design, and Sybase, the stocks are over-owned and no longer very attractively priced.
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