The latest issue of CFA Magazine features an article titled, "Lessons from Lehman," which derives five lessons from the court-appointed examiner's report. This report exposed a number of questionable behind-the-scenes activities at Lehman Brothers. These lessons are:
Lesson 1. Beware of "Window Dressing"
"According to the report, 'Lehman employed off-balance sheet devices (such as Repo 105 transactions) to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008.' In effect, this internal accounting transaction allowed Lehman to hide $50 billion, thereby reducing total liabilities and total assets on its balance sheet. More importantly, it allowed Lehman executives to obscure the firm’s true leverage ratio."
Lesson 2. Avoid Giant Leverage Machines Balanced on the Head of a Pin
Leverage allowed Lehman Brothers to boost returns when markets were rising, but the degree of leverage that Lehman operated with proved to be fatal in 2008. In fact, total debt was about 30 times equity at Lehman Brothers. As a result, "Lehman was a giant leverage machine balanced on the head of a pin."
Lesson 3. Verify Everything and, Don't Try to Analyze in a Vacuum
Although auditors can spot developing problems, not all problems are evident a company's independent auditor, especially if management is trying to hide something. As a result, investors must be prepared to do significant analysis if they are considering investing in a business as complex as an investment bank.
Lesson 4. Pay Special Attention to Hard-to-Price Level 3 Assets
When a liquid market does not exist for a specific asset, management will value that asset using proprietary models. These assets are referred to as Level 3 assets and give management quite a lot of flexibility in finding a carrying value. The court-appointed examiner’s report concluded that the valuations of Level 3 assets on Lehman’s balance sheet were completely esoteric.
Lesson 5. Watch for "Control Fraud" and "Crimiongenic" Circumstances
In the article, William Black,associate professor of economics and law at the University of Missouri–Kansas City , states, “Control fraud refers to individuals that control seemingly legitimate entities and use them as a weapon to defraud.”
"Lehman was the leading seller of non-prime assets. It primarily sold a no-income-verification loan, known in the trade as liars’ loans, Black says. Not being the underwriter for those loans means that, inherently, a risk was adverse selection, meaning at least some of those loans had what is called a “negative expected value,” according to Black. The phenomenon of adverse selection is “criminogenic” in that it produces widespread control fraud."
The article from CFA Magazine is embedded in its entirety below:
Lessons From Lehman
Lesson 1. Beware of "Window Dressing"
"According to the report, 'Lehman employed off-balance sheet devices (such as Repo 105 transactions) to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008.' In effect, this internal accounting transaction allowed Lehman to hide $50 billion, thereby reducing total liabilities and total assets on its balance sheet. More importantly, it allowed Lehman executives to obscure the firm’s true leverage ratio."
Lesson 2. Avoid Giant Leverage Machines Balanced on the Head of a Pin
Leverage allowed Lehman Brothers to boost returns when markets were rising, but the degree of leverage that Lehman operated with proved to be fatal in 2008. In fact, total debt was about 30 times equity at Lehman Brothers. As a result, "Lehman was a giant leverage machine balanced on the head of a pin."
Lesson 3. Verify Everything and, Don't Try to Analyze in a Vacuum
Although auditors can spot developing problems, not all problems are evident a company's independent auditor, especially if management is trying to hide something. As a result, investors must be prepared to do significant analysis if they are considering investing in a business as complex as an investment bank.
Lesson 4. Pay Special Attention to Hard-to-Price Level 3 Assets
When a liquid market does not exist for a specific asset, management will value that asset using proprietary models. These assets are referred to as Level 3 assets and give management quite a lot of flexibility in finding a carrying value. The court-appointed examiner’s report concluded that the valuations of Level 3 assets on Lehman’s balance sheet were completely esoteric.
Lesson 5. Watch for "Control Fraud" and "Crimiongenic" Circumstances
In the article, William Black,associate professor of economics and law at the University of Missouri–Kansas City , states, “Control fraud refers to individuals that control seemingly legitimate entities and use them as a weapon to defraud.”
"Lehman was the leading seller of non-prime assets. It primarily sold a no-income-verification loan, known in the trade as liars’ loans, Black says. Not being the underwriter for those loans means that, inherently, a risk was adverse selection, meaning at least some of those loans had what is called a “negative expected value,” according to Black. The phenomenon of adverse selection is “criminogenic” in that it produces widespread control fraud."
The article from CFA Magazine is embedded in its entirety below:
Lessons From Lehman
