How Cheap Money and ‘Storage’ Caused the Lehman Collapse

How Cheap Money and ‘Storage’ Caused the Lehman Collapse

One of the things we love about the US stock market is that even after a company goes into Chapter 11 bankruptcy protection, you can still trade the company’s shares on the market.

We’re not exactly sure why you’d want to buy shares in a Chapter 11 company. Unless you’re after a super risky punt. But it’s certainly a bonus if you want to sell shares you hold in a Chapter 11 company.

And we’d have to say that it’s a better process than the drawn-out and complicated state of affairs on the Aussie market. For instance, if you were an owner of ABC Learning stock you’d have to wait months and possibly years before you could claim your tax loss.

In contrast, if you had the misfortune to buy, oh, let’s say, one hundred Lehman Brothers shares at USD$80 in 2007 and you’d decided to hang in there all this time, well you could simply call your broker and get them to sell your hundred shares right now for…

11.2 cents per share. You can see Lehman’s amazing fall from grace on the chart below:

Chart for Lehman Brothers Holdings Inc. (LEHMQ.PK)

It’s perhaps appropriate that based on the chart above the price flat-lines from late 2008 until today!

Although looking at a shorter term chart we’ll guess a few small-time traders are playing around with it for some quick fire gains… and losses:

Chart for Lehman Brothers Holdings Inc. (LEHMQ.PK)

But there’s a reason we’ve brought up the subject of Lehman Brothers. A few big and little items have caught our eye in recent days. And I’ll get on to those in a moment.

Before I do, let me just remind you of one thing that we’ve mentioned several times before. And that’s the $13 trillion of off-balance sheet business Australia’s banks currently have an exposure to.

You can see the details for yourself by clicking here.

The only reason I mention it is to give you a reference point. Something to compare what I’m about to go through with you.

OK, you still got that number? Because here’s an even bigger one:

“The notional value of derivatives held by U.S. commercial banks increased $804 billion in the third quarter, or 0.4%, to $204.3 trillion.”

$204.3 trillion. That’s a big number. It’s contained in the quarterly report from the United States Office of the Comptroller of the Currency. But that’s not all, get this:

“Derivative contracts remain concentrated in interest rate products, which comprise 84% of total derivative notional values. The notional value of credit derivative contracts decreased by 3% during the quarter to $13 trillion.”

It’s hardly surprising that interest rate products account for 84% of the derivative exposure when the Federal Reserve has interest rates close to zero.

You can compare it to the position in 1998 when interest rate derivatives account for around 71% of banks’ exposure. And of course back then, the derivative exposure was just a paltry $28 trillion, compared to $204.3 trillion today.

Look, derivatives get a bad name, and these figures won’t do anything to improve the image. However, we will point out that in theory there’s nothing wrong with the concept of derivative contracts.

Remember we’ve a background in derivatives so work out for yourself if you think we’re biased.

A derivative is something that would naturally evolve even in a free market. A derivative enables an investor to gain or reduce exposure to an asset or liability without actually owning the asset or liability.

To our way of thinking there’s nothing wrong with that. The problem is not so much with the derivative but with the supply of money. Yep, funnily enough everything seems to revolve around that old chestnut.

It’s not the derivative instruments that are the bad guys, it’s the oversupply of money by central banks that’s the cause. The derivatives are merely the effect. Banks and traders have such an incentive to increase revenues and profits that they can do nothing else but take advantage of artificially cheap money and then use that money to leverage up as much as they can into derivative instruments.

Derivatives offer the best ‘value’ to traders because they’re leveraged. You can get more bang for your buck.

Bank A has to do it because it knows if it doesn’t then Bank B, C and D will. The effect is the same as all other inflationary impacts, the price of assets will soon run away and Bank A will have missed out.

That means lower revenues, lower profits, lower bonuses and lower shareholder returns.

The funny thing about it – which isn’t funny at all – is that it’s created absolutely no increase in net wealth for the economy.

It’s like every other inflationary cycle, it benefits those that get hold of the new money first and harms those that get hold of it last. The winners are the central banks, governments and bankers.

Everyone below them is either a winner to a lesser extent, right the way down to the ultimate losers. In general, that’s individuals – the man and woman on the street, including you.

Which brings us on to the half-way point in our story. This article appeared in today’s press:

“Lehman plans to end bankruptcy, create new company”

According to Reuters:

Under the Chapter 11 reorganization plan proposed by the company, Lehman sought authority to create an asset manager business called LAMCO that would specialize in management of Lehman’s commercial real estate, mortgages, principal investments, private equity, corporate debt and derivatives assets. Lehman said LAMCO would provide management services to Lehman, administer its assets and offer long-term employment opportunities for the hundreds of Lehman employees working to liquidate the former investment bank’s estate.”

Great! It’s going to create a company to manage the same investments that caused it to collapse. We can see that’s going to work out well!

But that news item fits in perfectly with what we’ve been reading over the last couple of days. If you’ve got a spare couple of weeks handy I’d suggest you read through the 2,292 page report by bank examiner Anton R. Valuka of Jenner & Block LLP.

You may have seen parts of the report quoted in the press, especially the parts that deal with Lehman’s ‘Repo105s.’ We won’t go into the details here, but in a nutshell a ‘Repo105’ was a simple way for Lehman to shift liabilities off its balance sheet just prior to issuing its quarterly reports.

It would give investors the impression that the investment bank was in much better shape than it really was.

After the end of each quarter Lehman would bring the liabilities back on to the balance sheet. Easy eh!

But amazing as it sounds, reading the 2,292 page report is, well, more interesting than you might expect.

In fact, based on what we’ve read so far – we’re up to the 152nd page of the document – we’re almost tempted to say that it wouldn’t take too much editing for the report to be adapted into a best-selling book on the downfall of Lehman’s.

It’s certainly got all the details, it just needs a bit of finesse.

But even though we’re only about 7% of the way through the document it’s already unveiled a tawdry tale of excessive risk taking.

As you might expect, Valuka’s report details some of the fancy goings-on that helped Lehman Brothers to disguise the fact that it was a debt laden and insolvent investment bank.

Fairly early on there’s a wonderful statement from Valuka:

“Lehman’s continued pursuit of this aggressive growth strategy, even in the face of the subprime crisis, was based on two important calculations by Lehman’s management. First, like some other market participants, not to mention governmental officials, Lehman’s management believed that the subprime crisis would not spread to other markets and to the economy generally.”

Who does Valuka rely on to make that sweeping statement? The footnote tells all, “Examiner’s Interview of Richard Fuld [CEO]… Examiner’s Interview of Treasury Secretary Timothy F. Geithner…”

In a nutshell, by early 2007 Lehman Brothers had decided that the worst of the subprime crisis was behind it. And furthermore it was the perfect time to strike at the competition in order to increase market share.

Apparently Lehman Brothers had executed a similar plan in the early 2000s, attacking the market aggressively on the front foot. If they’d done it before why wouldn’t it work again?

And so it was at this point that Lehman made the ultimately disastrous decision to change the business model from what they called a “moving” business to a “storage” business.

What they mean by that is this: a relatively low risk way of making money is to be the middle man. You buy from A in bulk and then sell as quickly as possible to C in smaller parcels at a marked up price.

‘C’ in this case is usually the bank’s clients – investors.

Providing you can keep the ‘goods’ moving and don’t keep the exposure on your balance sheet for any longer than necessary, the risk of losing on the deal should be relatively small.

However a couple of problems started to emerge. One is that by 2007 all the ‘C’s’ out there – investors – were starting to get cold feet on residential and commercial mortgage backed securities. Lehman’s was finding it much harder to offload its exposure.

Secondly, in order to make really big money on these deals you need to do a lot of them. And unfortunately for Lehman, as it was one of the smaller investment banks, it found itself missing out on the really big deals. The kind of deals that a bigger firm like Goldman Sachs could win.

The only option left to Lehman was to shift from “moving” stock to “storing” stock. In other words, Lehman would switch from being the middle man in the deal to becoming the owner – usually through partnerships with other firms – of the asset or liability.

As you can imagine, that’s a massive difference in the risk profile of the company. Something you’d think Lehman would let investors know about.

According to Valukas:

“One of Lehman’s major risk controls was stress testing. Historically, Lehman’s stress testing had not been designed to encompass the risks posed to the firm by principal investments in real estate and private equity, because those positions previously made up a small portion of Lehman’s portfolio… Lehman did not revise its stress testing to address its evolving business strategy.”

In other words, sure it was being good by conducting stress tests, however it was stress testing the wrong portfolio. It was using the old methodology that it used when the real estate investments only comprised a tiny fraction of its exposure.

And if you want an idea of how much the risk exposure had changed, take a look at this:

“For example, according to some estimates, covenant light loans – loans that did not include previously standard covenants requiring the borrower to maintain certain levels of collateral, cash flow, and payment terms – increased from less than 1% of all leveraged loans in 2004 to over 18% by 2007 industrywide.”

And this:

“Lehman’s real estate bridge equity positions in the United States increased tenfold, from $116 million to $1.33 billion, and then doubled to more than $3 billion by the end of the second quarter of 2008.”

But here’s the kicker. The following is a quote from Lehman’s own residential mortgage analyst. Not only had the Lehman balance sheet ballooned, but it had ballooned by the addition of all the wrong stuff. Here he’s commenting on the quality of the loans being written by Lehman’s Aurora Mortgage Maker originator:

Looking at the trends on originations and linking them to first payment defaults, the story is ugly: The last four months Aurora has originated the riskiest loans ever, with every month being riskier than the one before the industry meanwhile has pulled back during that time.”

That says it all. Lehman was powering ahead, believing it could snatch business away from the competition. But it was doing so by building up the balance sheet with crappy mortgages in the belief that they could flog them off to investors when the market had recovered.

In contrast many of Lehman’s competitors were walking away from this line of business, doubtless making it easier for Lehman’s to write these kind of deals.

Here’s how much and how quickly Lehman managed to grow its balance sheet. According to Valuka:

“Lehman’s growth strategy resulted in a dramatic growth of Lehman’s balance sheet:

“Lehman’s net assets increased by almost $128 billion or 48% in a little over a year – from the fourth quarter of 2006 through the first quarter of 2008. This increase in Lehman’s net assets was primarily attributable to the accumulation of potentially illiquid assets that could not easily be sold in a downturn. By one measure, Lehman’s holdings of ‘less liquid assets’ more than doubled during the same time period – increasing from $86.9 billion at the end of the fourth quarter of 2006 to $174.6 billion at the end of the first quarter of 2008.”

From what we’ve read so far, Lehman management felt they had no other choice. They were making a business decision to grow the investment bank. Did they do it because they were crooks or because they thought they could get one up on the competition?

Odds are it started out as the latter, but in the end maybe it turned into the former. Management feared that the other investment banks were either doing the same thing and therefore Lehman had to act to avoid losing ground, or that they could strike at the market while other investment banks were just consolidating their business.

Either way, Lehman’s saw what it thought was an opportunity to grab market share because as Valuka points out:

“[L]ike some other market participants, not to mention governmental officials, Lehman’s management believed that the subprime crisis would not spread to other markets and to the economy generally.”

But just remember, it’s not the interest rate swaps, or credit derivatives, or subprime mortgages that caused Lehman’s to collapse, those were the effects. As I mentioned above, the real cause is the easy availability of money. Add in the dangerous ingredient of artificially cheap rates, then you’ve got a metaphorical recipe for disaster.

Whenever the market for money is distorted in the way that it is by central bankers, market participants will always look to benefit from this distortion.

That’s just how markets work. The market can’t be manipulated favourably for the few without it creating unfavourable consequences elsewhere for everyone else. And ultimately even the few that benefit will get their comeuppance.

The usual reaction from governments is that they believe they can manipulate it and so they try. However, their actions merely create more problems. The only real and workable solution is to remove the initial distortion – artificial and non-market determined interest rates.

Once that distortion is removed everything else would naturally fall into place and the chances of a large scale repeat of the credit bubble would be virtually zero. But as long as central bankers and governments believe they can micro-manage the market to the benefit of all, the risks of a repeat increase.

I mean, look no further than the housing insulation scheme. If a government can’t sensibly and reliably manage the installation of housing insulation to 50,000 homes, how can it possibly micro-manage a $1 trillion economy with 22 million participants?

The answer is, it can’t and it never will.


Kris Sayce
Kris is never one to pull punches when discussing market developments and economic events that can affect your wealth. He’ll take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money. Kris is also the editor of Microcap Trader — where he reveals the best opportunities he’s discovered in the markets. If you’d like to more about Kris’ financial world view and investing philosophy then join him on Google+. It's where he shares investment insight, commentary and ideas that he can't always fit into his regular Money Morning essays.
Kris Sayce is the Publisher and Investment Director of Australia’s biggest circulation daily financial email, Money Morning Australia.Kris is a fully accredited advisor in shares, options, warrants and foreign-exchange investments. Kris has close to twenty years’ experience in analysing stocks. He began his career in the biggest wasp’s nest in the financial world — the city of London — as a finance broker back in 1995.
It’s there where he got his ‘baptism of fire’ into the financial markets, specialising in small-cap stock analysis on London’s Alternative Investment Market. This covered everything from Kazakhstani gold miners to toy train companies.After moving to Australia, Kris spent several years at a leading Australian wealth-management company. However he began to realise the finance and brokerage industry was more interested in lining its own pockets with fat fees, commissions and perks —rather than genuinely helping out the private investors they were supposed to be ‘working’ for. So in 2005 Kris started writing for Port Phillip Publishing — a company which was more attuned to his investment outlook. Initially he began writing for the Daily Reckoning Australia— but eventually, took over Money Morning. It’s now read by over 55,000 subscribers each day. Kris will take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money! Whether you agree with him or not, you’ll find his common-sense, thought-provoking arguments well worth a read. To have his investment insights delivered straight to your inbox each day, take out a free subscription to Money Morning here. Kris is also the editor of Tactical Wealth and Microcap Trader where he reveals the best opportunities he’s discovered in the markets that you could profit from. If you’d like to learn about the latest opportunity Kris has uncovered, take a 30-day trial of Tactical Wealth here or Microcap Trader here. Official websites and financial e-letters Kris writes for:

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“”””””I mean, look no further than the housing insulation scheme. If a government can’t sensibly and reliably manage the installation of housing insulation to 50,000 homes, how can it possibly micro-manage a $1 trillion economy with 22 million participants?”””””””””””

with the bank of fraser island