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Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks |
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Hindsight has brought a consensus that Lehman and Bear Stearns represented Wall Street firms at their worst, where reckless trading heads ran roughshod over weak risk management controllers.
It is often forgotten that Lehman and Bear Stearns were both lauded by many for a supposedly superior ability to manage risk in the years running up to their failure in 2008.
Rating agencies proved gullible – as they did on other fronts. So did much of the media. But among the chilling details in the Lehman report were examples of the extent to which regulators such as the SEC and the Federal Reserve took nominally sophisticated risk management frameworks at face value.
In reality the few advocates of prudence within Lehman were sidelined as chief executive Dick Fuld and president Joe Gregory endorsed a push for growth that featured regular and enduring breaches of token risk limits. They also led an effort to stifle communication about dissent – within the firm as well as to outsiders.
The Lehman report seems unlikely to serve as a wake-up call to the industry. Today’s renewed push for investment banking market share is once more placing relations between sales and trading heads and risk managers under strain. Whether it is potential new entrants hoping to break into the investment banking oligarchy or existing members trying to revive sales and trading revenues, there are plenty of banks that are showing alarming signs of going back to the bad old ways of managing risk.
The Lehman report provides a catalogue of the errors made in the approach to the biggest bankruptcy in history. The information about the Repo 105 scheme to shift liabilities from the bank’s balance sheet to manipulate its reported leverage ratios has drawn the most attention since the report was issued. This is understandable as Repo 105 was the most egregious example of distortion of Lehman’s presentation of its numbers to investors. The scheme – which shifted as much as $50.38 billion off balance sheet at a given quarter end – was never reported in footnotes to accounts and was not discussed on analyst calls as concern mounted about the bank’s financial health.
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“A timely wake-up call” |
But some of the most instructive aspects of the 2,200-page report are those that detail the battles within Lehman over how to manage risk and how – or whether – to explain the bank’s real exposure to its board and investors.
There is an understandable impulse on the part of former Lehman managers to blame colleagues for the bank’s woes. Some veterans are still active in the industry or would like to restart their careers. Others are keen to avoid civil or criminal sanctions as legal cases based on the examiner’s report get under way. This means that their accounts of the downfall of the bank have to be treated with some scepticism.
A combination of old emails and witness testimony in the report forms a credible picture of how Lehman worked, however.
A central conflict within the firm as the credit bubble developed in 2006 and 2007 surrounded the drive for growth in leveraged buyouts. Alex Kirk, head of credit products at the time, and Mike Gelband, overall head of fixed income, complained to Fuld about the dramatic rise in leveraged loans. Fuld registered their complaints but did not think that this represented a fundamental expression of concern about exposure. Instead he believed that the fixed-income heads were aggrieved that they were taking all of the leveraged loan exposure on their own balance sheet, while the investment banking group led by Skip McGee was receiving credit for half the income without sharing the risk.
Fuld testified to the examiner that he considered Gelband’s complaints “an intramural P&L grab”, which concerned him.
Fuld was guilty of many mistakes but he understood his people – he trained many of them after all and was a domineering manager who set the tone for the firm.
His cynical view that complaints about leveraged loan exposure were driven by personal concerns about resources and eventual bonus payments was almost certainly founded in reality.
Further deep-seated cynicism was demonstrated in the way senior Lehman executives treated the board of directors. Even simple sleight of hand seemed to work when managers wanted to steer board members away from problematic topics.
In an October 2007 board meeting, chief financial officer Chris O’Meara did not want to highlight that the bank was over its risk appetite limits, so he simply removed relevant information from a standard chart on monthly exposure. He then told the board that Lehman’s average daily risk appetite use for the previous month was $3.7 billion, or $200 million over a newly raised limit. He neglected to inform the board that the total on the day of the meeting was $4.269 billion, or $769 million above the new limit.
This approach to sharing information was also applied to the professional risk managers and department heads at the firm. Former chief risk officer Madelyn Antoncic testified that a firm-wide risk committee received an extensive package of information each week until 2007, when president Joe Gregory dictated that only a one-page summary of risk drivers should be provided. Gregory also “made it clear” that business heads would make risk decisions going forward.
Lehman may have provided an extreme example of the potentially disastrous consequences when senior managers pursue market share growth at the expense of established risk controls.
There was nothing unusual about relations between different business heads and risk managers at Lehman, however. Fierce competition for resources and compensation is at the heart of investment banking and similar mistakes were made at most other dealers in the approach to the credit crunch.
The extent to which Lehman appeared to tick all the boxes of modern risk management is the most alarming aspect of its downfall. This was a firm, after all, with a risk metrics framework that Moody’s described as “more formalized and more holistic than most others in the industry”.
There are numerous examples today of investment banks embarking on ambitious attempts to win market share, especially in the sales and trading businesses that provide the bulk of revenue.
Nomura is launching a global expansion drive that includes another assault on the US. Santander is aggressively pushing for extra capital market share. Citi, BofA, Morgan Stanley and UBS are trying to recover past glories and Barclays Capital is determined to push Goldman Sachs and JPMorgan from the top of the investment banking tree.
After reading the grisly details in the Lehman bankruptcy examiner’s report it is hard to escape the conclusion that further risk management disasters lie ahead.
