Dick Fuld and the Collapse of Lehman Brothers

4/28/2019 - Monocle Journal

In 1969, the same year that senior partner Robert Lehman died, Richard Severin Fuld Jr. joined Lehman Brothers as an intern. Starting out trading commercial paper, Fuld progressed in his career and earned a reputation as a competent fixed-income trader. Beginning right at the bottom and climbing the ranks, Richard “Dick” Fuld would eventually go on to work at Lehman Brothers for 39 years, commanding the firm as chief executive for fourteen of those years – making him the longest-serving Wall Street CEO at the time. So proud was Dick Fuld to be a “Lehman-lifer” that he told The Wall Street Journal in December 2007, “As long as I am alive this firm will never be sold. And if it is sold after I die, I will reach back from the grave and prevent it.”

Lehman Brothers

In 1993 – the year before Fuld took over as CEO – Lehman Brothers made an annual loss of $102 million. Th e next year, Lehman would spin off from its parent company American Express – which had acquired what was known as Lehman Brothers, Kuhn, Loeb Inc. in 1984 for $360 million – to list independently on the New York Stock Exchange as Lehman Brothers Holdings Inc. For the next fourteen years, under the guidance of its new chief executive, Lehman Brothers Holdings would not make a single annual loss, with its biggest year of revenue and earnings – $60 billion and $4 billion respectively – being reported at the end of January 2008 for the fiscal year ending November 2007. During his tenure as CEO, Fuld would not only successfully guide the firm through numerous crises, but would also aggressively grow what was the oldest investment bank in the United States at the time into one of the biggest financial firms in the world.

Having taken a substantial knock in the Asian Crisis in the late 1990s, Lehman Brothers looked to recover its severely diminished share price in the coming years. In line with all the major investment banks at the time, Lehman Brothers pursued a high-leverage model that relied on the confidence of counterparties to fund its daily activities. To understand the extent of this leverage, by 2008, Lehman Brothers had amassed $680 billion in assets, whilst holding just $22 billion in capital – a leverage ratio of 31:1, which was on par with investment banks such as Bear Stearns, Merrill Lynch and Morgan Stanley at the time. And with this increased leverage, Lehman Brothers, led by Fuld, heavily increased its exposure to the property market in the US. This market was growing at an accelerated pace during the early- and mid-2000s, thanks in large part to extremely low interest rates, as well as the easily-accessible home loans provided by banks – supported by government policies such as the Housing and Community Development Act and facilitated by the government-backed institutions of Fannie Mae and Freddie Mac.

According to the Valukas Report – compiled by the official bankruptcy examiner, Anton Valukas – by the mid-2000s, Lehman Brothers had gained significant exposure to the real estate and mortgage market through a variety of financial instruments. These included commercial real estate (CRE), residential whole loans (RWLs), residential mortgage-backed securities (RMBS) and collateralised debt obligations (CDOs). Ultimately, it was this concentrated exposure to the housing and mortgage market, and not necessarily Lehman Brothers’ highly-leveraged position in itself, that would be the eventual undoing of the firm.

Whilst many economic commentators primarily associate Lehman Brothers with the securitisation of real estate-related assets, in the form of mortgage-backed securities and collateralised debt obligations, in fact, it was also one of the first Wall Street investment banks to gain direct exposure to the mortgage origination business. In 2003, Lehman Brothers bought Aurora Loan Services and in 2006, it acquired a second home loans business, the West Coast subprime mortgage lender BNC Mortgage LLC. And by late 2007, these two subsidiaries were in combination signing new loans at a rate of nearly $4 billion every month, further increasing Lehman Brothers’ already heavily exposed balance sheet to the US housing market bubble.

In Valukas’ bankruptcy report – collaborated on for 18 months by government analysts, Lehman staff and their external auditors, Ernst & Young – it was found that the valuation of Lehman Brothers’ real estate-related assets was significantly overstated. “As the level of market activity declined in late 2007 and 2008, resulting in valuation inputs becoming less observable, and certain of Lehman’s assets became increasingly less liquid, Lehman progressively relied on its judgment to determine the fair value of such assets,” notes the examiner’s report. The “fair value” being the orderly hypothetical sale of the asset in the market, as prescribed by the Statement of Financial Accounting Standards 157 (SFAS 157) under GAAP. These “self-priced” assets, as the Valukas Report called them, would however come under increasing scrutiny by market participants following Lehman Brothers’ first two quarterly reports of 2008. In April, a well-known short-seller, David Einhorn of Greenlight Capital, made it publicly known that he believed that there was good reason to question Lehman Brothers’ fair value calculations, since it had significant exposure to a battered commercial real estate market and should have taken billions more in write-downs than it did in early 2008. To add to the scepticism, Einhorn noted that “Lehman does not provide enough transparency for us to even hazard a guess as to how they have accounted for these items”, suspecting that “greater transparency on these valuations would not inspire market confidence”.

When several statements of a similar nature began circulating in the press, market sentiment slowly started to turn against the firm – and for Lehman, confidence in its integrity was vital, as the slightest crack in its credibility would be detrimental to the continued funding of its highly-leveraged operating model by its counterparties. Without this continued short-term funding, Lehman Brothers would go out of business immediately, and therefore, they would do everything in their power to keep the confidence of their counterparties, even if this meant manipulating their balance sheet to seem more liquid than they really were.

In the examiner’s report, an entire chapter of the six-part document is dedicated to what was known within Lehman as “Repo 105” – an accounting gimmick used extensively by the faltering investment bank to maintain a façade of liquidity in the last few financial quarters leading up to September 2008. These off-balance sheet devices, as the Valukas Report describes, were used “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.” The Repo 105 was nearly identical to a typical repurchase agreement, but with one critical difference – instead of being accounted for as financing that needed to be paid back to the obligee, it was recorded as a sale of inventory. In common repurchase agreements, an obligor (borrower), such as a bank, will borrow funds from an obligee (lender) on a short-term basis, in exchange for securities to be used as collateral for the loan, which the obligor has agreed to repurchase on a specified date and at a specified price that includes an interest payment to the obligee. Ordinarily, repurchase agreements are recorded as short-term funding by the obligor, but in the case of Lehman Brothers, as described by the examiner’s report, it “did not disclose the known obligation to repay the debt”.

To achieve this, Lehman exploited an accounting standard loophole where they agreed to a higher price of 105% for the securities, hence the name Repo 105, allowing the firm to record this as a “sale” of securities, and thus, moving the securities off its balance sheet indefinitely. Whilst this would not have been approved by US authorities, the examiner’s report describes how Lehman managed to obtain a legal opinion from the British law firm Linklaters affirming the technique was, in fact, legal, thanks to the less stringent financial regulations that applied to its European broker-dealer in London, Lehman Brothers International (LBIE), governed under English law. This short-term transaction was used increasingly by Lehman Brothers in the last few quarters before its collapse, allowing the investment bank to use the funds from the Repo 105 “to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios,” according to the examiner’s report. And as would later be divulged by former Lehman Global Financial Controller, Martin Kelly, the timing of these Repo 105 transactions was explicitly coordinated with the end of each financial quarter, with the express aim of artificially bolstering the firm’s financial reports. In testimony to the examiner after Lehman Brothers’ collapse, Kelly claimed that he expressed concerns to two consecutive Lehman CFOs, Erin Callan and Ian Lowitt, advising them that “the lack of economic substance to the Repo 105 transactions meant reputational risk to Lehman if the firm’s use of the transactions became known to the public.” In the second quarter of 2008, it would be discovered, Lehman used this technique to move $50 billion off its balance sheet.

Despite every attempt to hide its true financial position, on 9 June 2008, Lehman Brothers recorded its first quarterly loss since its independent listing on the NYSE in 2013, ending a run of 55 consecutive quarters of profitability. In a desperate effort to disguise the bad news, Fuld announced on the same day that the firm would raise $6 billion in capital from investors through the sale of shares, but the announcement only spooked the market further. Upon posting the $2.8 billion loss, the market reacted swiftly and dramatically, plunging the share price to its lowest point in more than 10 years. And while disappointed by the loss, Dick Fuld told reporters at the time that he still believed Lehman Brothers was well positioned for a recovery. By later that year, however, Lehman Brothers’ position had become a concern for the US government. And on 13 September 2008, the President of the Federal Reserve of New York, Timothy Geithner, called a meeting to discuss the investment bank’s future. Facing imminent bankruptcy, Fuld assured government regulators that he had initiated discussions with both Barclays and Bank of America for the sale of Lehman Brothers, to avoid a calamitous collapse. Ultimately, however, both Bank of America and Barclays could not agree to the terms of a sale, with the latter ostensibly only wanting to scoop out the good assets of the failing investment bank – which it eventually did, just days after Lehman’s bankruptcy.

Having failed to secure a sale, Lehman Brothers filed for Chapter 11 bankruptcy protection just before 01:00 Eastern Standard Time on 15 September 2008, reporting bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion. That same day, Lehman shares dropped by over 90% in value and overall, the Dow Jones index lost over 500 points – the biggest single-day drop since the September 11 attacks in 2001. The bankruptcy marked a turning point in the financial crisis, as Lehman’s collapse was the largest investment bank failure since the collapse of Drexel Burnham Lambert in 1990. It furthermore triggered in the same week the dramatic collapse and government bailout of the American International Group (A.I.G.) for $182.3 billion.

Like Lehman Brothers, other large investment banks also suffered from bloated positions in the subprime mortgage securities market, including Bear Stearns and Merrill Lynch, which would ultimately be sold to J.P. Morgan Chase and Bank of America respectively. However, the fact that Lehman Brothers was left to fail, makes it a unique case – a fact that many believe was a grave mistake, including former Merrill Lynch CEO, John Thain. In an interview with the BBC he notes that the amount of money it would have taken to save Lehman – $20 billion or $30 billion – would have been marginal, “compared to the destruction in value that followed the Lehman bankruptcy, the complete shutdown of the credit markets, [and] the billions and billions and billions of losses that were experienced in the markets subsequently.”

The day after Lehman went into bankruptcy, Secretary of the Treasury, Henry “Hank” Paulson, told the press: “I never once considered it appropriate to put taxpayer money on the line in resolving Lehman Brothers.” But with the benefit of hindsight, he says, “I ought to have been more careful with my words. Some interpreted them to mean that we were drawing a strict line in the sand […] and that we didn’t care about a Lehman collapse or its consequences. Nothing could have been further from the truth. I had worked hard for months to ward off the nightmare we foresaw with Lehman. But few understood what we did – that the government had no authority to put in capital, and a Fed loan by itself wouldn’t have prevented a bankruptcy.”

Today, the argument is still made that it was an oversight by government to let such a systemically important institution completely collapse – especially since many other firms in a similar position were bailed out in the months and weeks following 15 September 2018, as well as taking into account that Bear Stearns had already been rescued in March of that year. The retrospective justification given by the US Treasury for not saving Lehman Brothers was that, at the time of Lehman’s collapse in September 2008, it was not yet within the Treasury’s mandate to put money into a private firm to cover its obligations, unless that institution could directly influence the stability of the US dollar. This was, however, not seen to be the case with Lehman Brothers at the time. It would not be until the introduction of the Troubled Asset Relief Program (TARP) on 3 October 2008 – which made available $700 billion in government funds to purchase toxic assets and equity from financial institutions – that Treasury could more readily bail out private institutions through the purchase of “troubled assets”.

In the wake of Lehman’s collapse, Dick Fuld came under immense scrutiny from authorities, who wanted to know how the giant investment firm had found itself in such a disastrous position in 2008. In the congressional hearings that followed, Fuld blamed politicians for not recognising the overly-lax mortgage lending regulations in the build-up to the crisis. He also argued that the collapse of the investment bank was caused by the unregulated naked short-selling of Lehman Brothers’ shares, accompanied by false rumours about the firm’s financial health. On November of 2008, Fuld sold his $13-million Florida seaside mansion to his wife for $100 to avoid repossession in case of legal action against him. As it turned out, however, he needn’t have worried, since, despite receiving a grand jury subpoena in connection to three criminal investigations led by the United States Attorney, Fuld would never be convicted of any charges. Ultimately, the court could not convincingly argue that Fuld, or any Lehman executive, knowingly misrepresented facts that would result in a charge of fraud, with the examiner’s report simply stating that Fuld’s conduct “ranged from serious but non-culpable errors of business judgment to actionable balance sheet manipulation.”

In 2018 – ten years after the collapse of Lehman Brothers – Fuld emerged from a long sabbatical and decided to make a return to Wall Street. His new firm, Matrix Wealth Partners, caters to wealthy family funds seeking corporate finance advice. In a statement to the Financial Times about his new venture, Dick Fuld says that the current economic environment provides “clear opportunities in a flawed and highly fragmented financial services market.” As of September 2018, in the lobby of Fuld’s newly re-branded financial advisory firm, as The Wall Street Journal reports, visitors and potential investors are greeted by a large artwork proclaiming, “That Was Then, This Is Now.”

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