In a scene reminiscent of Jeff Skilling’s congressional testimony over the bankruptcy of Enron Corporation, today’s 800-point intraday drop in the Dow was accompanied by a hearing on the “Causes and Effects of the Lehman Brothers Bankruptcy” held by the House Committee on Oversight and Government Reform, and testimony by Lehman’s (ex-) CEO Dick Fuld. When Melange associated Lehman with Enron in a May 31^st post and pointed the finger at the financial company for its poor disclosure, we did not dare imagine that the similarities would go that far.

On September 15, 2008, Lehman filed for what is clearly the largest bankruptcy in history, dwarfing the Worldcom bankruptcy 6 to 1 in terms of assets. Its causes and effects certainly merit our attention, and so this is probably not going to be the last Lehman post you will see on this website.

To set the stage, remember that congressional hearings do not serve the purpose of finding the whys and wherefores of the events: rather, they are a platform for grandstanding and tough-talking by politicians. Accordingly, these hearings gave ample opportunities to representatives from both sides of the isle to show how little they understand about finance and how loath they are to doing their homework (if you need further proof, watch a congressional testimony by the chairman of the Federal Reserve: you will see politicians asking questions on anything but monetary policy).

This case was no different, with one congressman at the beginning of the hearing pointing out to Fuld that Lehman only spent $300,000 in payments to Washington politicians, enormously out-lobbied by the real pros of the business, Fannie and Freddie, who spent $135 million. The congressman’s constituency will be glad to know that their representative used the entire time at his disposal to point out this enlightening difference, and to submit his own explanation of the events to the person who had been summoned to elucidate them.

Nevertheless, there were some instructive moments. The hearings began with some prepared remarks (the full texts are available here) by a finance professor, a public policy research firm president, a representative of a pension fund (CoPERA) that probably invested in Lehman stock, and, of course, Dick Fuld himself.

In his written testimony, Fuld said that Lehman “was forced to declare bankruptcy as a result of an extraordinary run on the bank.” He blamed the failure on “a litany of destabilizing factors: rumors, widening credit default swap spreads, naked short attacks, credit agency downgrades, a loss of confidence by clients and counterparties, and strategic buyers sitting on the sidelines waiting for an assisted deal were not only part of Lehman’s story, but an all too familiar tale for many financial institutions.” (page 8).

Rationalizing, he pinpointed two main factors responsible for Lehman’s demise. The first was a “lack of confidence” (page 8), not just in Lehman but in the investment banking business and in our financial institutions at large. The second was – surprise surprise – naked short selling in its lethal combination with unsubstantiated rumors: “I believe that unsubstantiated rumors in the marketplace caused significant harm to Lehman Brothers.” (page 10).

 

As a quick comment, I would point out that the business of banking is a business of confidence, and that Fuld and other Lehman executives (all duly fired by Fuld) did a fine, fine job at undermining confidence in the firm thanks to “its management’s stonewalling of legitimate questions coming from the financial community and its unwillingness to come clean on the makeup of its balance sheet.” This is what we said in our May 31^st post; in that same post we also said argued that “Lehman has veered down a path of Enron-like practices that will threaten its existence as an independent firm.” I erroneously stopped short of predicting a default, on the grounds that not even Bear Stearns defaulted, and that Lehman, unlike Bear, had access to the Fed’s  Term Securities Lending Facility (TSLF), the Primary Dealer Credit Facility (PDCF) and to the discount window. To this day, I find Lehman’s bankruptcy unfathomable, and I still maintain that Lehman was “too big to fail” (a point on which we will have to return in a future post).

 

Moving to the questions and answers session, Fuld asserted decisively that Lehman never walked out of a sale negotiation. This is an important revelation: if true, it says that Lehman never got greedy about the selling price. I accept that statement as true, and would note that the Financial Times reported yesterday that Lehman had been seeking a merger or sale since as early as 2006 (in that year, Lehman approached AIG for a possible deal …). The complementary implication of that statement is that every entity that got a close look at Lehman’s books was frightened away: this speaks to the extent of the toxicity of the assets that were lurking in that balance sheet.

 

When asked what he would have done differently in terms of the company’s strategy, Fuld admitted that Lehman had excessive exposure to three areas: the mortgage origination business, commercial real estate and leveraged loans. He also said that residential mortgages were never Lehman’s problem, which I find a strange statement to make under oath: as we reported in a March 23^rd post, in the March 18 earnings release Lehman’s then-CFO Erin Callan said that the company’s balance sheet had “39 billion in commercial real estate assets and $37 billion more in residential mortgages,” whose (rather arbitrary) accounting valuation  appeared suspect to several people.

 

In that March 23^rd post we also observed that Lehman, while claiming to be in the process of deleveraging, announced (yet another) multi-billion dollar buyback program to fund its executive compensation program, and noted that this had the effect to increase, not decrease, leverage. We also computed Lehman’s leverage at the end of February to be 31.7, basically equal to the leverage of now-defunct hedge fund Carlyle Capital Management.

 

Yet, Fuld repeated several times that Lehman had “had sufficient and strong capital and liquidity” all the way until September 10. It emerged from the testimony that some Lehman executives had warned Fuld that the firm’s liquidity position was precarious (at least one such executive was later fired).  We know this because some Lehman email records have being seized by investigators. Some of these emails can be read at the House Committee website.

 

In an uncharacteristic display of financial acumen, one Ohio representative (not Dennis Kucinich) pointed out that quite early on in his state there was an investigation as to why house prices were increasing so much. The result of that investigation was that house prices were artificially inflated by an exuberant market and did not correspond to their fair value. The representative asked Fuld whether perchance Lehman took advantage of such overpricing in housing (or mortgage) assets to pump up its balance sheet. Fuld failed to see the point of the question. But here is the point, gentle reader: Lehman and other companies took advantage of mark-to-market accounting to inflate the value of their balance sheet and added generous amounts of leverage when house prices were going up. Lehman’s share price, accordingly, was pumped up too.

 

Of course nobody was crying foul at mark-to-market accounting back then. But now, with house prices still declining and mark-to-market rules causing large write-downs, many are advocating a repeal of mark-to-market accounting as the crucial step that will mark the end of this credit crisis.

 

Like with Enron, the failure of Lehman Brothers is attributed to accounting and the short sellers. Like with Enron, books will be written on the downfall of Lehman. Eventually, clarity will prevail and the lessons of Lehman’s bankruptcy will be taught in school, but, once again, it will be a long and arduous process.