Preface

in Lehman Brothers

Preface

The purpose of this book is to explain the fundamental causes of the bank's failure, including the inadequacy of the regulatory and supervisory framework. For some, it was the repeal of the Glass-Steagall Act that was the overriding cause, not just of the collapse of Lehman Brothers, but of the financial crisis as a whole. The argument of this book is that the cause is partly to be found both in weak and ineffective regulation and also in a programme of regulation and supervision that was simply not fit for the purpose. Lehman Brothers certainly contributed to its own demise. When the company pursued its more aggressive policies to increase its profits and its market share, it moved away from purchasing residential real estate loans, even when these were subprime, and packaging them into mortgage backed securities, which were then sold on. From 2006 onwards, its more aggressive strategy focused on commercial real estate, leveraged loans and private equity. Its move into commercial real estate increased the levels of risk for the company, with increasingly illiquid assets. Dick Fuld, the chairman and CEO, and his senior management, ignored the increased risks, choosing to rely on over-valuations of the firm's assets.

One of the continuing puzzles is why Lehman Brothers was allowed to fail. The main players in that decision, Henry Paulson, Timothy Geithner and Chairman Bernanke, have generally claimed that the Federal Reserve did not have the legal powers to rescue Lehman Brothers in the absence of a buyer for the company. This explanation was always difficult to reconcile with the decision to bail out AIG two days later.

That is not the only issue to be considered. The failure of Lehman Brothers has many facets, and each of those is examined in the second part of the book. Much has been said about the ‘destruction of value’ in the financial press and academic analyses. Trillions of dollars ‘disappeared’ through plummeting asset prices and, as some would argue, the crisis entailed not the destruction of ‘real’ value but the exposure of fictitious or virtual capital and artificial value. The appointed examiner for the bankruptcy proceedings stated that ‘valuation is central to the question of Lehman's solvency’. That was the conclusion of his Report, which is over 2,200 pages, based on collecting over five million documents. An analysis of some of the key elements in the Report, as well as other documents and reports, leads to the conclusion that this is indeed the case.

However, this opens up the questions about what is meant by value when it comes to valuing assets and how that value is to be measured and explained. In Chapter 7 it is argued that the valuation of Lehman's real estate assets was problematic to say the least, as the regulators did not require the investment banks to adopt a recognized methodology of valuation, and that Lehman's own methods were flawed. Chapter 8 spells out the recognized methodologies and procedures for valuation that were available at the time and which, in effect, Lehman chose to either ignore or not apply in any rigorous way. Fuld and his team ignored the risks involved; his board was not in a position to monitor the risks involved in his aggressive ‘real estate’ programme and did not do so.

The underlying question is: what is meant by value in the context of a market? A brief look at contemporary theories of value suggests that they provide an inadequate explanation of the way in which assets are priced by the market, and especially the role of trust. The collapse of Lehman Brothers destroyed confidence, which is why the markets froze. There is no intrinsic or enduring value in any asset. Its value, and hence its price, is simply what the market will pay at any one time.

This is the second in my series of books on the financial crisis. The first was Fannie Mae and Freddie Mac: Turning the American Dream into a Nightmare. The distinctiveness of my approach is to describe the role of the major institutions in the events leading up to the crisis. Lehman Brothers has a specific role in that. It was the collapse of Lehman Brothers which, though not the sole cause of the crisis, was the trigger for it. The next book will examine the role of leading financial institutions and the regulators in the financial crisis and its aftermath.

Lehman Brothers

A Crisis of Value

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