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Lehman Brothers

A Crisis of Value

Oonagh McDonald

This book explains 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 book argues 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' long history began with three brothers, immigrants from Germany, who sold selling groceries and dry goods to local cotton farmers. 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. The book examines the regulation of the Big Five investment banks in the context of the changes which took place in the structure of banking after the repeal of the Glass-Steagall Act. It describes the introduction of the European Union's Consolidated Supervision Directive in 2004. The book examines the whole issue of valuing Lehman's assets and details the regulations covering appraisals and valuations of real estate, applicable at the time and to consider Lehman's approach in the light of these regulations. It argues that 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.

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Oonagh McDonald

Five investment banks, only to banks regulated by the agencies: the Office of the Comptroller of the Currency (OCC), the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of Thrift Supervision (OTS). That left another regulatory gap. The SEC did not examine the real estate risks Lehman ran, lacking a mandate and regulations to do so. In other words, it was not the process of bankruptcy that destroyed value. Lehman's real estate assets did not have the value the company had attached to them. Ultimately, the value of the derivatives

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Oonagh McDonald

balance sheet risk, reinforcing our focus on our client-facing business and returning the Firm to profitability. 1 The early announcement included an increase in total stockholders' equity of $28.4bn, up from $26.3bn, an estimated liquidity pool of $42bn, and plans to sell a majority stake in its asset management unit. Lehman also revealed that it would separate off a ‘vast majority of the firm's commercial real estate assets from our core business by spinning off those assets to our

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Oonagh McDonald

confidence because it made a series of business decisions that left it with a heavy concentration of illiquid assets of deteriorating value in commercial and residential real estate. He found that the policies Lehman followed were in error, but that they fell within the ‘business judgement rule’. However, the decision not to disclose the effects of those judgements does give rise to colorable claims against senior officers who oversaw and certified misleading financial statements – Richard Fuld and its Chief Financial Officers

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Oonagh McDonald

8 Measuring Value Previous chapters have set out the ways in which Lehman Brothers sought to value its assets and to hide its losses. Professional standards for the valuation of commercial and residential real estate existed at that time, but as the bankruptcy Examiner Valukas demonstrates in his report, Lehman showed little interest in conforming to them or hiring those who knew how to apply them. Against that background it can be seen that the bankruptcy process did not itself cause the destruction of value, although it

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From Hubris to Nemesis

January to September 2008

Oonagh McDonald

mortgage and asset-backed securities, about $3.5bn in commercial mortgages and $2bn in leveraged loans, but these were offset by hedging benefits of approximately $7.5bn, although some of the hedging had not been as beneficial as expected. Hedging would be continued. Lehman also disclosed that its liquidity pool had increased from $35bn to $54bn, decreasing its gross assets by $130bn by the end of May. As a result, its exposure to mortgages and real estate investments decreased by 15–20 per cent, while its exposure to leveraged business was 35 per cent lower. 6

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Oonagh McDonald

-backed securities, but in 2006 Lehman started to retain the assets, both residential markets and commercial real estate, as its own assets. The risk and return remained with Lehman. The effects of this policy were that Lehman had to continually roll over its debt because of the mismatch between short-term debt and long-term illiquid assets. The company had to borrow billions of dollars on a daily basis. Its business risk was increased because of its investments in long-term assets – residential and, especially commercial real estate, private equity and

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Thailand

Crisis, reform and recovery

Shalendra D. Sharma

with lower interest rates abroad encouraged Thai investors to tap foreign funds aggressively and without hedging, and then to speculate in local real estate, securities and other baht-denominated assets. For external investors, Thailand’s exchange-rate stability (given the fact that the baht was pegged to the dollar) and booming growth rates offered a profitable venue for interest arbitrage and speculation. As Gilpin (2000, 145) notes, “anticipating strong economic growth and believing that their investments were secure, foreign banks, hedge funds, and other financial

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Indonesia

Crisis, reform and recovery

Shalendra D. Sharma

found its way into the non-tradeable sector and, in particular, real estate. As Dominique Fischer (2000, 225) notes, “from an almost non-existent stock in 1987, modern office space grew to 2.8 million square meters, shopping centers reached 1.2 million square meters and the stock of luxury condominiums was estimated at 15,000 units.” Such aggressive development only fueled speculative overbuilding, particularly in Jabotabek, or the greater Jakarta area.7 Why real estate? The surge in private capital inflows relative to the size of the equity market quickly drove equity

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Oonagh McDonald

Commission, Miller provided more of the background to ‘Armageddon’. On 15 September 2008, Lehman was party to over 10,000 derivatives contracts relating to about 1.7 million transactions, and a major participant in hundreds of substantial real estate and loan transactions. To a limited extent, Barclays' purchase of Lehman's North American Capital Markets business to BarCap for $1.75bn plus $250m. in cash for its trading assets valued at $72bn and trading liabilities worth $68bn, within five days of the beginning of bankruptcy proceedings, helped. Miller described the sale