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A 2,200 report page-turner
Mar. 13th, 2010 06:10 pmWill Anton Valukas go down as one of the heroes of the decade? I think that he should. This Chicago lawyer has written a report, all the more damning for being written by an insider, that rips open the current scandals in business, auditing and the legal profession. And, apparently, it's a well-written narrative. It's not often that I'n tempted to go out to buy a 2,200-page report, but I am with this one.
Compare what Valukas has done with the kind of shit that would have appeared in the UK if the Serious Fraud Office had been in charge. It would have taken 10 years; it would have been as dull as ditchwater, and it would have fudged. Valukas has produced a report within 18 months; it doesn't fudge, and it names names. Top man!
There's so much that I would love to write about this. But first, the simple facts about what Lehman Bros did that was wrong.
1) Every three months, Lehman "sold" securities to certain counterparties, in return for cash. Now, securities can go down in value, whereas cash is, well, cash is the measuring stick that accountants use. If you have a billion dollars worth of Anton-staxty megaplax loans, it isn't worth a billion dollars, because the borrower might default and the collateral might not fetch as much as the loan. If you have a billion dollars in cash, then it's cash.
So, Lehman noticed some time in 2001 that its leverage was a bit high -- i.e., its capital didn't really cover its securities. The repo market is simple. You often need some ready cash. You have some illiquid securities. So you borrow some cash and use the securities as collateral. What Lehman did instead was sell the securities, with the side-agreement that it would buy the "illiquid" securities back after the quarterly figures. This created an illusion of more cash and fewer things that might blow up in your face. Your "gearing" was reduced. You appeared to be a less risky company than you actually were. Lehman did not tell anyone about this, not even its auditior, Ernst & Young.
As time went on, the amount that was being parked outside the company every quarter increased. By early 2008 it had reached the stage that, had Lehman not been parking securities outseide the company, it would have been declared insolvent. But this was not what bankrupted Lehman -- what it did was postpone the dread date.
Now, as you know, knowingly trading while insolvent is a criminal act. So, although these "false sales" might be what sends some people to jail, they weren't the cause of the disaster. For that, we have to go to:-
2) Value-at-risk requires stress-testing. These are sophisticated modelling techniques that basically work out what chances there are of you blowing up. Lehman Bros excluded its main real-estate investments, its private equity investments, and its leveraged loans backing management buyouts, from its stress-testing.
In May 2007 a $2.3bn bridge loan was made for the buyout of Archstone-Smith Real Estate Investment Trust. Anyone looking at the mortgage market at the time would have said that this had a serious risk of blowing up. But not in the land of Lehman, where "bricks and mortar" was counted at 100%.
The death of Lehman effetively became a certainty in March 2008, when Bear Stearns went under. I didn't know this, You didin't know it. Ernst & Young didn't know it (although, if they had looked a bit harder, they could have). The Bear Stearns collapse turned Lehman's illiquid assets into stuff that it couldn't offload. The rating agencies looked at Lehman's balance sheet and said that it had to reduce its gearing if it wanted to maintain its rating. But Lehman couldn't reduce its gearing without booking large losses, and it couldn't book those large losses, because these were not included in the stress-testing. What to do?
Its solution was to ramp up the false Repo deals. Internal memos show frantic pleas from fund managers as the end of each quarter approached. It will be this period from March 2008 to September 2008 that will likely play out in the courts, but it was Lehman's actions from 2006 on, when the smart money was getting out of the US housing bubble, but Lehman was getting in, that caused the collapse. Unfortunately, being a crap judge of the market is not illegal. Concealing the fact that you are a crap judge of the market is distinctly dodgy.
And here we come to Dick Fuld, one-time Lehman dictator and now probably not welcome anywhere south of 128th street. "Did Dick know?" Well, Valukas has to look at facts, and refers to emails from Lehman's Bart McDade to Fuld in March 2008, with attachments that refer to the fake Repos. Fuld's lawyer is claiming that Fuld did not use a computer and that he didn't know how to open attachments. A possible smoking gun is the June 2008 meeting, where Bart McDade, by now COO, claims that he walked Fuld through the fake Repos, and that Fuld said that, if it was necessary, it should be done.
++++++++
But this is just the Lehman side of things. Two other operations do not come out of this smelling of roses -- the auditor and the legal firm.
Ernst & Young is the auditor and, once again, it plays the standard auditor card. Its key statement is that, on its report to November 2007
Two issues arise from this. Note that E&Y does not write that "Lehman's financial statements for the year were fairly presented". But, more important, we are told that, although Lehman Bros kept these fake Repos secret from E&Y, E&Y was told of these transactions by a whistleblower. It chose not to investigate these allegations. It was a "see no evil, hear no evil" approach.
Ernst & Young won't go the way of Arthur Andersen over this. It will cite "the letter of the law" and will get away with it. However, the more diligent accountants in the world are beginning to realize that just saying "we followed the rules; it's not our job to be detectives", just might not cut it in future.
The legal firm is Linklaters, and here we have a situation which shows up how much legal firms deal with "the law" and not "justice". it's worse than that; when the two conflict, the legal firm must go with the law.
No US legal firm would sign off on Lehman's fake Repos. In effect the US lawyers said that it was the spirit of the transaction rather than the paperwork that mattered. Clearly the spirit of the transaction was a loan, not a true sale. So they refused to sign off the deal.
Not to be put off, Lehman went to the UK. English law was not so fussy. Linklaters said that, sure, it was fine under English law. So Lehman Bros conducted the Fake Repo deals through its European subsidiary.
Linklaters actually seems genuinely surprised that Valukas has singled it out. It said that Valukas hadn't consulted them (but, well, why should he have? What difference would it have made, apart from delaying the release of the report?). And, blind to the concept of morality (as is the case with most lawyers), it simply said that it had been asked a quesion on a point of law, and had given its opinion on that point of law. It was not Linlaters' job to question why Lehman Bros, a US firm, had come to a UK firm to ask about the legality of a transaction in the UK. A child would have spotted that the only reason for Lehman to do this would be if US lawyers had told them that it was a no-go in the US, but Linklaters would claim that this was not its concern. The wider moral compass is irrelevant to a law firm and (and this is the frightening point), this is how it thinks it should be. Linklaters will never, ever, be able to see why it might come in for some criticism, because, as far as Linklaters is concerned, it was just doing its job.
Meanwhile, the real world sees a collection of dodgy lawyers in a dodgy country that lets companies get away with murder.
As Peston puts it this morning:
Compare what Valukas has done with the kind of shit that would have appeared in the UK if the Serious Fraud Office had been in charge. It would have taken 10 years; it would have been as dull as ditchwater, and it would have fudged. Valukas has produced a report within 18 months; it doesn't fudge, and it names names. Top man!
There's so much that I would love to write about this. But first, the simple facts about what Lehman Bros did that was wrong.
1) Every three months, Lehman "sold" securities to certain counterparties, in return for cash. Now, securities can go down in value, whereas cash is, well, cash is the measuring stick that accountants use. If you have a billion dollars worth of Anton-staxty megaplax loans, it isn't worth a billion dollars, because the borrower might default and the collateral might not fetch as much as the loan. If you have a billion dollars in cash, then it's cash.
So, Lehman noticed some time in 2001 that its leverage was a bit high -- i.e., its capital didn't really cover its securities. The repo market is simple. You often need some ready cash. You have some illiquid securities. So you borrow some cash and use the securities as collateral. What Lehman did instead was sell the securities, with the side-agreement that it would buy the "illiquid" securities back after the quarterly figures. This created an illusion of more cash and fewer things that might blow up in your face. Your "gearing" was reduced. You appeared to be a less risky company than you actually were. Lehman did not tell anyone about this, not even its auditior, Ernst & Young.
As time went on, the amount that was being parked outside the company every quarter increased. By early 2008 it had reached the stage that, had Lehman not been parking securities outseide the company, it would have been declared insolvent. But this was not what bankrupted Lehman -- what it did was postpone the dread date.
Now, as you know, knowingly trading while insolvent is a criminal act. So, although these "false sales" might be what sends some people to jail, they weren't the cause of the disaster. For that, we have to go to:-
2) Value-at-risk requires stress-testing. These are sophisticated modelling techniques that basically work out what chances there are of you blowing up. Lehman Bros excluded its main real-estate investments, its private equity investments, and its leveraged loans backing management buyouts, from its stress-testing.
In May 2007 a $2.3bn bridge loan was made for the buyout of Archstone-Smith Real Estate Investment Trust. Anyone looking at the mortgage market at the time would have said that this had a serious risk of blowing up. But not in the land of Lehman, where "bricks and mortar" was counted at 100%.
The death of Lehman effetively became a certainty in March 2008, when Bear Stearns went under. I didn't know this, You didin't know it. Ernst & Young didn't know it (although, if they had looked a bit harder, they could have). The Bear Stearns collapse turned Lehman's illiquid assets into stuff that it couldn't offload. The rating agencies looked at Lehman's balance sheet and said that it had to reduce its gearing if it wanted to maintain its rating. But Lehman couldn't reduce its gearing without booking large losses, and it couldn't book those large losses, because these were not included in the stress-testing. What to do?
Its solution was to ramp up the false Repo deals. Internal memos show frantic pleas from fund managers as the end of each quarter approached. It will be this period from March 2008 to September 2008 that will likely play out in the courts, but it was Lehman's actions from 2006 on, when the smart money was getting out of the US housing bubble, but Lehman was getting in, that caused the collapse. Unfortunately, being a crap judge of the market is not illegal. Concealing the fact that you are a crap judge of the market is distinctly dodgy.
And here we come to Dick Fuld, one-time Lehman dictator and now probably not welcome anywhere south of 128th street. "Did Dick know?" Well, Valukas has to look at facts, and refers to emails from Lehman's Bart McDade to Fuld in March 2008, with attachments that refer to the fake Repos. Fuld's lawyer is claiming that Fuld did not use a computer and that he didn't know how to open attachments. A possible smoking gun is the June 2008 meeting, where Bart McDade, by now COO, claims that he walked Fuld through the fake Repos, and that Fuld said that, if it was necessary, it should be done.
++++++++
But this is just the Lehman side of things. Two other operations do not come out of this smelling of roses -- the auditor and the legal firm.
Ernst & Young is the auditor and, once again, it plays the standard auditor card. Its key statement is that, on its report to November 2007
"Lehman's financial statements for that year were fairly presented in accordance with generally accepted accounting principles".
Two issues arise from this. Note that E&Y does not write that "Lehman's financial statements for the year were fairly presented". But, more important, we are told that, although Lehman Bros kept these fake Repos secret from E&Y, E&Y was told of these transactions by a whistleblower. It chose not to investigate these allegations. It was a "see no evil, hear no evil" approach.
Ernst & Young won't go the way of Arthur Andersen over this. It will cite "the letter of the law" and will get away with it. However, the more diligent accountants in the world are beginning to realize that just saying "we followed the rules; it's not our job to be detectives", just might not cut it in future.
The legal firm is Linklaters, and here we have a situation which shows up how much legal firms deal with "the law" and not "justice". it's worse than that; when the two conflict, the legal firm must go with the law.
No US legal firm would sign off on Lehman's fake Repos. In effect the US lawyers said that it was the spirit of the transaction rather than the paperwork that mattered. Clearly the spirit of the transaction was a loan, not a true sale. So they refused to sign off the deal.
Not to be put off, Lehman went to the UK. English law was not so fussy. Linklaters said that, sure, it was fine under English law. So Lehman Bros conducted the Fake Repo deals through its European subsidiary.
Linklaters actually seems genuinely surprised that Valukas has singled it out. It said that Valukas hadn't consulted them (but, well, why should he have? What difference would it have made, apart from delaying the release of the report?). And, blind to the concept of morality (as is the case with most lawyers), it simply said that it had been asked a quesion on a point of law, and had given its opinion on that point of law. It was not Linlaters' job to question why Lehman Bros, a US firm, had come to a UK firm to ask about the legality of a transaction in the UK. A child would have spotted that the only reason for Lehman to do this would be if US lawyers had told them that it was a no-go in the US, but Linklaters would claim that this was not its concern. The wider moral compass is irrelevant to a law firm and (and this is the frightening point), this is how it thinks it should be. Linklaters will never, ever, be able to see why it might come in for some criticism, because, as far as Linklaters is concerned, it was just doing its job.
Meanwhile, the real world sees a collection of dodgy lawyers in a dodgy country that lets companies get away with murder.
As Peston puts it this morning:
So Lehman obtained an "opinion letter" from Linklaters in London that said the relevant deals were permissible under English law - and the relevant transactions that hid the assets were then conducted through Lehman's London operations.
There's no suggestion that this was illegal or in breach of any rules.
But some would say it is unedifying that the deals that buried the $50bn of assets were not permissible on Wall Street but could be done in London.
.
++++++
Most people are comparing this to Enron, which also used various tricks to move stuff offf its balance sheet. But I am more reminded of two insurance cases. The first was HIH, which went bust in Australia around 2001, shortly after buying FAI. FAI's books looked much better than they should have, because it booked fake reinsurance deals.
These "financial reinsurance" deals (with a subsidiary of Berkshire Hathaway) were in essence exactly the same as the fake Repo deals. You theoretically take risk off your books via reinsurance, but in fact there is a secret agreement that the reinsurer will not really bear any of the risk and that this is really just a loan.
This was followed by AIG's "book-balancing" under which similar deals were signed with General Re, which is, yes, a subsidiary of Berkshire Hathaway. Five people went to jail over this, including AIG's head of reinsurance Chris Milton. AIG's boss to 2004, Hank Greenberg, has long maintained that the deals were legal and that they just served to smooth AIG's numbers rather than falsify them. But they did "shift risk" off the books, with the understanding that the risk was never really transferred.
++++++++
There's a common theme to this -- that being the hiding of risk. Accounting procedures are very bad with risk. That leaves room for loopholes. This is not quite the same as Enron, which was a blatant fraud. Lehman Bros wasn't a fraud, not until post-March 2008. But it was was too risky for its capital. Fuld, being the man that he is, didn't want to be bothered with such niceties as capital requirements, simply because, so long as things didn't blow up, it wouldn't matter.
So, you "hide" the risk. This is not the same as hiding a fraud, because in a sense you are hiding a secret roll of the dice. So long as a six doesn't come up, you make money. The problem is, accountants (and the law) would say "ahh, but what if a six does come up. You must have the capital in reserve to cope with that". Fuld would say "Fuck it, I'm a master of the universe. A six won't come up".
Yup, it's the "masters of the universe" thing again. It's the degenerate gambler thing again. It's the urge to fight a war with God again.
This problem will not go away because it is this kind of cutting corners that creates the big winners in the first place. No-one got to be top of the tree in capitalism by saying "hmm, but what if....?" You get to the top of the tree by taking the gamble and assuming that it will come out okay.
So, for the people who get to the top of the tree, they are the lucky ones for whom it did turn out okay, and they stop believing that they are lucky and start believing that they can do things that ordinary mortals can't. And for that reason, the laws of accounting that apply to ordinary mortals should not apply to them, because they are different
Except they aren't. As Taleb has observed, and also as an old episode of the X-Files once observed, pure laws of chance dictate that a very few people will be very very lucky for a very long time. But that doesn't mean that they will carry on being lucky.
I hope that Fuld enjoys his retirement, and I am really looking forward to Ernst & Young's defence in court.
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