Lehman’s internal board minutes show the bank’s leadership failing to grasp the situation as ‘quantifiable risk’ turned into genuine uncertainty
The author has asked for their identity to be withheld
I’d been working in investment banking in the United States, and more particularly in fixed income/asset backed-lending, for a number of years prior to the onset of the financial crisis. At the time of the Lehman bankruptcy in 2008 I worked for a large competitor bank who had a very specific interest in Lehman’s outcome, and so had some first-hand insight into the last days before it collapsed.
On the Friday before the Lehman bankruptcy, I had been tasked with assigning market values to esoteric assets for which – at that time – there was no such thing as a market. Only weeks previously, those same assets had been considered much less esoteric and much more mundane: not as liquid as treasuries, but, by their spreads, not that far off.
My defining recollection of the crisis is sitting in a conference room with not very much time and a lot of assets to value as the banking sector teetered. At that time there was no meta-realisation of quite what we were truly dealing with. We were trained to ascribe values based on measurable, probabilistic risks, but we were confronted with a situation of pure Knightian uncertainty – something not measurable other than at the lower bound where an asset is effectively worthless. The contrast between the mundanity of this exercise and the momentousness of events outside did not register at the time. Values had to be assigned and we were pragmatists. We ran our analysis, arrived at some numbers, and that was that.
I was only a small cog in a much larger securitization/CDO, originate-to-distribute business. We were more concerned with the mechanics of numbers, spreadsheets, and, in the loosest sense of the word, ‘values’. But in the Lehman boardroom those meta-, or even philosophical, questions about the nature of risk relative to uncertainty, must have been defining distinctions. Strategies were being built around them in real time, although they are perhaps not the strategies we would expect.
I have since transitioned out of banking and into a mixture of consulting and academic research. Part of that research has focused on how corporate governance works in practice versus theory – about the disconnect between the process and the behaviours.
Lehman Brothers board minutes (made public along with much other correspondence as part of the post-crisis inquiry) provide an illuminating story about the inefficacy of those corporate governance arrangements. The minutes provide a sanitised, but no less interesting insight on board-level reconciliation to these questions of risk and uncertainty – they give us perhaps as close an inside look into the decline of an investment bank as we are likely to get from ‘official’ documents. Did board members influence the strategic direction of a firm at a time of crisis, or were they just ‘meat in the room’ to borrow Armando Iannucci’s fantastic phrase from his film ‘In The Loop’? Although board minutes are by no means transcripts, the dominance of Richard Fuld, Chairman and Chief Executive at the time of Lehman’s collapse, and the timidity of the board members are there to see: Fuld accounted for 63% of all reported board discussion, with the Chairman of the Compensation and Benefits Committee accounting for a further 13%.
The board minutes also reveal several phases of concern as Lehman’s parlous financial state became more apparent.
The first phase was denial. The minutes show concern about the signals Lehman might send to the market, but an unqualified confidence about the Lehman’s broader underlying security:
“I don’t think we can issue converible [sic] now, especially after Countrywide. This will signal a major stress sign (which obviously isn’t true and will feed into rimors [sic].”
This denial formed part of a broader boardroom detachment and hubris where Lehman’s vulnerability could not be acknowledged – they were, after all, better than that:
“Any potential investor that would consider BS [Bear Stearns] in the same breath as LB [Lehman Brothers] should go fungoo themselves!!!”
A second phase was frustration and blame: Lehman’s problems were viewed as a market perception problem, not a balance sheet problem. The diverging perceptions of the market and the boardroom resulted in some interesting investor calls:
“As I mentioned on telephone, I come away from our conversation Friday…feeling you have been very disingenuous… my goal was to have an open dialogue with you and help you get a better understanding of some of the facts.”
To which, the (now) less than friendly short-seller responds;
“I suspect that your claim that I have been “disingenuous” stems from your own knowledge that you may have made untrue statements …You and your management seek and receive press for your expert crisis management skills – which from my perspective mostly means denying the reality”.
A third phase was acceptance. It brought with it a reconciliation with the world of Knightian uncertainty, but a recognition that they were – as an institution – too big to fail. The board changed tack, realising that the catastrophe you may visit upon the world may become your strongest hand to play. Hence;
“[redacted] expressed the view that the Federal Reserve needs to provide lending facilities, as a wind-down would not be orderly. [redacted] stated that the Firm’s bargaining chip is the systemic risk from its default. [redacted] responded and indicated that the systemic risk issue had been emphasized to the Federal Reserve and that the Federal Reserve is very much aware of it”
Or more directly: “(f)rustration was expressed about the Firm being “over a barrel” – with the Firm’s negotiating leverage being the systemic risk…”
A fourth and final phase involved bravely trying to avoid personal loss:
“[redacted] also reported that the Committee is considering changing the annual equity retainer component of Director compensation starting in 2009, to base the annual equity retainer on a fixed dollar value rather than a fixed number of shares in order to eliminate the volatility in Director compensation arising from fluctuations in the Firm’s stock price.”
It goes without saying that the consequences of the events at Lehman had very significant effects on the lives of many that were in no way connected with the arcane workings of a global investment bank.
But, as I cast my mind back all of those years ago, what I recollect is that, at least in the firm that I worked for, we weren’t looking to load one boat full of ‘toxic assets’, then happily cast off from that on the luxury yacht we’d bought with the proceeds. We thought we were dealing with quantifiable risk, as I suspect did those beneath the board at Lehman and elsewhere. But when that ‘risk’ turned into genuine uncertainty, then we really were navigating uncharted waters and reaching out for anything that could help us steer a course.