Reckless Drivers at Lehman Brothers

Today, the U.S. House Financial Services Committee will conduct a hearing to examine the failure of Lehman Brothers. One of the panelists slated to testify is the bankruptcy court appointed examiner, Anton R. Valukas.  Mr. Valukas will testify that like many financial services firms, Lehman Brothers had a robust risk management program.  However, Lehman Brothers' fatal flaw was the fact that it routinely overrode the risk controls and limits to achieve greater short-term profits.  Here is what Mr. Valukas found.

We conducted an extensive investigation to learn how Lehman managed, monitored and limited its exposure to risk. Lehman had adequate corporate governance procedures in place. It had quantitative risk models that accurately calculated risk and that accurately warned that Lehman was taking on significant levels of risk in excess of the limits generated by the models. Lehman’s procedures included reporting of the limits, and exceedances of the limits, to senior management and the Board.

But we found that Lehman was significantly and persistently in excess of its own risk limits. Lehman management decided to disregard the guidance provided by Lehman’s risk management systems. Rather than adjust business decisions to adapt to risk limit excesses, management decided to adjust the risk limits to adapt to business goals.

Much like a reckless driver who consistently exceeds speed limits and other traffic laws, Lehman Brothers eventually crashed.  In the short-term, the reckless driver may get to his/her destination quicker.  However, it is at the risk of not only his/her own life, but also the lives of everyone else in the way.

Ignoring Risk Management at Lehman Brothers

The court appointed examiner for the Lehman Brothers bankruptcy case issued its final report yesterday.  The report provides some interesting insight into the final months of the firm's existence.  Most notable are the firm's efforts to shift massive exposures off of its balance sheet to prevent credit rating downgrades.  At the same time, the firm ignored its own risk management limits as it continued to pursue a high growth strategy. Here is what the examiner noted in the report.

In 2006, Lehman made the deliberate decision to embark upon an aggressive growth strategy, to take on significantly greater risk, and to substantially increase leverage on its capital. In 2007, as the sub‐prime residential mortgage business progressed from problem to crisis, Lehman was slow to recognize the developing storm and its spillover effect upon commercial real estate and other business lines. Rather than pull back, Lehman made the conscious decision to “double down,” hoping to profit from a counter‐cyclical strategy. As it did so, Lehman significantly and repeatedly exceeded its own internal risk limits and controls.

While many critics like to point the finger at the failure of risk management in the financial crisis of 2008, more evidence is pointing to the fact that it was the failure of management to acknowledge the risks that were made apparent by risk management practices.