1 - 16 Dec 2011 GLOBIS GRADUATE SCHOOL OF MANAGEMENT SEMINAR

Lehman Shock An Insiders Perspective
Jean-Paul LEBOUTET
GLOBIS UNIVERSITY SEMINARS, 16 December 2011
Jean-Paul Leboutet
French, born in Paris Married, 2 half children! H.E.C. (Finance)
8 major financial crisis 15 years in Bank Internal Audit 10 years in Corporate Strategy and General Management 15 years in Japan and Asia Advise entrepreneurs and investors as member of their
advisory boards, train professionals in finance

2
GLOBIS Seminar
: Lehman Shock, an Insiders Perspective
Objective of the Presentation
1.
Provide you with an insight on what happened to Lehman Brothers Draw some lessons for the future
1.
GLOBIS Seminar
1 What happened 2 Lessons for the future
1. What happened to Lehman Brothers: What the Lehman Shock was
Global interbank market froze, stocks and bonds fell Panic occurred
Banks dont know how much others own in or owe to Lehman Hundreds of thousands of deals are pending to be confirmed
Major banking systems - except Japan - ended in emergency rescue from their government by mid-October
GLOBIS Seminar
1. What happened to Lehman Brothers: 2 key factors
2 key factors led to collapse

a) b)
A unusual worldwide bubble exploded A very large bank with a unique culture was aggressively engaged in it
GLOBIS Seminar
1. What happened to Lehman Brothers: a) A unusual worldwide bubble
What is a Bubble ?
With a pile of debt, asset prices rise, but will necessarily fall.
Example of house loans (same for any investment):
At the beginning, borrowing is normal and nice In a second time, new borrowers and lenders are more aggressive and optimists
Savings My home Debt
GLOBIS Seminar
What is a Bubble ?
Types of mortgage loans (US definition): PRIME MORTGAGE: At least 10% of initial down-payment (equity), i.e. no more than 90% of the value of the property in loan Loan reimbursement + interests < 38% of disposable income Amount of the loan < ceiling defined by Federal regulation ALT - A MORTGAGE: Criteria close to prime mortgage, at least one qualifies
SUBPRIME MORTGAGE: Everything else: Large size investment, robust income growth prospect Low income families with good credit record NINJA: comes from nowhere, flies by night
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GLOBIS Seminar
What is a Bubble ?
With a pile of debt, asset prices rise, but will necessarily fall.
Example of house loans (same for any investment):
At the beginning, borrowing is normal and nice In a second time, new borrowers and lenders are more aggressive and optimists In the last phase, some borrowers fall in foreclosure, provoking a market downturn
Savings My home Debt
Too much debt in the market comes from? too low interest rates
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GLOBIS Seminar
Long term interest rates declined from 1995like while years? How didrates were maintained very low from 2001overshort interest rates look to 2011,to 2005 term
%
10 9 8 7 6 5 4 3 2 Fed Funds 1 day US Treasuries 10 Years Euro Benchmark 10 Years
1
0 Jan-91
Jan-93
Jan-95
Jan-97
Jan-99
Jan-01
Jan-03
Jan-05
Jan-07
GLOBIS Seminar
Why were interest rates so low and for so long in USA and Europe? 3 possible causes:
Tolerance for high inflation? NO Economic stimulus? Yes BUT not sustainable Continuous excess of capital inflows? YES
USA foreign current payments (trade, services, interests, dividends, etc)
accumulated deficits from 1990 to 2010: 7,386 billion $

China foreign reserves at end of 2010: 2,914 billion $ (34 billion $ in 1990) Japan foreign reserves at end of 2010: 1,096 billion $ (88 billion $ in 1990)
GLOBIS Seminar
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BUT THIS WAS NOT ALL:

Also a
deregulation process in financial services from 1998 onward.
- More competition in investment banking Commercial banks are allowed to enter - Less capital needed per $ of risk Regulators accept banks internal valuation models to assess capital needs
The bubble has been exacerbated and under-estimated. How?
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GLOBIS Seminar
Constant Lobby for
Deregulation
High Competition
Struggle to reduce Assets
Low Return on Assets
Asset creation & financial innovation

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GLOBIS Seminar
Continuous asset creation: insurance on insurance on insurance
Example:
Bank A wants to reduce its risk on corporate X; It purchases to Bank B an insurance (under a Credit Default Swap agreement); It pays a yearly premium, and will receive an agreed amount if corporate X defaults; Bank C has heard that bank B sells insurance (CDS) on corporate X; though it has no exposure to corporate X, it buys an insurance to bank B
13
GLOBIS Seminar
Constant Lobby for
Deregulation
High Competition
Struggle to reduce Assets
Low Return on Assets
Asset creation & financial innovation

14
GLOBIS Seminar
1.
2 key factors led to collapse:

a)
A unusual worldwide bubble due to:

Trade imbalances Low interest rates for tool long Easy
borrowing Leverage
Deregulation of financial sector Competition Lower yields
Asset creation
b)
A very large bank aggressively engaged
2.
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Lessons for the future

GLOBIS Seminar
1. What happened to Lehman Brothers:

b) A very large bank aggressively engaged
For the year 2006

Ranking by amount of new issues 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Global Bonds
Merrill Lynch JP Morgan Chase Goldman Sachs Citigroup Morgan Stanley Barclays Capital Lehman Br. Deutsche Bank Bank of America HSBC Credit Suisse Bear Stearns Wachovia RBC
US Bonds
JP Morgan Chase Citigroup Morgan Stanley Bank of America Lehman Br. Merrill Lynch Goldman Sachs Credit Suisse Deutsche Bank Barclays Capital Wachovia UBS HSBC Bear Stearns
Global Equity
Goldman Sachs Citigroup UBS Morgan Stanley Merrill Lynch JP Morgan Chase Credit Suisse Deutsche Bank Lehman Br. Nomura ABN AMRO Daiwa Bank of America Macquarie
US Equity
Goldman Sachs CItigroup Morgan Stanley Merrill Lynch Lehman Br. JP Morgan Chase UBS Bank of America Credit Suisse Deutsche Bank Wachovia Bear Stearns Jefferies (JP M) Piper Jeffrey
US MBS
Countrywide Washington Mut. Lehman Br. Residential Fund. Bear Stearns Wells Fargo Goldman Sachs Indy Mac New Century JP Morgan Chase Option One Fremont Morgan Stanley Credit Suisse
15
TD
BNP Paribas
BNP Paribas
Thomas Weisel
First Franklin
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GLOBIS Seminar

Lehman Brothers was a major actor, with 600 billion $ + in assets.
In the early 2000s already, market positions were close to 2006 level.
They were improved despite the emergence of universal competitors.
It means that in 2008 markets perceived it as too big to fail
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GLOBIS Seminar

Lehmans Brothers growth and fall 1994 ~ 2008
Million $
32000
Net income
Net revenues
Total stockholders' equity
27000
15% CAGR
22000 17000 12000 7000 2000 -3000
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007 Q2 2008
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GLOBIS Seminar

Growth in revenues and net income had been strong since floatation in 1994: in line with the sector but among the high performers Income per employee was second only to Goldman Sachs (30,000 employees) This meant both: faster market penetration, and faster asset turnover This reflects the strategy: grow faster than competitors to maintain independence as an investment bank.
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GLOBIS Seminar

b) A very large bank aggressively engaged,
with a unique culture
A large size and a high growth through the bubble are only part of the explanation for the collapse:
Before things turned really sour, problems were seen But not voiced well enough
And not heard:

A culture behind success and failure.
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GLOBIS Seminar

Problems, at least a large part of them, were seen

Example: Internal Audit
Alerted that the P&L was increasingly uncertain in 2006 and 2007
Called for a pause with growth for 2007 on sensitive areas

Questioned liquidity in the first half of 2007
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GLOBIS Seminar

But not voiced well enough

Internal audit allowed to be distracted by a different role It carried messages through technicalities Same for risk management, business development, etc.
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GLOBIS Seminar

Messages were not heard:

Governance proved deficient, so that remedy was late
How was Governance at Lehman Brothers?

Complying organization with external directors (high rating from ISS) Directors not meeting frequently enough Many in position for 15 years Feedbacks from audit committee reflect questioning but on internal
control systems more than risks and governance
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GLOBIS Seminar
1. What happened to Lehman Brothers

Culture turned out to be too much aligned. This is amazing, considering the diversity of employees.
Culture is the key to survival Fluid communication Absence of bureaucracy Strong success track record Strong selfconfidence Outlier personality LEHMAN YES YES YES YES YES GOLDMAN NO NO YES YES NO SSSB CITI NO ~YES NO NO NO SOCGEN NO NO NO YES NO
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GLOBIS Seminar
1.

a) b)
A unusual worldwide bubble A very large bank aggressively engaged

Too big to fail is not a buzz word Faster growth was not only a result but also a strategy Governance was too weak to hear warnings The culture ended working against the firm
2.
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GLOBIS Seminar
2. Lessons for the future: Have we learned anything? 3 concerns
2.

a)
A better detection and management of bubbles?
b)
c)
Reforms of the financial markets?

More efficient corporate governance?
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GLOBIS Seminar
2. Lessons for the future: a) Detection and management of bubbles?
Bubbles repeat The use of simple graphs and rules of thumb should guide But the issue now is different Countries debt
Country
USA UK Germany France
% of GDP in bail out of the financial system and stimulus 2008

50% 25% 20% 20%
Hence, high risk of recession in 2012 and of inflation later on The next bubble seems far awayexcept in emerging countries?
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GLOBIS Seminar
In Real Estate, a bubble most probably BRICs account for 18% of the world GDP (USA + EU + Japan: 58%)
Russia house price index Brazil house price index
India house price index
China house price index
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GLOBIS Seminar
In Stock markets this is less obvious BRICs account for 18% of the world GDP (USA + EU + Japan: 58%)
BRAZIL IBOVESPA
80000 70000 60000 50000 40000 30000 20000 10000 0 3000 2500 2000 1500 1000 500 0
RUSSIA RTSI
MUMBAI SENSEX
25000 20000 15000 10000 5000 0 7000 6000 5000 4000 3000 2000 1000 0
SHANGHAI Composite
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GLOBIS Seminar
2. Lessons for the future: b) Reform of financial markets?
A good point: some key weaknesses in bank accounting have been addressed Many donts in the financial markets have been listed But no key text is yet implemented momentum has been lost And large banks now need time before being able to absorb more stringent rules on capital and asset valuation Once again, priority is now how to carry bank losses through national debt without depressing the economy too much
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GLOBIS Seminar
2. Lessons for the future: c) Better Corporate Governance?
In this context, confidence will come back only with better governance:
Tax payers must learn that regulators are not the last resort insurer: they are It is better to claim transparency than require piles of reporting
Investors must learn that a diligent and capable board cannot work without proper information. So governance starts with, but goes beyond the composition of a board.
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GLOBIS Seminar
2. Lessons for the future: c) Better Corporate Governance
Governance is the windshield for both Management and Shareholders
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GLOBIS Seminar
1.

a) b)
A unusual worldwide bubble A very large bank aggressively engaged
2.

a) b) c)
With the national debt problems we may forget what a bubble is Reforms in regulation have lost momentum Corporate Governance is key
33
GLOBIS Seminar

1 - 16 Dec 2011 GLOBIS GRADUATE SCHOOL OF MANAGEMENT SEMINAR

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Lehman Shock An Insiders Perspective

GLOBIS UNIVERSITY SEMINARS, 16 December 2011

advisory boards, train professionals in finance

: Lehman Shock, an Insiders Perspective

Objective of the Presentation

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: What the Lehman Shock was

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: 2 key factors

2 key factors led to collapse

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: a) A unusual worldwide bubble

Savings My home Debt

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: a) A unusual worldwide bubble

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: a) A unusual worldwide bubble

Savings My home Debt

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: a) A unusual worldwide bubble

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: a) A unusual worldwide bubble

accumulated deficits from 1990 to 2010: 7,386 billion $

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: a) A unusual worldwide bubble

BUT THIS WAS NOT ALL:

deregulation process in financial services from 1998 onward.

The bubble has been exacerbated and under-estimated. How?

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: a) A unusual worldwide bubble

Constant Lobby for

Struggle to reduce Assets

Low Return on Assets

Asset creation & financial innovation

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: a) A unusual worldwide bubble

Continuous asset creation: insurance on insurance on insurance

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: a) A unusual worldwide bubble

Constant Lobby for

Struggle to reduce Assets

Low Return on Assets

Asset creation & financial innovation

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: 2 key factors

2 key factors led to collapse:

A unusual worldwide bubble due to:

A very large bank aggressively engaged

Lessons for the future

: Lehman Shock, an Insiders Perspective

1 What happened 2 Lessons for the future

1. What happened to Lehman Brothers: