Monday, December 14, 2009

Buffett Avoids the Lehman Brothers Bullet - Alpha

In a WSJ article this weekend (Scott Patterson, "In Year of Investing Dangerously, Buffett Looked 'Into the Abyss'", WSJ, DECEMBER 14, 2009), Warren Buffett claims he had a mediocre year in 2008, where his best deals were bad deals he avoided. He says: "I made plenty of mistakes," he says. "I didn't maximize the opportunities offered by the chaos. But in the end, it worked out OK."

As one example of a well-missed deal, Buffett avoided investing in Lehman Brothers Holdings before it went bust. Attached as a pdf, the WSJ published Buffett's scribbles on Lehman's 10-K, where Buffett noted pages where he found problematic items. The 10-K is here (and if you go to the "Print Preview" mode in Firefox, the page numbers approximately correspond to Buffett's notes):

Also, for the concerns that the short seller David Einhorn, of Greenlight Capital, had with Lehman Brothers, here see Einhorn's speech at the Ira Sohn conference in May 2008:

Below are some comments on what I believe Buffett found troubling, given his notes/scribbles:

1) LIQUIDITY POOL FUNDING INADEQUATE: Lehman's Liquidity pool (to cover expected cash outflows for the next 12 months, in a stressed environment), is only sized for a ratings downgrade of one notch (compare to Enron and Dynergy, who suffered multiple notch downgrades in the early 2000s, as wholesale funding ran out and the fell into a vicious circle of downgrades and fleet-footed funding).

2) LEHMAN's BOGUS LEVERAGE RATIO: Lehman has a bogus "net leverage ratio", where it reduces debt and increases equity to make leverage look lower. The actual leverage ratio is horrible. For example, the net leverage ratio only increased from 14.5x to 16.1x from 2006 to 2007 (11%), but the real leverage ratio increased from a shocking 26.2x to 30.7x (17%). Only Fannie and Freddie, of major financial entities, have higher leverage ratios (and note they went bust a few weeks before Lehman). Here is their definition and the table:

Lehman's "go-for-bust" definition of a leverage ratio:
"Our net leverage ratio is calculated as net assets divided by tangible equity capital. We calculate net assets by excluding from total assets: (i)cash and securities segregated and on deposit for regulatory and other purposes; (ii) collateralized lending agreements; and (iii) identifiable intangible assets and goodwill. We believe net leverage based on net assets to be a more useful measure of leverage, because it excludes certain low-risk, non-inventory assets and utilizes tangible equity capital as a measure of our equity base. We calculate tangible equity capital by including stockholders’ equity and junior subordinated notes and excluding identifiable intangible assets and goodwill. We believe tangible equity capital to be a more meaningful measure of our equity base for purposes of calculating net leverage because it includes instruments we consider to be equity-like due to their subordinated nature, long-term maturity and interest deferral features and we do not view the amount of equity used to support identifiable intangible assets and goodwill as available to support our remaining net assets. These measures may not be comparable to other, similarly titled calculations by other companies as a result of different calculation methodologies."

3) LEHMAN's CONDUIT: A conduit is a structure where a bank borrows short-term to lend long-term to poor credit-risks using highly illiquid assets as collateral. A very bad idea - some major banks in Germany were ruined by their conduits, and Citigroup had to tap dance like an elephant to overcome its conduit and VIE exposure. Overall, Lehman's $2.4bn conduit isn't that large (but it's basically an off-balance sheet liability).

4) LEHMAN's ACCOUNTING FOR PENSION LIABILITIES: Under SFAS 158, it seems Lehman underreserved for what it's pension liability would be. For 2007, that would have lowered earnings by $210mn. A drop in the bucket given other concerns.

5) LEHMAN's MBS AND ABS EXPOSURES: Lehman (almost proudly) states:
"We originated approximately $47 billion and $60 billion of residential mortgage loans in 2007 and 2006, respectively, and approximately $60 billion and $34 billion of commercial mortgage loans in 2007 and 2006, respectively."
The question is, how much of this did Lehman sell to suckers in other countries, and how much did they keep on their balance sheet? Ouch! The inventory from the past few years, which they kept, is quite high (and the subprime stuff is worth pennies on the dollar):

6) LEHMAN's DERIVATIVES BOOK: This is basically a black box, as over-the-counter derivatives are valued by Lehman itself. Lehman's total derivatives contract book is a stunning $738bn. Buffett writes elsewhere: "Like Hell, both [reinsurance and derivative contracts] are easy to enter and almost impossible to exit." Hence Lehman can sell an OTC derivative to a counterparty and book a $50mn profit, while the other side can also book a $50mn profit (traders on both sides get year end bonuses on these gains). But one side is wrong, and you only find out years and years later with massive losses, as Buffett laments about his General Re acquisition here (see the "Derivatives" section on page 13): (this is also pasted in the most recent post on this blog). Buffett's final comment: "When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running." (If that's true, Mr. Buffett, why buy convertible debt in GE and Goldman Sachs?)

7) LEHMAN's ASSET LIABILITY MISMATCH PER ITS FAIR VALUE TABLE: All financial firms need to list the liquidity level of their assets, per the accounting rule SFAS 157 on Fair Value. Assets at Level 1 are very liquid and easy to value, wheras Level 3 are illquid and hard to value. Lehman has many Level II and Level III assets (~$219bn are Level 2 and 3 out of $291bn total ), but the liabilities behind these assets are Level 1 ($109bn out of $149bn total). Hence, wholesale funders can ask for their money back but Lehman can't sell assets to pay them (this is how Lehman actually went bust). To be fair to Lehman, all the big broker-dear/money center banks had this problem (all banks do, to some extent). It's just that Lehman was swimming much more naked than the rest (and didn't have a former CEO as the US Treasury Secretary to bail them out).

8) LEHMAN's SECURITIZATION MODEL: Lehman is heavily in the business of buying small assets (mortgages, credit card loans, auto loans, etc.) and securitizing them (making bonds out of pools of loans). It then sells these securities to foreign buyers. Two points to this. First, Lehman has $798bn in client securities, and it pledges $725bn of them as collateral for Lehman's own financings. This was made painfully clear to hedge funds who used Lehman as a prime broker and found out what the word "rehypothecate" meant when they couldn't get their money and securities back in 2008. Second, Lehman's machine is a monster and it's heavily exposed to residential mortgages (what turned out to be the worst stuff to securitize, unlike auto loans which pay off in 5 years). Lehman issued $294bn of securitizations in 2006 and 2007, of which $246bn was for residential real estate.

9) LEHMAN's QSPE AND VIE EXPOSURES, PLUS LENDING COMMITMENTS: QSPE's and VIEs are off-balance-sheet vehicles to make (often dumb) investments. Lehman engaged in writing credit default swaps and investing in real estate deals. For Lehman's real estate prowess, read about some of its deals here:
Lehman also has a mindboggling $122bn of lending commitments it has to make in 2008, many of them to private equity firms for bonds and loans in dumb buyout deals (it has to break out the deal lawyers and try to get out of these).

10) LEHMAN's EMPLOYEE COMPENSATION: Like most Wall Street firms, it's outrageously high in terms of total levels and composition (far too short term, heavy on cash and light on restricted stock). For example, Lehman has stock compensation amortization at ~$1bn to 1.3bn on average, but pays out a whopping $8.7bn to 9.5bn in total compensation. That's because the employees are smart and don't want to own equity (who would, for such a doomed ship)? They prefer hard cash paid monthly, with that big annual bonus.

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