Read Alongside The Examiner's Report

Elsewhere, I've reviewed the book, "A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers," by L.G.McDonald and P.Robinson. Here's the review, which still rings true in light of the new data:

"This is a very compelling, informative, and irreverent account of the housing bubble and Lehman's demise. McDonald's distressed debt group was making money shorting the bad actors in these markets. Independently, Lehman's CEO was drinking poison by directing the irratonal purchase of large commercial properties around the world based on no analytics and with no oversight.

Lehman CEO Dick Fuld comes off as aloof and totally isolated from the people who were taking huge risks and making money for his firm. When the fateful meeting with Treasury Secretary Henry Paulson took place and Lehman was at death's door, Fuld's arrogance, a lack of mutual respect , and a misplaced sense of competition with Goldman Sachs probably made Paulson uninterested in bailing out Lehman. In the end, whether it's at Yalta or on Wall Street, so much turns on personalities and on their interactions.

As the bubble grew in earnest from 2003 through 2006, there were ample warning signs, but few took the time, and had the industry and horsepower to challenge the Kool Aid being handed out in the housing market. Distressed debt analyst Christine Daley does old fashioned, analytical grunt work under enormous pressure, and her conclusions that Delta, Calpine, and New Century Financial were going under provided the foundation for traders like McDonald to place enornous bets against these firms that resulted in a $5 million trading profit DAY for the Lehman distressed desk. I know that I would like her if we met--she did the work, took a contrarian stand, felt the heat and made lots of money for herself and the firm. If you haven't worked in or around a trading desk, you'll get a great flavor from reading this book.

If you're interested in genuine financial market reform and what we've learned, you'll have a Scotch and turn out the lights. (From where we are now, this seems prophetic)

The stories and sequence of events in this book dovetail very well with the dryer, more analytic and legal document provided by the Bankruptcy Examiner. It's a sad tale, and one that will likely be repeated sometime in the next up leg of the cycle.

Lehman's Failures: Lots of Blame to Be Shared

The Wall Street Journal has published the 2,200 page Examiner's Report on the Lehman Brothers Holdings bankruptcy. Here's what I gleaned from volume one of nine volumes. First, the Lehman bankruptcy was part and parcel of the global meltdown rather than being the trigger. Lehman's business model was not dissimilar to that of the other major investment banks, except to the extent that it relied on repos to open for business on a daily basis, which was something I didn't realize. Repo markets more than others, rely on confidence of counterparties, and this had to be maintained at all costs, or Lehman couldn't make it through a trading day. Basically, a $700 billion balance sheet was supported by $25 billion in equity. So, we have a highly leveraged business running on a very short term funding mechanism that could freeze up at any moment.

To rush ahead, high level decisions are made, as the subprime crisis was starting to emerge, to "double down" and raise Lehman's exposure in order to gain market share at the expense of competitors who were pulling back. The two mortgage companies that Lehman bought had their "weightlifter" sales people generating all types of "ninja" and "liar" loans in the hottest markets, and Lehman was already having trouble securitizing them, and so they remained on the balance sheet. At the same time, other businesses were increasing their risk profiles, such as leveraged loans to private equity groups and global commercial real estate transactions. These stories have been documented in other books.

In order to appease the credit rating agencies and to lower its reported leverage ratios, Lehman's financial team created an accounting subterfuge called Repo 105 that allowed the troubled assets to be treated as sales rather than as a financing and hence to disappear from the balance sheet for a short time. These transactions are quoted by senior financial staff, from the Controller on up, as being sham transactions with no economic purpose. Remember Enron? Does this sound familiar? They had no purpose other than to temporarily shrink the balance sheet and to allow the CEO, amid rising losses, to report that Lehman had lowered its leverage ratio, when it had done no such thing.

The external auditor, Ernst & Young, received a copy of a warning letter from a senior financial staffer, Mr. Lee, that these transactions had no substance and needed to be looked into. The audit committee apparently specifically requested that the auditor look into Mr. Lee's allegations and report back. Ready? E&Y apparently did not look into the Lee memorandum and did not follow up with the audit committee!

According to the report, "There are colorable claims around Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in their financial statements." A colorable claim is one that would support a recovery.

So, the audit committee was apparently not aware that these transactions were behind the decrease in leverage ratios, and neither were the shareholders because they were not called out in any notes to the financial statements. This kind of complete breakdown of the audit function is eerie, because if reminds me of the very similar breakdown in the bankruptcy of New Century Financial.

Law students and business school students may pore over this examiner's report, but the sad thing is that there won't be any penalties or clawbacks. The examiner notes that the Delaware business judgment rule will cover the decisions to increase the risk profile of the Lehman book of business. That is disappointing, but not unexpected. To paraphrase a Chancery judge, "The business judgment rule does not outlaw or punish stupidity."

Congress To Design Your Brakes

Executives of Toyota America are now bleating in the press for more transparency from Japan about "quality issues." It seems as if they are trying to avoid accountability for the current issues. Customer complaints on American-made Toyotas originate here, and they are either reported through dealers or directly to Toyota America phone numbers. The NHSTA regulates the handling of these complaints. It's a pretty clear cut issue, and much simpler than the broader issue of quality.

Customer complaints about braking, sudden acceleration and the like entail the technician hooking up a handheld unit to the on board computer and downloading the error codes; the technician then checks the codes against the service bulletins issued by the company. I think that one mistake Toyota is making, at the behest of its lawyers probably, is not being more candid about what error codes it has or has not found in the reported complaints to date. One Toyota official somewhere stated that they had been unable to recreate the "situation" that generated a sudden acceleration incident. This statement is problematical because it suggests that the dealer's tech found a code that related to the sudden acceleration problem, and was unable to recreate sudden acceleration. If such a code exists, it must be in some service bulletin. Why not just report the facts?

Right now, the biggest problem is the dearth of facts. The only numbers tossed around are complaint numbers. We know that self-reporting systems typically under-report the number of real problems. Per mile-driven, it seems as if the number of sudden acceleration complaints for Toyotas is relatively small, but it would be nice to benchmark these against the same complaints for midsize sedans from all other makers. The NHSTA must have all this data. Meanwhile, the press reports a large number of compaints about sudden acceleration, but it seems as if 80 percent of these came after the announcement of the recall, so they should be viewed with caution.

Senator Jay Rockefeller chided the NHSTA for not being expert enough on sudden acceleration issues. If they don't have engineers who can work with the industry to understand this problem, then heaven help us. However, Congress is expert enough to recommend smart brake pedals being installed on all new vehicles. Congress can't balance a budget, but they can design our brakes!

Now, suddenly we have large recalls coming from other makers like Nissan also. Is everyone afraid of legislative scrutiny? The auto industry here is being its own worst enemy, and instead of increasing advertising to get minor changes in share, they should really work together to get to the bottom of complaint reporting, analysis, and data sharing with the Federal government. In the end, candor and real transparency will benefit consumers and the industry.

A New Foreign Policy?

We've now decided to ship "upgrade kits" to the Pakistan military that will help turn large bombs into laser-guided, smart bombs.  We have also given control over a number of drones and used F-16s.  All this because of the largely ceremonial flurry of activity by Pakistan to work with us in capturing Taliban leaders.  This foreign policy is no better than the one that the Administration disavowed when it came in.  India, to its credit, is keeping relatively quiet.

However, this does nothing in the long term to stabilize the realtionship between India and Pakistan in the tinderbox that is Kashmir.  The Pakistan government and the ISI know how to perform in order to get U.S. aid, and while we probably had to have some show of reciprocity for increased activity against Taliban strongholds, I wish that we had a vision of how to bring meaningful rapprochement between these long-feuding neighbors. 

No Coke, Just Pepsi

The decision by Coca-Cola to acquire the North American assets of Coca-Cola Enterprises, on the face of it, seems like a real head scratcher.  Aside from the fact that Pepsi has agreed to do something similar, after years of nixing this strategic option, it's a hard one to figure.  Warren Buffet, the Oracle of  Omaha, fresh from publishing his 2009 shareholder letter, seems to be giving a tepid "thumbs not down" approval. 

Since both Coke and Enterprises are NYSE publicly traded companies, it's hard to believe that the assets of Enterprises are not priced at something close to fair market value, so it's unlikely that Coke shareholders would be grabbing a bargain.  In addition, Coke shareholders take on the pension obligations of Enterprises just at the time when most companies are waking up to the potential understatement of their PBO's because of overly optimistic assumptions about returns on pension assets of 9% or so. 

It seems as if Enterprises shareholders get some liquidity benefits from a couple of special dividends, and there might be some value in this event for them.  These will be funded by debt, which then, if I understand, will be assumed by Coke.  Enterprises shareholders will then be left owning 100% of the assets of a new distribution and bottling company whose most significant operations will be concentrated in Germany.  So, their portfolio is now without the largest market, namely the U.S. and more concentrated around Europe.  Does this make sense for them? 

Taxes and Tea Parties

My Columbia College classmate, Senator Judd Gregg has partnered with Oregon Democrat Senator Ron Wyden to propose a simplified tax system, with  three marginal brackets, a unified deduction, and elimination of the alternative minimum tax.  The current tax system, which creates work for accounting firms, CPA's, lawyers and estate planners is fundamentally undemocratic in that a fraction of one percent of the population can explain how what they pay is related to what they earn.  The journey from one amount to the other goes through the miasma of exclusions, ceilings, deductions, and finally the absurd alternative minimum tax.A citizen  should be able to fill out a return on one page without having a Ph.D. in taxation or a J.D.  Bravo to a bipartisan proposal that is relatively simple, reasonable and a meaningful improvement on what we have.    We don't need to reinvent the wheel by having another Commission.  Unlike reform of financial regulation, here's hoping that this proposal gains momentum.  Instead of the unfocused ire of the Tea Party group, this proposal could provide something meaningful to our democractic body politic. 

Credit Getting Easier?

A recent newspaper article trumpeted a great leasing deal on a 2010 Honda Accord for $199 a month for 36 months, with 12,000 miles per year allowance.  In one sense, it could be an opportunistic grab for potential customers of a Toyota Camry, and so it's to be expected.  One of the disappointing features is that it's for a 4 cylinder, stripped model that seems like it should be in a rental fleet, but even that's okay.  The kicker was that the article said Honda's finance arm was looking at FICO scores of 710 or above for customers interested in the deal.  This is a pretty strong credit score.  It was not so long ago that this kind of deal would be aimed at a FICO score of 650 or better. 

Someone with the credit score, and by extension that income would hardly seem interested in a stripped down model.  They could probably do a better deal with a bank or their credit union at work, though that's an assumption on my part.  I don't think that this kind of deal signals any kind of credit easing in consumer lending, in fact it suggests continuing fear and trepidation.  Even as a marketing ploy, this deal seems to have little prospect of driving sales.