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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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Kamakura Blog

Sep 22

Written by: Donald van Deventer
9/22/2009 2:52 AM 

We’ve done a series of posts on how failures of management and failures of analytics caused financial institutions to fail  in the 2007-2009 credit crisis.  Lehman Brothers is a classic example of how this process unfolds in a large organization.  This post sings the praises of “A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers,” by Lawrence G. McDonald with Patrick Robinson.  Every risk manager should read it.  So should every board member of a major financial institution.

Up until yesterday, my favorite book on risk management was actually about baseball, Michael Lewis’ classic Money Ball, the story of how the Oakland Athletics used better analytics to outperform their peers, at least on a “value per dollar” basis.  As of today, my favorite is now Lawrence G. McDonald’s book on the fall of Lehman.  My own experience as a senior vice president at Lehman Tokyo in the late 1980s was very hard to write-up in a PG-13 fashion.  We posted “Eulogy for Lehman Brothers: Hasta la Vista, Baby” on September 14, 2009:

I cracked open “Colossal” with mixed emotions.  I knew McDonald’s view of Lehman would be dramatically different from mine, 2008 versus 1988, New York versus Tokyo.  I wondered whether a vice president on the trading floor had a good enough “information pipeline” to fill a few hundred pages.  I expected the answer to be no, because the senior vice presidents and managing directors in Tokyo were nearly always clueless to the reality of what was happening in New York except when the “big guys” deemed to bless us with their presence.  Much to my surprise, McDonald’s account is a magnificently detailed story of how and why the firm failed.  I believe that every risk manager should read this book and buy copies for the CEO and Board of their own firm.  That would do more to reduce the risk of bank failure than the Troubled Asset Relief Program of the U.S. Treasury.

One of the things that is remarkable about McDonald’s story is his obvious affection for the firm and his co-workers. It’s hard to join a firm, get fired, and not celebrate the demise of the whole organization when it fails.  McDonald takes the high road and it makes his account a much more credible account of the firm’s failure than a book written by someone more cynical about Wall Street in general.  My favorite excerpt from the book is this sentence on page 234:

“The World War I British Army was once described by a German general as ‘lions led by donkeys.’ Mike Gelband’s [head of fixed income] opinion of the chain of command in Lehman’s little army could scarcely have been more succinctly phrased.”

In our series of blog posts on Lessons from the Failures of Silo Risk Management (Countrywide, Washington Mutual, and New Century), we made the point that the risk of  those institutions to changes in a macro factor like home prices was not disclosed to shareholders.  In some cases, the risk was well known to the staff but it was either ignored or misunderstood by the CEO and the Board.  McDonald’s story of the fall of Lehman parallels this pattern with a few twists.  McDonald’s point of view is the distressed debt unit of Lehman, so we only get an indirect view of what the mortgage group and risk management group were telling senior management.  What we do know from “Colossal’ is that the primary risk management tool at Lehman was historical value at risk, a risk technology so grossly inaccurate that we featured its failings in a blog post entitled “Is Your Value at Risk from ‘Value at Risk’: Beware…” on April 6, 2009.

We also know that the securitization group continued to originate product almost to the very end of the life of Lehman, so if warnings within that group were being sounded, McDonald didn’t cite them in his book.  He did make it clear that CEO Dick Fuld went so far to ban the Chief Risk Officer from the risk committee meetings, so we assume that she was delivering the message loud and clear.  That message wasn’t being conveyed to shareholders, and responsibility for that lies clearly with Dick Fuld and a succession of chief financial officers at Lehman.

We also know from McDonald that Lehman was leveraged to at least 44 times capital, so a decline in the value of assets of only 1/44 (2.27%) would wipe out the firm.  That’s not a calculation that requires anything more than an elementary school education, but it was quite clear that Dick Fuld didn’t get it.  As Bennett Golub, chief risk officer at BlackRock, and I agreed in a series of exchange in our blogs on the role of the chief risk officer, when the CEO refuses to face reality, the only option available to senior people at the firm is to resign.  Much to the credit of Michael Gelband and Larry McCarthy, McDonald’s superiors, they did exactly that after conveying the message of the firm’s risk to senior management.  That’s a wonderful part of this book—the human drama of efforts to save the firm.  In the end, the direct reports to Fuld and Joe Gregory banded together and implicitly threatened to resign in mass if Fuld didn’t step aside to let them try to save the firm by liquidating assets and lowering leverage before it was too late.  Alas, as we all know, it was too late.

On page 317, McDonald pointed out the irony of this quote from Dick Fuld:

“The key to risk management is never putting yourself in a position where you cannot live to fight another day.”

At the heart of the problems at Lehman was a complete lack of accurate disclosure of the value of the assets of the firm both to insiders and to outsiders.  This is the first step in measuring risk correctly, and it wasn’t done.  The second step in risk management is to stress test this market value based risk position with respect to the risk factors (like home prices) that can put you in “a position where you cannot live to fight another day.”  If this was done at Lehman, it wasn’t made clear to shareholders or to key members of the management team.  It may well be that this information could not have been produced even if management had ordered it produced, as a lot of Lehman’s risk infrastructure was identical to that which we profiled for Countrywide, Washington Mutual and New Century.

Where was the Board in all of this?  Asleep at the wheel.  In the end, they have complete and total responsibility for Dick Fuld’s destruction of 100% of shareholder value.  We won’t go as far as to blame Fuld for the decline in fertility in Japan as a result of the “Lehman Shock,” like this article:

Nonetheless, he deserves total responsibility for the failure of the firm, and the Board deserves total responsibility for not removing Fuld from the CEO post.  Lawrence McDonald, with Patrick Robinson, have produced a must read “what not to do” manual for every member of the Board of Directors of major financial firms.

Donald R. van Deventer
Kamakura Corporation
Honolulu, September 22, 2009