Graphs, Tables&Analysis

Company Leverage Ratio (Assets-to-Equity), 2007
Bear Stearns 34:1
Morgan Stanley (NYSE: MS ) 33:1
Merrill Lynch 32:1
Lehman Brothers 31:1
Goldman Sachs (NYSE: GS ) 26:1
Data from Capital IQ, a division of Standard & Poor's.
Investment banks don’t like to follow the capital requirements, always takes higher risks
to gain higher short-term profits and returns.
- Regulators require banks to keep their leverage under control by holding a certain
amount of capital as a cushion in case their investments lose money. Capital
requirements also reduce a single bank's footprint on the financial system; helping to
limit collateral damage on the rest of the economy should a bank fail.
Two provisions in the financial-reform bill are critical to avoiding the next Lehman
Brothers:
- The first is the Speier Amendment, which would require systemically dangerous
financial companies to keep their leverage below 15-to-1. Hopefully the House can
clarify that it means assets-to-shareholder-equity instead of debt-to-equity, because
that would be a stricter metric.
- The second important provision is the Collins Amendment, which would effectively
require banks to hold good-quality capital. The amendment passed unanimously in
the Senate -- bank lobbyists admit they completely blew it -- and FDIC Chairwoman
Sheila Bair is also a major supporter.
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 (see table in website cites).
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 (FNM) and Freddie (FRE), of major financial entities, have
higher leverage ratios (and note they went bust a few weeks before Lehman).
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.
Tables see from Website cites.
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 its 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): see tables from website cites.
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.
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, whereas 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 centre banks
had this problem (all banks do, to some extent). It's just that Lehman was swimming
much more naked than the rest.
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.
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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Company Leverage Ratio (Assets-to-Equity), 2007

Bear Stearns 34:1

Morgan Stanley (NYSE: MS ) 33:1

Merrill Lynch 32:1

Lehman Brothers 31:1

Goldman Sachs (NYSE: GS ) 26:1

Data from Capital IQ, a division of Standard & Poor's.

Tables see from Website cites.

3) Lehman’s CONDUIT: A conduit is a structure where a bank borrows short-term to

5) Lehman’s MBS AND ABS EXPOSURES: Lehman (almost proudly) states: We

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