All things tend to entropy...

Entropy - A thermodynamic quantity representing the unavailability of a system's thermal energy for conversion into mechanical work, often interpreted as the degree of disorder or randomness in the system.

A year has passed since Lehman Brothers, my former employer, passed into the annals of the has-beens. This week has seen plenty of media commentary looking into the lasting impact of that moment on 15th September 2008 when all the avenues of potential rescue had been exhausted, including a final desperate phone call from a relative of George W. Bush who worked for the bank, and Lehman declared itself bankrupt.

I'm currently reading a book called "A Colossal Failure of Common Sense", written by a former Lehman trader which looks at the whys and wherefores of the the bank's collapse. The basic gist seems to be that a long serving CEO, with a gigantic ego, lost the plot and either stopped listening to his subordinates or removed those that disagreed with him. There is an amazing sense of inevitability about the implosion - the hugely successful mortgage group at Lehman printed money for the bank in the boom times in the early 2000s, and more success gave them more and more power and more and more capacity for risk. In the end, the strongest part of the Lehman artillery became the weakest link, as they took some massive risks sanctioned by a management team that has lost all grounding in common sense.

Lehman's demise it seems was representative of the 2nd Law of Thermodynamics - that even the most orderly process will tend to disorder over time - that all things tend to "entropy".

I vaguely knew the guy who wrote the book - Larry McDonald. He was a trader in the distressed debt group in New York - a group that traded the bank's capital in companies with a "complicated" past or future. He and his cohorts would look deep into the balance sheets of distressed companies, or even bankrupted companies and buy and sell their debts on the basis of whether the market price of the debt undervalued or overvalued them. For example, when Delta airlines went bust, his group became the market in the bankrupted debt. The Atlanta based carrier was assailed by $18bn worth of debts. In addition they had significant pension obligations and every time jet fuel went up by a cent it cost Delta $25mm annually. Basically the airline didn't work. Nevertheless it did have lots of valuable assets - lots of grounded planes, which if they were all sold would give a "recovery rate" on Delta's bonds of over 50%. So when the less well-researched members of the investment community saw that Delta had gone bankrupt, they rushed to sell - on the first day the Lehman group acquired around $200mm worth of Delta bonds at prices between 15-20% of par, and over time pocketed significant profits as the wider market started to understand what the real price should be for this debt.

I tell this story to demonstrate that these guys were pretty astute - they worked very hard to understand the intrinsic value of these complicated situations, which gave them the edge on the rest of the market, which tended to be either lazier or less competent. As the property market reached fever pitch in 2007 these guys started to turn their attention to some of the US home builders as more and more reports suggested that things had become "toppy" or overdone. Tales of "NINJA" mortgage loans (no income, no job and no assets) struck all but the daftest as odd and worthy of further investigation. As this group started to investigate some of the companies involved in the process of subprime mortgage lending - they were struck by the fact that a lot of the dangerous lending led back to Wall Street, and a significant part of the market to their own front door. Brokers with mortgage companies like New Century, Ameriquest, BNC and Aurora Loan would "originate" mortgages in faraway states, and wholesale flog them to Wall Street banks who would sit on them for a short period of time before selling them off in bits to investors around the world - so called securitisations. The distressed debt group that Larry McDonald was part of had started to take an interest in this market as they thought there might be a way to profit from the potential doom that they saw might be coming, but in the end found themselves more concerned about their own institution's bigger picture situation.

The mortgage group within Lehman had been hugely successful in the few years previously, basically minting it in a market of endless liquidity and asset price inflation. Their gameplan as it turned out, wasn't all that complicated - acquire as much capacity as possible in the US and European mortgage markets, and then repackage and ship the risk to institutional clients from Dublin to Tokyo.

Where I sat in all this was a seller of the these securitisations - trying to offload these risks. I recall in a meeting in early 2006, a group of senior guys from the mortgages group in New York had despatched themselves to London with the intent of educating the European salesforce on the the US mortgage platform, with the ultimate aim of selling more of their product through our channels. The standard investment banking type pitch-books were handed around, outlining the strengths of the US housing market, the quality of the Lehman platform and the madness that we should accuse our clients of if they did not choose to buy into the subprime dream.

One of the pages in the pitch book had a summary of the expected performance of different types of securitised bonds on the basis of US HPA (House Price Appreciation). I noticed that the axis on which HPA had been plotted began at zero - as in there was no conceivable scenario in which house prices would fall. I put my hand up cautiously (as always in these meetings) and inquired as to what would happen if there was a situation where house prices fell - as surely my clients to whom I would be pitching these deals would be inclined to want to know. I don't remember the guy's name who was running the presentation, but he very publicly balled me out and suggested that such a notion would be ridiculous, and quoted what seemed to be the mantra - that the worst single year fall in house prices since the Great Depression had been 5%, but even in that scenario the following year had been positive. I didn't pursue this any further, more concerned about being publicly embarassed and not thinking that there was any upside for me. I did leave Lehman in the few months afterwards, and would like to think in hindsight that this meeting played a part in that decision.

Interestingly on reading Larry McDonald's account, it turns out the same mantra was being peddled in the US - and while the profits were rolling in senior management was more than happy to listen to it. Nevertheless his group were starting to form a cabal of non-believers - who were beginning to push the idea quietly that the US property market was "pumped up like an athlete on steroids, rippling with a set of muscles that did not naturally belong there." Mike Gelband, who was the global head of fixed income, held a semi-secretive meeting as early as June 2005, outlining his contrarian point of view on the US property market. In this meeting he had cited the "shadow banks", the vast complex network of mortgage brokers that were not really banks at all but had somehow managed to insert themselves into the lending process, making an enormous number of mortgages available while having to borrow money themselves to do so. He cited the interest only loans, the no down-payments, the no-docs, the negative amortization loans (the one where the mortgage gets bigger as you pay), and the option ARMs (Adjustable Rate Mortgages) which gave you a cheap initial interest rate on your mortgage for the first couple of years and then hammered you with a massive rate rise. At that point in mid-2005 most of the option ARMs had yet to reset to their higher rates, which meant that defaults on mortgage payments would surely spike in the coming year or so.

He raised the issue of the securitisation market, that was being used by Wall Street to repackage and distribute these mortgages - Lehman for one was buying up $300k mortgages, in pools of 10,000 a time, parceling them into collateralized bonds, getting them highly rated by the rating agencies, and selling them into the market. A standard 1% commission on a $3bn bundle of collateralized debt added $30mm to the Lehman coffers, and multiples of that were being done on a monthly basis. The problem being that the $3bn worth of assets were sitting on Lehman's books until they were sold - he foretold of the situation where the market for this securitised debt caves in and Lehman gets caught with many billions of these unsellable assets - and that happens at a time where every other Wall Street bank is rushing to the door to sell.

Through the end of 2005 Mike Gelband started to push harder on this point of view - taking it directly to the CEO Dick Fuld, and also to the heads of the mortgage group. While his views were latched onto amongst his own people on the Fixed Income trading floor, he was perceived to have developed something of an attitude problem elsewhere. On taking his presentation to the mortgage group he was viewed as way too conservative, and clearly unappreciative of the fact that the they were carrying Lehman's balance sheet quarter by quarter.

Basically, it seems he had formed a view, that with hindsight was an entirely accurate perception of how the world would play out, but his view was falling largely on deaf ears. The past successes of the mortgage business had stopped senior management from separating the wood from the trees. It didn't help that the rest of Wall Street was up to the same activity, but just not quite the same extent of risk. In the end Mike Gelband quit Lehman in early May 2007, unable to continue to accept the direction the bank was being taken. While it's easy to point to the person who was right in hindsight, what was evident was that senior management had lost the ability to reasonably debate a contrarian point of view - something for which there always has to be a place. The inevitable process towards entropy was hastened by a basic loss of common sense.