We have heard the old computer adage "garbage in - garbage out" to highlight how even a sophisticated computer program will produce nonsensical output if provided nonsensical input. The world of risk management is no different. The quants on Wall Street that are hard at work developing the next best trading and risk management systems are not perfect, but their job and measured performance becomes even more difficult when they are given bad information (see NY Times blog article).

On the surface, the goal of the risk management quants seem simply - tell me how much of the portfolio is at risk, and then tell me how much I need to sell, or how much capital I need to set aside so that I can sleep at night. In a sense, prepare me for the 100 year flood. Yet the 100 year floods seem to be occurring more often. Why is this? One possible reason is the "garbage in - garbage out" phenomenon, the problem of which is exacerbated as the markets continue to become more complex. Recent case in point, Lehman Brothers. As talk continued about a potential failure with Lehman, it became almost impossible to tell what their exposure was. Who are the counterparties? What are the default rates? What are the recovery rates? And most frightening of all, was does this new product even do? If companies cannot even understand the products they are selling, how can one expect to develop an adequate risk management system to help protect against the 100 year flood when it is not clear that water damage is even the problem, or that the strength of the levees is even important?

There is no doubt that some systems on Wall Street were provided optimistic data and assumptions, or had smoothed-out historical data in order to reduce the number of times the warning bells sounded, ultimately keeping companies from scaling back positions or redeploying capital to less profitable areas. But I suspect that there was an equal number of firms that diligently tried to provide the best information possible, but were simply in the dark. Why is this the case? There are no doubt a number of reasons, many of which are financial, but the separation between those that develop such risk management systems from those that develop products that need to be managed is not helping the situation. The information gap most likely goes both ways as the financial engineers are unaware of the workings of the risk management systems, while the risk managers are blind to the real exposures of the complex structured products that are being purchased and sold.

As more retail investors enter the markets, institutional trading continues to rise, and the securitization and engineering of products increases, both volatility and the values at risk will continue to affect markets. As new products are offered to the markets, it is essential that those who develop such products are on the same team as those who manage the risk. Risk management truly needs to be an enterprise-wide proposition, with incentives in place to reward those who properly managing risk, just as they are in place for those who engineer and sell the latest structured product. Performance on Wall Street is measured in money. If risk managers start to become rewarded in a similar manner, or if the risk management of new products begins to influence how new products are rewarded, we may then begin to find that the garbage provided to risk managers will begin to smell a little better.

The current problems with Lehman Brothers, AIG, and Merrill Lynch are uncovering a number of issues that will no doubt change the way we look at the health, valuation, of operations of businesses going forward. Of interest is how the current environment has resulted in Lehman Brothers being a company with liquidity that is not solvent, compared to AIG that may be solvent (for now), but has a liquidity issue. Just last week the WSJ Deal Journal blog highlighted some of the various anomalies between Lehman's valuation and its apparent asset values as its stock price plummeted. As of Friday, the closing price of Lehman put the market capitalization of the company at around $3 billion. Yet, many analysts highlighted that the current price reflected little on the true value of the company. Analysts expected the company to receive about $3 billion for a 55% stake in Neuberger Berman - as much, if not more than the value of all of Lehman. The bonus pool for Lehman's 24,000 employees itself was estimated to be around $3 billion. On the other hand, the company has $25-30 billion in toxic real estate assets to deal with, and there-in lies the issue for Lehman. How much is the exposure, how much are they worth, and what are the potential losses? Even with the ability to spin off the real estate into another company, and further inject it with $5-7 billion in liquidity, solvency was still not guaranteed. As Ken Lewis, the CEO of Bank of America stated today, the difference between the balance sheets of Merrill and Lehman was "night and day". Time will tell on BAC's move on Merrill. In the mean time AIG is scrambling to find capital to sure up its balance sheet and keep from getting a ratings downgrade, and subsequent higher cost of capital - as if selling off assets was not a high enough cost. The Fed window may stay closed to AIG, but funds might travel out the back door before all is said and done (New York is already granting permission to access $20 billion in capital from subsidiaries, see WSJ article).

So, are the issues with Lehman, AIG, and even Merrill a result of bad risk management, lack of good regulation, poor accounting rules, circumstance, or some combination of each. The easy answer is some combination of each, but the situation is of course more complicated than that. Good risk management should help us to avoid failure, if not excessive loss when circumstances go against us, but there are no guarantees. Regulation can force us to set aside risk capital, even when we don't want to, but again, it could be argued that a good risk management system that is actually both honest and honestly followed could serve a similar purpose (whether it does and would be followed, and whether that is why regulations exist in the first place is another issue and debate). That leaves of course accounting, and I suspect this area in particular will receive a lot of attention in the coming months, especially with regard to mark-to-market. The questions of whether each of these companies would have the same liquidity issues if accounting rules were different will certainly get some play, causing it to be a busy fall, possibly followed by an busy winter, spring, and summer. For all the regulators and agencies tasked with these problems, they may come to question the validity of the old proverb: "may you live in interesting times." Right now, something a little more boring would be nice.

Update: On another site a reader responded that leverage was the problem, and any new regulations will probably overstep. I could not agree more. Just looking at things a little down stream. In fact, the mark-to-market issues may be nothing more than an identification / realization of the leverage problem. Nonetheless, I suspect the regulators will be busy trying to prevent a similar problem. Hopefully, any changes will be measured and focused with few unintended consequences.

Lehman Brothers (LEH) is considering shifting approximately $32 billion of commercial mortgages and real estate to a new company, nicknamed Spinco, using a good-bank, bad-bank model of the 1980s (see a recent SeekingAlpha article on the good bank, bad bank debate). Lehman would fund the bank with $8 billion of equity coming from Lehman (Korea Development Bank is in discussions to purchase 25 percent of Lehman for $6 billion), with the remaining $24 billion borrowed from Lehman or outside investors (see Bloomberg article). The Spinco option would allow Lehman to off-load 80 percent of its commercial mortgages, establishing a company capitalized and managed by outside investors. One benefit of spinning off the mortgages to its own shareholders is that Lehman can allow existing shareholders to benefit from any recovery in asset prices, thereby eliminating the need to sell at fire sale prices. If the plan fails, Lehman may be forced to seek out private equity funds and sell parts of the company, such as their asset management business Neuberger Berman (see previous post here and here).

While Lehman brothers certainly seems to be getting hit from every direction (see comments on Opsraie's problems here, of which Lehman has a 25 percent stake), they are certainly trying to be creative in how they pull the company out of potential failure. While taking the Merrill Lynch route of selling assets for 22 cents on the dollar (and financing much of the sale themselves) may have not even been a possibility for Lehman, current actions do indicate the they seem to think the worst is behind them, at least as far as the credit crisis is concerned. Maybe they have no other alternatives. Liquidity and confidence issues remain, but if they can get the needed capital, and keep from selling the entire company and its assets on the cheap, Lehman may in fact come out stronger, or at least be able to survive. Of course, this really depends first on staying afloat and not becoming the next Bear Stearns. Fortunately for Lehman, so far they have appeared to have a little less panic from their nervous investors (not much), a few more options available to them, and a little more time than a weekend to get something done. But as they say, paraphrasing, "act now - while 'capital' supplies last."

The news with Lehman Brothers just keeps coming. In a yesterday's post I highlighted some recent articles that discussed the value of Lehman Brothers Headquarters (article), potential private equity investment and/or purchase of Neuberger Berman (article), and plans for Lehman to cut 1,500 jobs (article). Now it appear that even as plans for reducing the work force are being put into place, Lehman Brothers is looking to hire at various B-schools (see DealBreaker article). While the move is not unprecedented (companies often hire cheap college grads to replace expensive long-timers), the timing and focus are interesting. Not only does news of the job ads come less than a week after the news of lay-offs (granted, it may have been in the works for a long-time), but Lehman is apparently looking for an "Investment Banking Full Time Associate." Of interest in the job description is the following:

"The division provides comprehensive financial advisory and capital raising services. This includes advice relating to mergers and acquisitions, privatizations, and debt and equity financings and restructuring."

No doubt that capital raising and private equity experience would certainly be useful at Lehman right now. Then again, a potential drawback is that "the program begins with four weeks of training in New York." The company could look very different in one month. As mentioned in the DealBreaker article, new hires better "act now, before they go under." Yes, I know. This is too easy to make fun of, and real people are losing real jobs. Nonetheless, given Lehman's recent moves, in particular its desire to have both a quick and sensible sale of their mortgage-related assets, at some point reality will need to step in. To see just how silly things have gotten, check out a recent Here In The City News article regarding a funny spoof email making the rounds on Wall Street. Who ever thought Lehman Brothers, the Tooth Fairy, and Tinkerbell would be in the same article. As with most good humor, there is often a little bit of truth hidden in the satire.

Of course, all of this has the contrarian in me wanting to poke around a little in the stock. I mean, how much worse can it get? Bear Stearns II cannot happen again, can it? Recent valuations certainly seem to be pricing the possibility. The moves have also been extreme enough that the technicals don't provide much help. Some support exists around $13.50, and even near the current price around $16, but both are weak. Downward trend line resistance is near $20. Investors could wait until this trend is broken, but one would have to give up four points and over 25 percent while waiting for confirmation. Traders, acting a little quicker could capture the moves, but as we saw with Bear Stearns, even nimble traders sometimes don't have enough time to act. In the mean time I will probably just sit on the sidelines and enjoy the show. There are just too many other stocks with better risk-reward ratios for investing and trading, even if they are not quite as entertaining.

It is never a good sign when your company is in financial trouble to find out that reporters, analysts, and private equity investors are suddenly interested in the value of the building that houses your headquarters. As reported in a Here Is The City News article, apparently this is exactly what some at the Financial Times and elsewhere are doing. The Lehman Brothers Times Square headquarters building is estimated to be worth $1.3 billion, or about twice what Lehman paid for the building in 2001. When you add its worth to that of asset manager Neuberger Berman, which may be valued anywhere from $6.5 to $13 billion, the sum of the two could dwarf the current market cap of Lehman, currently around $9 billion. This of course opens up the possibility of value for investors, or more likely, private equity investment (see a recent Bloomberg article on the private equity companies interested in Neuberger Berman).

This week it was also reported in a MarketWatch article and elsewhere that Lehman is planning to cut 1,500 jobs, and is also developing plans to off-load some of its real-estate loans (see the WSJ article). The company has $40 billion in commercial real estate assets and another $24.9 billion in residential assets. Lehman is desperately looking for ways to unload the mortgage-related assets for more than the 22 cents on the dollar that Merrill Lynch received (which was even worse when you considering the financing deal Merrill offered Long Star). The sale of these toxic assets may eventually make it easier to value Lehman Brothers, moving them from a "bad bank" to a "good bank" (see an interesting article by Roger Ehrenberg on the importance of separating such assets). By getting the hard to value assets off the balance sheet, Lehman should go a long way towards allowing investors to see the real value in the company, and in the process hopefully reverse the trend of their decreasing market cap. Unfortunately, it may take a fire sale of their good assets to keep them afloat long enough to see it happen. Another reason why a quick and sensible sale of their mortgage-related assets is so critical.

The Washington Post is reporting that sovereign wealth funds are becoming some of the largest commodity speculators. While the CFTC recently told Congress that its internal monitoring did not show influence by SWFs, it is believed by some that the CFTC may not be detecting their influence since the SWFs are working through swap dealers, which are often unregulated and operate through investment banks such as Goldman Sachs, Morgan Stanley, and Lehman Brothers. Officials have requested additional data from swap dealers, with these finding expected in September. It is believed that many of the foreign funds are coming from countries less familiar to SWF investing, such as Norway, Singapore, Kuwait, Australia, Russia, Libya, and even Iran. Estimates believe such funds represented 12 percent or more of investment bank commodity activity. The collective value of such funds is estimated at more than $2 trillion and is expected to increase 5-fold by 2012.

As recently discussed in a post at Bull Bear Trader, the exchanges were beginning to join up with the operators of the various dark pools of liquidity. Now both the Financial Times and the WSJ are reporting a new union between the London Stock Exchange (LSE) and Lehman Brothers. Per the agreement, the LSE will offer trading of European companies that don't currently list on its exchange, matching buyers and sellers across more than ten European countries. The new service will be based on the Lehman Brothers dark pool trading environment. The multilateral trading platform, called Baikal, is expected to combine algorithmic trading functionality with dark pool liquidity. The venture with Lehman is hoped to allow the LSE to gain exposure into dark pools trading, and get back exchange volume that has been moving to other platforms and environments. According to the Tabb Group, dark pools currently account for about 10% of daily U.S. trading volume.

The recent trends toward dark pools and specialized trading has caused the exchanges to lose out to new electronic trading platforms that are aimed specifically at servicing computer-driven algorithmic traders. Such algorithmic traders are increasing responsible for driving trading volume and providing liquidity. Such threats are causing the margins in the public order books to come under increased pressure. Electronic-based algorithmic trading is also cited for the increase levels of volume and short-term price spikes that are seen in a number of equities and commodities. Unlike in the past, it is not that unusual anymore to see crude oil spike up or down $3-4 in less than an hour as a flood of buying or selling pressure hits the market from electronic orders.

The move to decimalization, with price spreads down to the penny, is also making it difficult for some specialists to create a market that is both profitable and also offers the level of liquidity that is required at each price point. Some market operators are even arguing for going back to larger spreads, such as a nickel, in order to increase the number of shares offered at each price and keep the exchanges in business, but it is doubtful the regulators will allow this. As more market participants use dark pools, the exchanges will look to move more trading volume to this environment due to the cost advantages over the public order books. As a result, the price transparency, increased liquidity, and smaller spreads that decimalization was ironically hoped to provide retail traders is likely to be compromised.

As discussed in a recent Bloomberg article, the spread between the 3-month Libor and the overnight index swap (OIS) rate, traded forward 3 months, is greater than similar expiring spreads. This recent movement in the spread is signaling that traders are concerned that banks will have difficulties obtaining cash to fund existing assets, as well as putting into question their ability to shore-up their balance sheets. In general, an increasing spread signals that funds are becoming less available. The recent activity appears to be driven more by traders leaving the short-term, closer to expire positions early over worries about Libor and its reliability.

The spread has averaged about 11 basis points over the last 10 years, but has ranged between 24 bps to 90 bps this year, and has gotten as high as 106 bps last December. The activity in the swaps market is worrisome, indicating that derivative traders do not feel that the sell-off of financial companies in March was the low, and that the worst is not behind us. Recent problems/concerns with Lehman Brothers, Wachovia, and UBS, as well as the recent sell-offs in Goldman Sachs, Merrill Lynch, JP Morgan, and Citigroup are also highlighting concerns with the financial companies. As usual, this is not good news for the economy and the market as a whole as it needs a strong financial system to keep greasing the gears of expansion. It may be a long summer until the credit markets start showing a little more confidence.

The WSJ has an interesting article that describes a situation of how even the best intentions for hedging risk do not always work out exactly how you had hoped. In an effort to stem the tide of losses resulting from bad real estate and leveraged loans, many firms on Wall Street began shorting vehicles that would allow them to profit as these markets collapsed. Unfortunately, tracking error raised its ugly head, and now many are finding that not only were they not getting close to 1-1 back ($1 loss in assets followed by a $1 gain in the hedge - often unrealistic, but a high goal nonetheless), many are getting much less, with a 70% efficiency being a relatively good recovery. To add insult to injury, some are finding that their assets are continuing to fall in price, even as the tracking index they shorted against has been rallying - causing a double loss on both the falling long asset and the rising short index.

It looks like the company with the worst hedges in place is Lehman Brothers, which is expected have write-downs on BOTH assets and ineffective hedges somewhere in the range of $1.5-2 billion. Morgan Stanley will have about half this amount of losses, with both Goldman Sachs and Merrill Lynch being less effected, so far - Goldman in particular has less real estate, but more leveraged loans than its competitors, and may eventually post some losses from these hedges.

As highlighted in the article, it looks like Wall Street has a long way to go in the area of risk management.

Some of the same financial engineering that contributed to the recent credit problems is being used to provide liquidity during the recent credit crunch - with the help of the new Fed Primary Dealer Credit Facility. Apparently, Lehman Brothers has moved about $2.8 billion in loans and risky LBO debt to an off-balance sheet structured investment vehicle, which then issued debt securities that were backed by the loans and debt. The vehicle used was a CLO (collateralized loan obligation), which was split into two parts (tranches). The first part, around $565 million, was not rated, but was structured to incur the first 20% of losses. The second part contained the remaining $2.26 billion in securities. Since the pool would need to lose at least 20% before the second part would suffer losses, credit rating agencies assigned it an "A" rating - yes, those same agencies that many don't really trust anymore.

This is the point where the Fed comes in. Since the $2.26 billion has an investment grade rating, Lehman can pledge it as collateral, utilizing the Primary Dealer Credit Facility to obtain low interest, short-term loans. Why all the trouble? The Fed only takes securities that have market prices and investment grade ratings. The risky LBO junk rated debt does not qualify. This is where the CLO comes in, allowing Lehman to create an entirely new vehicle with investment grade ratings.

Of interest is how some on Wall Street are calling the move "brilliant," allowing "investment banks to get liquidity from assets that they don't want to sell at fire-sale prices," while others are disgusted that the credit rating agencies are being used again in this way. Finally, some just think the move was more of a test to see what the Fed would accept. I guess now we know.

An interesting article in this week's Barron's about how fair-value accounting is allowing companies to boost earnings by recognizing "gains" from being able to buy back their declining debt at cheaper prices. As mentioned in the article: "When a company's credit weakens and the yield on its debt rises relative to risk-free Treasuries, the debt becomes worth less to the holder. The financial company, which is the debt issuer, then takes a gain, because theoretically it could buy back its debt below face value." Given the level of exposure, the gains are not insignificant. For the first quarters, widening credit spread allowed Morgan Stanley to report $848 million in gains, Lehman Brothers reported $600 million, while Goldman Sachs reported $300 million. Of course, given that most of the long-term debt matures at par, any gains realized will reverse over time. But in the short-term when losses need to be covered, fair-value accounting allows for higher reported earnings, even though these earnings do not really justify the P/E ratio generated. As the market starts to move up, a reversal of recent accounting gains will be necessary.

Tickers: GS, LEH, MS

Lehman Brothers is offering 3 million convertible preferred shares in an effort to sure up their balance sheet, even though, as stated by their CFO: "We still maintain that we don't need capital, but we've realized that perception is the dominant issue in today's markets." The convertible preferred shares being offered have a 7-7.5% coupon. The terms of deal also include a conversion premium of 30-35% above the current stock price. Demand was oversubscribed three times greater than the amount on sale. Probably not a bad return in the current market - as long as you can handle and quantify the market and credit risk.

Ticker: LEH