The math that killed Lehman Brothers

The article contains a few errors. One, the article claims Lehman owned lots of senior tranches, which lost value when default rates unexpectedly rose. That's incorrect. We could sell that stuff to pension funds and make money on it, so we did, and losses in that tranche didn't hurt us; it hurt the retirees.

Lehman got hit hard because they could not sell the highest risk tranches (referred to as "toxic waste"). But they made enormous fees on originating the CDOs, and the toxic waste paid high interest rates (20-30%), so Lehman reluctantly kept it on their balance sheet and constantly tried to sell it off to other people (most of whom were too smart to take it).

We tried to hedge the risk by shorting the mezzanine tranches (those were between the toxic waste and the senior AA or AAA tranches). If default rates went up, and we hedged correctly, the gains from the synthetic shorts would make up for the losses on the toxic waste subs.

But for a variety of reasons this wound up not working as well as expected. Particularly, the correlation of default rates between subprime and quality debt decreased substantially and unexpectedly, which means these shorts did not generate as much cash as was lost when the equity tranche tanked.

Also, for an amusing tangent, we had bomb-proof windows to the outside world on the trading floors. A fertilizer bomb could go off in Times Square and we'd still be trading. Unfortunately we were not so well protected from the bomb that went off inside the trading floor.

I also take issue with the fact that the unconcern for subprime risk was the insurance--that ignores the risk model they had that showed real estate value going up. They didn't care if subprime defaulted because they'd get the property which would be worth more than the note and they'd make even more money. They knew the gig would be up if the CDS had to be executed en masse, they just didn't think that would ever need to happen. It's not that they drove drunk because they had insurance, they didn't know they were intoxicated (only had one drink, I swear!).

So much for child prodigies.

even worse though, its flat out wrong in other areas.. lehman absolutely knew the risk of its CDOs and in fact was trying to offload them as quickly as possible. in contrast to goldman, lehman was famous for making money packaging and selling its bonds on a fee based model. whereas goldman's model relied more on proprietary trading - actually making bets on the direction of bond moves, lehman would theoretically be profitable regardless because they were making fees from the beneficiary of the bond and taking a cut from placing the bond with customers. the problem that killed them was the turnaround time from when lehman received the assets and "commission" to create the bond and when they could offload it to customers. during this time the bond was actually on lehman's books. basically, wall street caught lehman holding a bad hand of these bonds before they could unload them to the rest of wall street. rumors were started just like they were for bear sterns and financing got pulled like a house of cards..

I have also seen strong arguments (but no concrete evidence yet) which suggest the government officials involved were pro-Goldman and anti-Lehman.

Article is obviously watered down to make it more digestible, but how he came up with such flawed logic on this example is beyond me.

http://en.wikipedia.org/wiki/Long-Term_Capital_Management

They were bailed out when they failed too so that set the precedent for the bailouts we had recently.

It seems more likely to me to fall under the Wall Street koan, "You'll be gone, I'll be gone", rather than bad math.