Risk Management at Lehman Brothers- 2007-2008

C-758-E
June 2013

This case was prepared by Professor Markus Maedler and Scott van Etten, MBA 2011, as the basis for class discussion
rather than to illustrate either effective or ineffective handling of an administrative situation. June 2013.

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1

Risk Management at Lehman Brothers, 2007-2008

On September 15, 2008 – 158 years after its founding as a cotton brokerage in Alabama –
Lehman Brothers Inc. shocked the world of finance by filing for bankruptcy protection.1 With
$613 billion in assets, it was the largest bankruptcy in U.S. history, and its repercussions set
off a breakdown in global financial markets. Prior to its collapse, Lehman Brothers was the
fourth largest and the oldest of the five major global financial-services firms.2 As recently as
January 2008, the firm had a market capitalization of more than $30 billion.3

That same morning, Matt Rojas was sitting at his desk in the Lehman offices where he had
worked as product controller for the last 18 months. Because his boss had told him not to
touch anything business-related, so as not to open the door for legal liabilities, he surfed the
web and read the latest news about the bankruptcy. The majority of the press concurred:
“Lehman was more the consequence than the cause of a deteriorating economic climate”4
and many structural factors had contributed to its eventual bankruptcy. Some commentators
noted that Lehman had sponsored an “aggressive” and “counter-cyclical” growth strategy
that resulted in a balance sheet stuffed with “illiquid assets.”5 Others claimed the company’s
culture of risk management had eroded, with high-level defections and a unwillingness to
acknowledge its own internal risk framework.

1 Lehman Brothers Holdings Inc., “Lehman Brothers Holdings Inc. Announces it Intends to File Chapter 11 Bankruptcy Petition;
no Other Lehman Brothers’ U.S. Subsidiaries or Affiliates, Including its Broker-dealer and Investment Management Subsidiaries,
Are Included in the Filing,” Press Release, New York, 15 September 2008.

2 Yalman Onaran and John Helyar, “Fuld Sought Buffett Offer He Refused as Lehman Sank,” Bloomberg, 10 November 2008,
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aMQJV3iJ5M8c, accessed 25 June 2010 (from hereon simply
referred to as “Onaran and Helyar”).

3 Lehman Brothers Holdings Inc., Form 10-K for the fiscal year ended November 30, 2007 (filing date 29 January 2008), from
hereon simply referred to as “10-K 2007.”

4 Anton R. Valukas, United States Bankruptcy Court Southern District of New York in re: Lehman Brothers Holdings Inc.,
Chapter 11 Case No. 08-13555, 11 March 2010, p. 2 (from hereon simply referred to as “Valukas”).

5 Valukas, pp. 4, 16.

IES370

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C-758-E Risk Management at Lehman Brothers, 2007-2008

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These claims struck Matt – he knew a thing or two about risk management at Lehman: this
had been his job! He sat back and sipped his coffee: had risk management at Lehman spun
out of control? Had it foundered to the point that Lehman’s way of managing risks had
turned into the biggest risk of them all?

Origins6

Lehman traced its roots back to 1849, when Henry, Emmanuel and Mayer Lehman arrived
from Bavaria and established a dry-goods business in Montgomery, Alabama. From an
original business in retail, the brothers began to accept payments and trade in cotton,
an important commodity at the time, becoming early brokers. They later expanded to New
York, were involved in the founding of the New York Cotton Exchange in 1870, and became
active in coffee, sugar, cocoa and petroleum. In 1899, the firm underwrote its first security
offering, touching off the beginnings of an investment banking business that would
eventually underwrite some of early America’s most important security offerings.

By the early 1980s, the firm was considered one of the most profitable and powerful on Wall
Street. In 1983, however, internal power struggles between traders and investment bankers
resulted in the firm being sold to American Express, which then pursued a strategy aimed at
creating a “financial supermarket.” When American Express abandoned this strategy in 1994,
it spun off the firm under the name Lehman Brothers Holdings Inc., with Richard Fuld, a
former trader, as its CEO and Chairman.

From the 1990s on, Lehman experienced the resurgence of its past glory. The firm’s size more
than doubled, while its revenues increased six-fold. In 2003, the firm aggressively re-entered
the investment management business, making numerous acquisition to form a peripheral
business with over $275 billion in assets under management. All told, since going public in
1994, the firm’s profit had increased from $114 million in 1994 to $4.2 billion in 2007, with
a 20-fold increase in market capitalization (see Exhibit 1).

2007-2008

Lehman was hugely successful in its mission “to build unrivaled partnerships with and value
for our clients, through the knowledge, creativity, and dedication of our people, leading to
superior results for our shareholders.”7 By the winter of 2007-2008, it was considered one of
the top investment firms in the world, with market-leading positions in sales & trading, asset
management and investment banking.

Lehman’s traditional strength was in “fixed income,” in which it was among the perennial
leaders in underwriting (see Exhibit 2 and Exhibit 3). In 2007, Lehman’s Fixed Income
Division (FID) earned $4 billion in net revenues (31% of the firm’s total net revenues, a
decrease from the previous years’ level of approximately 50%). The firm, however, was

6 This section is based on: Alan D. Morrison and William J. Wilhelm Jr., Investment Banking: Institutions, Politics and Law,
Oxford University Press, New York, 2007.
7 Lehman Brothers Holdings Inc., Mission Statement, undated, p. 1.

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actively diversifying, bolstering its investment banking and equities franchises and growing
internationally. As recently as January 2008, the company’s stock was trading at $65 per
share, resulting in a market capitalization of over $30 billion.8

“On the street” the perception was that Lehman was one of the best-run investment banks,
and that CEO Richard Fuld was one of the industry’s most skilled executives (see Exhibit 4).
With less capital than rivals such as Goldman Sachs and Morgan Stanley, Lehman was
known for punching above its weight and seizing opportunities faster than others. 9
According to a January 2008 report by Brand Finance Company, the Lehman brand alone
was worth over $4 billion, a testament to the value of the franchise.10

“Similar to other investment banks, Lehman’s business model depended on some variation
of a high-risk, high leverage model, requiring the confidence of counterparties to sustain
it. Lehman maintained approximately $700 billion of assets and corresponding liabilities,
on capital of just $25 billion. But the assets were predominately long term, while the
liabilities were largely short term. Lehman funded itself through the short-term repo
markets and had to borrow tens or hundreds of billions of dollars in those markets each
day from counterparties to be able to open for business. Confidence was critical.”11

Matt Rojas

In March 2007, Matt Rojas joined Lehman in the Fixed Income Division’s Product Control
(see Exhibit 5), a typical “middle office” function.12 Matt had previously worked for three
years as an auditor at Ernst & Young in New York City, specializing in financial services and
structured products. He had graduated from Villanova University in 2004 with a double
degree in Accounting and Finance and had aspired to work on Wall Street ever since he first
picked up the finance non-fiction classic Liar’s Poker.13

Within the Fixed Income Division, Matt was assigned to the U.S. Interest Rates Derivatives
Group, where his first task was to cover the Swaps Desk. A desk is a small organizational
unit that consists of a handful of traders who specialize in specific capital market products;
swaps are certain derivatives. The Swaps Desk was considered an introduction to the world
of derivatives, being the most basic structure within the group. Matt’s training consisted of
becoming familiar with a couple of process-description documents and approximately a week
spent shadowing the group’s senior member while he performed the main duties.

8 10-K 2007.

9 Onaran and Helyar.

10 Brand Finance, Brand Finance Banking 500, January 2008, http://www.brandfinance.com/knowledge_centre/reports/brand-
finance-banking-500-2008, accessed 15 June 2011.

11 Valukas, p. 3.

12 Frequently, financial institutions employ the terms front office to describe functions like trading, sales, and others that
require a direct market contact and generate revenues; middle office for the support functions that monitor overall risks, capital
adequacy, and regulatory compliance; and back office for the remaining support functions, like accounting, IT and operations.

13 Liar’s Poker is a non-fiction, semi-autobiographical book by Michael Lewis describing the author’s experiences as a bond
salesman on Wall Street during the late 1980s. Source: Wikipedia, v.s. Liar’s Poker, http://en.wikipedia.org/wiki/Liar’s_Poker,
accessed 16 June 2011.

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Matt recalled that when he was introduced to the traders he would be working with, one of
them joked that he was now a “revenue protector” and that he was “there primarily because
of management’s fear and deep mistrust of the traders and salespeople.”14 Matt mentioned
this to his manager, who laughed, but did not disagree. His manager pointed out that the
desk he would be managing had generated revenues of $150 million the previous year,
and that is was not unheard of to see gains or losses of $10 million in any given day, if the
market was particularly volatile. Matt realized that the term “running the business” was not
just a metaphor – each desk was its own little franchise, bringing in more money each year
than most companies he could think of.

After one week, Matt was off and running. His first few days in the driver’s seat were a little
stressful, but he drew on the strength of the group and leveraged the collected experience
around him to get through the first weeks. After about a month, he felt confident in his
knowledge of the nuances of the product control process and could perform his responsibilities
unassisted.

Trading

In finance, a trader is someone who buys and sells financial instruments such as stocks,
bonds, commodities and derivatives.15 Traders generate gains from the volatility of these
instruments, simply referred to as risk. While other individuals or corporations are able to
transact in these products, investment banks are uniquely positioned in this field due the
financial expertise generated in other areas of the business.

In a bank, the term “trader” is a generic concept that includes market makers, proprietary
traders, and so-called flow traders. The market maker accepts or structures trades with clients
in the financial markets. In addition, his role is to add liquidity to the financial system by
always being willing to trade in a financial product and by always offering both buy (bid)
and sell (ask) prices (commonly seen in equities, government bonds, etc.). The positions held
by the market maker are the result of the deals he makes. He must always be careful to cover
these positions as he tries to generate profits.16 A proprietary trader does not take any client
trades. Rather, he only trades for his own book using the bank’s capital, effectively
speculating on movements in the financial markets. Lastly, flow traders lie between these two
extremes, accepting or structuring client trades but also speculating in their market, which
they know well: they are a mix of speculator and risk manager. In structured products
such as swaps, most traders are flow traders and manage their books with a tremendous
amount of freedom.

A trader’s functions are generally defined first by product rates, equities, commodities,
foreign exchange) and then by type (market maker, flow, proprietary). Within each division,
the product is broken down further to reflect its region, class of issuer and specific risk

14 This quote is borrowed from Satyajit Das, Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of
Derivatives, Pearson Educated Limited, Edinburgh Gate, 2006, p. 65.

15 Wikipedia definition for “trader,” http://en.wikipedia.org/wiki/Trader_(finance), assessed 16 June 2011.

16 Jérôme Fabre, “The Trader’s Job,” FiMarkets, http://www.fimarkets.com/pagesen/trader-job.htm, accessed 11 September 2010.

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Risk Management at Lehman Brothers, 2007-2008 C-758-E

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profile. For example, in structured products, one group was U.S. Interest Rate Derivatives,
which traded standard or “plain-vanilla” derivative products on interest rates linked to U.S.
government bonds. Within this group, specific teams traded in swaps and swaptions
highlighting different risk aspects. The goal was to organize the trading room “so that traders
are responsible for trades related to just one market variable (or perhaps a small group of
market variables)” in order to achieve risk decomposition.”17

Daily Product Control Process

As product controller, Matt Rojas was responsible for monitoring the activity of the traders
on the Fixed Income Swaps Desk. This entailed various tasks related to monitoring data
integrity, profit, profit potential and risk on a daily basis.

Matt spent most of his time reconciling the daily risk and Profit & Loss (P&L) reports,
respectively, between the firm’s IT accounting systems and the traders’ own records. This task
was necessary because Lehman used numerous proprietary and vendor-managed systems to
track and monitor trading for different products (equities, CDOs, options), activities (risk,
collateral, accounting, exposure) and parties (regulatory bodies, clients, exchanges, and
internally). Overall, it was estimated that Lehman “maintained a patchwork of over 2,600
software systems and applications that were highly interdependent (although numerous were
arcane or outdated).”18 Matt considered working with about 25 of them as being integral to
his daily responsibilities.

When Matt arrived in the morning, his first task was comparing the IT system’s risk report with
the traders’ records to verify all trades had been documented and were accounted for
consistently across the multiple systems and records. It was critical that the risk reporting
system correctly represented all data because it fed into “downstream” management
information systems crucial to other users in the firm. Risk reports would be aggregated into
business, divisional and corporate level reports; and consistency guaranteed that all users –
traders and end-users in risk, treasury, funding and top management – relied on one and the
same set of information for their analyses and decisions.

Next, Matt needed to perform a similar reconciliation of the P&L statements between the
accounting systems and the traders’ records. During this process, Matt would research any
differences he found between the various systems using a combination of trade confirmations,
desk inquiries and personal knowledge of the trades. A trade discrepancy was considered
resolved when the reason for the difference had been found, an agreement had been reached
on how to resolve it, and the corresponding changes had been entered into the IT system or the
traders’ records. Resolving inconsistencies was rather straightforward if the error had been
introduced by an obvious coding mistake or was due to insufficient integration across IT
platforms (unfortunately, the latter was not uncommon). Resolving data conflicts was more
difficult, and at times controversial when the trader disagreed with the system’s records
because he believed, for example, that a specific trade’s unique, idiosyncratic features were not

17 John C. Hull, Risk Management and Financial Institutions, 2nd ed., Pearson Education Inc., Boston, MA, 2010, pp. 226-227.

18 Valukas, p. 33.

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C-758-E Risk Management at Lehman Brothers, 2007-2008

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well-captured by the system’s generic algorithms. When disagreements about how to record an
individual trade could not be resolved with the trader involved, Matt escalated the issue to his
area senior vice president, who would then have conversations about the nature of the error
with the desk. If it persisted, the issue could be elevated further through the product control
chain of command to Clement Bernard, CFO of FID, Gerry Reilly, global product controller, and
ultimately to Lehman’s CFO (see Exhibit 7).

After all position discrepancies were cleared up or explained, Matt would verify that traders
had been transacting within their trader mandates, which specified the exact counterparties,
risk exposures, P&L limits and products that were allowed. Much of this process was
automated (counterparties, products) and once set-up, it provided an effective barrier that
ensured these mandates were being followed. However, risk and P&L limits were “soft” limits.
When they were exceeded, Matt would send notifications to the head of the business desk
and the CFO of FID. Depending on the nature of the breach, these two managers would agree
on the course of action. In rare circumstances, the trader would be forced to trade out of
some risk but, more typically, his mandate would be amended temporarily or even
permanently. Matt would then reflect the mandate changes in the relevant IT systems and
monitor their adherence.

On an average day, Matt could expect to see about 300 transactions flow through the swaps
portfolio for which he was responsible. Approximately 100 of these were new deals with
clients, 50 were terminations or novations19 of existing deals, and the remaining were hedges
for swap or exchange transactions. These transactions resulted in a plain-vanilla swaps
portfolio of about 75,000 trades, on average.

The vast majority of these trades was fairly straightforward, requiring very little manual
processing and reviewing. However, Matt noted that in about 1% of transactions, the
following types of problems would materialize:

Overruling the Model:

Sometimes, due to the complexity of the trade, the IT system could not value it correctly.
Product Control would then escalate this trade to the Quantitative Risk Management
group for analysis, explaining why it should not be re-marked, i.e. valued according to
the system’s model. The goal was to provide information that justified disregarding the
model price and maintaining a different, manually-calculated mark or valuation, which
was usually the trader’s.

Out of Mandate:

Occasionally, traders would want to trade products outside their mandate. This would
generally result from sales attempting to satisfy a client request for a non-standard
product whose risks were difficult to allocate to an individual trading desk. Other times,
traders noted a correlation with a complementary product that could be used to hedge
some of their risk more cheaply or effectively.

19 A novation is the substitution of a new contract for an old one, or of one party in a contract for another party.

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Synthetic Trades:

Some trades just didn’t “fit the system” due to system parameters or unusual product
characteristics. In these cases, Matt would escalate the problem to Quantitative Risk
Management and risk managers, describing the specific problem and the risks it entailed.
It was important to identify these risks and possible issues early on: if the system could
not capture the specifics of the trade correctly, then manual adjustments would be
required daily as long as Lehman had the trade position in its books. Sometimes a
combination of separate systems would be needed to synthetically represent the trade.

As is usually the case with exceptions or problem cases, resolving this 1% of transactions
would take up around 30% of Matt’s time. Attention to it was critical, given this 1% of
transactions could easily represent millions of dollars of risk.

At times, Matt had difficulties explaining why the model valuations were overruled yet there
were no changes in the pricing models. In these situations, he would have to come up with
formulaic explanations that were, in his opinion, not meaningful and rather formulaic, such
as “based on discussions with the desk, the position is marked appropriately” or “continue to
monitor.”20 Even if he didn’t actually agree with these explanations, not having them would
force him to continue to question the desk. Sometimes, Matt thought traders were just
“buying time,” seeing where the asset was trending as they were uncertain about their own
valuations.

Matt also felt that risk management was compromised by a lack of information and that
Product Control often took the business desk’s word on valuation or booking issues at face
value.21 While Matt was familiar with many of the pricing methodologies, he was not an
expert in quantitative finance and he felt that the desk would often give him explanations
or spreadsheets deliberately meant to overwhelm him. He frequently raised these concerns to
management when he sought support to obtain further information on a trade, or to unwind
it. His concerns, however, were rarely addressed if the trade strategy was proven profitable.

Risk Management

Because Matt’s responsibilities included monitoring risk, his position was part of Lehman’s
extensive risk management function. He’d heard Lehman viewed risk management “as one of
its core competencies,”22 with “significant resources (including investments in employees and
technology)”23 devoted to it. He also knew that in industry circles it was regarded as one of the

20 Valukas, p. 325.
21 Valukas, p. 327. The extensive reliance on the business desk was justified by its “familiarity with the valuation models and
the underlying business fundamentals of each position” (Valukas, p.328). In extreme cases, business desks tried and managed to
impose their perspective, as an email from a desk manager to a product controller illustrates: “I have given you guidance on the
senior deals that we feel were incorrect. Please make the changes and let us know how this changed the total.” (Valukas, p.328).

22 Valukas, Appendix 8, p. 1.

23 Lehman Brothers Holdings Inc., Form 10-K for the fiscal year ended November 30, 2006 (filing date 13 February 2007), from
hereon simply referred to as “10-K 2006,” p. 57.

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best.24 In the summer of 2007, Matt assembled the following information about corporate risk
management and how his job contributed to it.

The Case for Risk Management

The case for risk management in financial institutions was pretty straightforward. Financial
institutions are exposed to a multitude of risks that are inevitably associated with their
business. Because of their business model and their social and economic significance,
financial institutions’ risk taking is extensively governed and strongly regulated on national
and supra-national levels. 25 In addition, financial market authorities impose detailed
disclosure requirements so that investors and other stock market participants can assess
financial institutions’ risk exposure and risk mitigation strategies. The banking industry itself
had sponsored a 1993 Risk Management Survey, which effectively became the foundation for
the establishment of institutionalized risk management practices.26

Risk Management Philosophy

Lehman appeared to have a strong risk management philosophy and marketed itself as having
“a culture of risk management at every level of the firm.”27 Its stated risk management mission
was to “protect and enhance the value of the franchise by proactively identifying, evaluating,
monitoring and controlling firm market, credit and operational risks.”28 Also, one of Lehman’s
operating principles was to demonstrate smart risk management: “Many of our businesses
require us to take risks, but we only take those risks we understand, where we have unique
insight, and where the rewards are sufficient to justify the potential cost. Taking these risks and
managing them well is the job of every employee.”29

It was as if risk management ran through the veins of all its employees. In a speech at the
Banking and Financial Services Investor Conference in 2005, CEO Fuld proudly attributed the
firm’s superior results over the preceding years to increased risk management and to the fact
that “every employee of the firm is responsible for risks.”30 In the industry, the ability to
churn out more revenue per dollar of capital was crucial to competing with bigger, better
capitalized rivals. Both Moody’s and Standard & Poor’s cited Lehman’s “top-notch market

24 Valukas, Appendix 8, p. 2.

25 Probably the most widely known piece of supra-national regulation that governs risk management is the so-called Basel
framework. This framework provides international standards on capital adequacy for banks, building on a solid foundation of
prudent capital regulation, supervision, and market discipline, and enhancing risk management in, and financial stability of, the
banking sector. It is issued and updated regularly by the Basel Committee of Banking Supervision at the Bank of International
Settlements in Basel, Switzerland. For more details, consult www.bis.org.

26 Global Derivatives Study Group, July 1993, http://www.prmia.org/pdf/Case_Studies/G30_Summary.pdf, accessed 16 June 2011.

27 Lehman Brothers Holdings Inc., Annual Report to Security Holders for the fiscal year ended November 30, 2007, from hereon
simply referred to as “Annual Report 2007,” p. 2.

28 Lehman Brothers Holdings Inc., Risk Management Update Presentation to Lehman Board of Directors, 15 April …