How Warren Buffett Analysed Lehman Brothers

A friend of Jeremy and I recently shared a tweet with us from Andrew Kuhn, a partner at the investment firm Focused Compounding, that I found fascinating. It mentioned an interview Warren Buffett did with the Wall Street Journal in 2018 where he explained his reasons for rejecting Lehman Brothers’ plea for financing during the 2008-09 Great Financial Crisis.

Prior to its bankruptcy in September 2008, Lehman Brothers was a storied investment bank that was founded more than a century ago in 1847. Lehman first approached Buffett for help in March 2008. After studying Lehman’s then-latest 10-K – for the financial year ended 30 November 2007 (the 10-K is the annual report that US-listed companies have to file) – Buffett discovered multiple red flags and decided to turn the bank down.

During his interview with the Wall Street Journal, Buffett showed a physical copy of Lehman’s 10-K that he read and made notes on. I managed to find a copy of Buffett’s 10-K and thought it would be an interesting exercise to run through all the pages he marked out as red flags to understand how he analysed Lehman Brothers in 2008.

Before I continue, here are some important things to note:

• What I’m about to share are merely my interpretations and I make no claim that they accurately portray Buffett’s actual thought process.
• This is the most complex set of financial statements that I’ve seen since I started investing in 2010 so I might be getting some of the details wrong (it’s also a great reminder for me to proceed with extreme caution when investing in banks!).
• Kuhn created a video with his colleague, Geoff Gannon, that featured their analysis of Buffett’s copy of Lehman’s 10-K. I watched it while reading the document and it was really helpful for my own understanding of the red flags that Buffett noted.

Buffett’s mark ups: Page 106 & 107

These pages contain Figure 1 below, which shows the high yield bonds held by Lehman in FY2007 and FY2006.

Three things stood out to me: 

• The high yield bond positions increased significantly by 137% from US$12.8 billion in FY2006 to US$30.4 billion in FY2007. 
• The increase was a result of Lehman being unable to offload these positions, an indication that perhaps these assets were of poor quality. Per Lehman’s 10-K (emphasis is mine): “The increase in high-yield positions from 2006 to 2007 is primarily from funded lending commitments that have not been syndicated.”
• The high yield bond positions need to be seen in relation to Lehman’s shareholder’s equity of merely US$22.5 billion in FY2007. If these high yield positions – US$30.4 billion – were to decline sharply in value, Lehman’s shareholder’s equity, and thus financial health, would be in serious trouble.

Pages 106 and 107 also mentioned that Lehman was authorised to buy back up to 100 million shares of itself “for the management of our equity capital, including offsetting dilution due to employee stock awards.” I’m guessing this did not sit well with Buffett from a capital allocation perspective because buying back shares merely to offset dilution is not an intelligent nor prudent use of capital.

Buffett’s mark ups: Page 115

This page is linked to the following passages (empahses are mine): 

“We enter into various transactions with special purpose entities (“SPEs”). SPEs may be corporations, trusts or partnerships that are established for a limited purpose. There are two types of SPEs— QSPEs and VIEs.

A QSPE generally can be described as an entity whose permitted activities are limited to passively holding financial assets and distributing cash flows to investors based on pre-set terms. Our primary involvement with QSPEs relates to securitization transactions in which transferred assets, including mortgages, loans, receivables and other financial assets, are sold to an SPE that qualifies as a QSPE under SFAS 140. In accordance with SFAS 140 and FIN-46(R), we do not consolidate QSPEs. We recognize at fair value the interests we hold in the QSPEs. We derecognize financial assets transferred to QSPEs, provided we have surrendered control over the assets.”

What these passages effectively mean is that Lehman had off-balance sheet entities (the QSPEs) that housed certain assets so that they would not show up on Lehman’s own balance sheet. But it was exceedingly difficult to know (1) the value of these assets, (2) what these assets were, and (3) Lehman’s liabilities that were associated with these assets. Buffett might have been worried about the damage these unknowns could wrought on Lehman if trouble manifested in them.

Buffett’s mark ups: Page 125

This page is linked to the following passages (emphases are mine):

“Derivatives are exchange traded or privately negotiated contracts that derive their value from an underlying asset. Derivatives are useful for risk management because the fair values or cash flows of derivatives can be used to offset the changes in fair values or cash flows of other financial instruments. In addition to risk management, we enter into derivative transactions for purposes of client transactions or establishing trading positions. The presentation of derivatives in our Consolidated Statement of Financial Position is net of payments and receipts and, in instances where management determines a legal right of offset exists as a result of a netting agreement, net-by-counterparty. Risk for an OTC derivative includes credit risk associated with the counterparty in the negotiated contract and continues for the duration of that contract.

The fair value of our OTC derivative assets at November 30, 2007 and 2006, was $41.3 billion and $19.5 billion, respectively; however, we view our net credit exposure to have been $34.6 billion and $15.6 billion at November 30, 2007 and 2006, respectively, representing the fair value of OTC derivative contracts in a net receivable position after consideration of collateral.”

Lehman had OTC (over-the-counter) derivative assets of US$41.3 billion in FY2007. These assets were problematic because (1) it’s hard to tell what’s in them and thus if Lehman had any counterparty risk, (2) it’s hard to tell what their actual values were since they were traded over-the-counter, and (3) they had more than doubled in value from FY2006 to FY2007. Moreover, Lehman’s shareholder’s equity in FY2007 was just US$22.5 billion, as mentioned earlier. This meant the investment bank did not have much cushion to absorb any significant declines in the value of its OTC derivative assets if they were to occur. 

Buffett’s mark ups: Page 173 & 175

These pages are linked to Figure 2, which shows all the financial instruments and inventory owned by Lehman in FY2007 and FY2006:

I think what troubled Buffett here would be the owned derivatives and other contractual agreements of US$44.6 billion in FY2007. The number was double that of FY2006 and as Figure 3 below illustrates, all of these assets were traded over-the-counter and thus had values that could not be easily determined. Let’s not forget too, that Lehman’s shareholder’s equity – US$22.5 billion in FY2007 – would provide only a thin buffer if any large decline in value for the owned derivatives and other contractual agreements happened. 

Buffett’s mark ups: Page 180

This page is linked to a description of the way Lehman groups its assets based on how their values are derived. Per the 10-K (emphases are mine):

“Level I – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. The types of assets and liabilities carried at Level I fair value generally are G-7 government and agency securities, equities listed in active markets, investments in publicly traded mutual funds with quoted market prices and listed derivatives.

Level II – Inputs (other than quoted prices included in Level I) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life. Fair valued assets and liabilities that are generally included in this category are non-G-7 government securities, municipal bonds, certain hybrid financial instruments, certain mortgage and asset backed securities, certain corporate debt, certain commitments and guarantees, certain private equity investments and certain derivatives.

Level III – Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model. Generally, assets and liabilities carried at fair value and included in this category are certain mortgage and asset-backed securities, certain corporate debt, certain private equity investments, certain commitments and guarantees and certain derivatives.”

Put simply, Lehman had three types of assets: Level I assets had values that were determined simply by publicly-available prices while Level II and Level III assets had values that were determined using management’s inputs. Page 180 is also linked to Figure 4 below:

What Figure 4 shows is that one of Lehman’s single-largest asset categories – mortgage and asset-backed securities – were nearly all Level II and Level III assets. They are thus assets whose prices were not easily determinable by third-parties at that point in time. And their collective value was US$89.1 billion, four times higher than Lehman’s shareholder equity of US$22.5 billion. Buffett might have been worried that Lehman would be wiped out if these assets were to fall by just 25% in value – a distinct possibility given that the US housing market was already shaky back then.

Another aspect of Lehman’s financials linked to Page 180 of its 10-K that might have troubled Buffett is shown in Figure 5: Lehman’s Level III mortgage and asset-backed positions had surged threefold from just US$8.6 billion in FY2006 to US$25.2 billion in FY2007. 

Buffett’s mark ups: Page 184

This page is linked to the following paragraphs (emphases are mine):

“The Company uses fair value measurements on a nonrecurring basis in its assessment of assets classified as Goodwill and other inventory positions classified as Real estate held for sale. These assets and inventory positions are recorded at fair value initially and assessed for impairment periodically thereafter. During the fiscal year ended November 30, 2007, the carrying amount of Goodwill assets were compared to their fair value. No change in carrying amount resulted in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. 

Additionally and on a nonrecurring basis during the fiscal year ended November 30, 2007, the carrying amount of Real estate held for sale positions were compared to their fair value less cost to sell. No change in carrying amount resulted in accordance with the provisions of SFAS No. 66, Accounting for Sales of Real Estate, SFAS No. 144, Accounting for Impairment or Disposal of Long Lived Assets, and other relevant accounting guidance. The lowest level of inputs for fair value measurements for Goodwill and Real estate held for sale are Level III.”

It turns out that Lehman’s real estate held for sale of US$21.9 billion in FY2007 – first shown in “Buffett’s mark ups: Page 173 & 175” – could have been Level III assets. So the stated value of US$21.9 billion may not have been anywhere close to what these assets could fetch in an open transaction, since the US housing market was already in trouble at that point in time.

Final word

Buffett’s marked-up copy of Lehman’s 10-K contained more pages that he noted down as red flags, such as pages 188, 199, 209, and more. But when I read them, there was nothing that jumped out at me as being highly unusual so I’ve not included them in this article.

Again, everything I’ve shared earlier are merely my interpretations and I make no claim that they accurately portray Buffett’s actual thought process when he studied Lehman’s 10-K. Nonetheless, I found it to be an interesting exercise for myself and I hope you find my takeaways useful too. The biggest lesson I have is that if I were to research a bank, I need to study its footnotes and I should be extremely wary of banks with complex balance sheets that contain a significant amount of assets with questionable values.

---

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time. Holdings are subject to change at any time.