

The math that killed Lehman Brothers - vaksel
http://plus.maths.org/issue51/features/boedihardjo/index.html

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mediaman
Note: In a prior life I was a part of the CDO research group supporting the
clients at Lehman's trading desk in NYC. I'm familiar with what happened
there.

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.

~~~
tlrobinson
For an amusing tangent to your amusing tangent, Blizzard's offices have
bullet-proof windows and doors to prevent disgruntled World of Warcraft
players from going on shooting rampages.

(<http://pc.ign.com/articles/662/662143p1.html>)

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jonknee
I have a hard time reading an article about why CDS instruments are to blame
when the author doesn't know what they are. CDS = Credit Default Swaps, not
Credit Derivative Swaps. All it takes is putting CDS into Google, five seconds
tops.

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.

~~~
jdrock
<http://en.wikipedia.org/wiki/Credit_default_swap#Description> The terms are
synonymous, apparently.

~~~
jonknee
No, that just says that a credit default swap is one type a credit derivative
contract. Derivatives can have many triggers, default is the one talked about
here.

------
jwb119
this article leaves more questions than it answers. how does the author know
the contents of an "investment plan" that was on the CEOs desk? where does the
3% number come from that is the bulk of the assumptions about the housing
market.. and more than a few others..

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..

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padmanabhan01
'math' killed? or stupid assumptions made by the analysts ?

~~~
mattyb
_In English, however, the noun mathematics takes singular verb forms. It is
often shortened to math in English-speaking North America and maths
elsewhere._

<http://en.wikipedia.org/wiki/Mathematics#Etymology>

The author goes to Oxford.

~~~
padmanabhan01
I was not talking about the usage 'math' or 'maths'. I was saying, it is not
the fault of math/maths when we make wrong assumptions like 'house prices
can't go down' or 'prices will always increase' etc. GIGO.

~~~
grellas
In the early 1980s in California certain prominent second mortgage lenders
filed bankruptcy after advertising long and loud that "you can't lose on
California real estate."

In theory, when you invested, you loaned your money directly to a California
homeowner secured by a deed of trust.

In reality, given that the borrower was paying 15 points on the loan, plus 24%
interest, the loan hardly fell into a typical "secured" category. These
borrowers were in fact taking out 3rd, 4th, and 5th loans on properties whose
only "equity" consisted of paper value generated by mass phony appraisals done
by or in coordination with a whole set of players who had a stake in keeping
the game going.

When it all collapsed, people were observing how naive all those investors
were to invest in something that sounded too good to be true.

It looks like our Wall Street wizards fell victim to the same impulse. This
led to the bad assumptions that fueled their greed and to their ultimate
demise.

Nothing new under the sun, said Solomon. It is all too true.

~~~
grimoire
Large gains always means you are assuming a large risk. No one has yet to come
up with a way of removing (or greatly reducing) risk without also greatly
reducing the gains.

Ignore large gains at your own peril.

------
ajju
Blind reliance on models killed Lehman Brothers. Math was just the tool they
used to inflict lethal injury on themselves.

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

~~~
mediaman
Dick Fuld was never 'one of the boys': Lehman had a tortured past, and grew up
after its spinout from American Express as a bond house, not an elite
investment bank, and only began rising in the M&A league tables in the 2000s.
Until then they made money and were good but never had the social status of
the GS execs.

To the other commenter: Lehman was too terrified of its own capital base to
participate in the LTCM bailout, but yes they didn't win any friends with
that.

------
snewe
The article does little to show hows maths brought down Lehman Brothers.
Rather, it shows how important assumptions about the future (and your
uncertainty surrounding those assumptions) are for structuring financial
contracts.

------
BRadmin
"Therefore, investing on CDO is a riskier choice than betting for Manchester
United."

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.

~~~
bwanab
I think the point he didn't make very well was that CDOs and the direction of
the stock market were correlated and most CDO participants also were stock
market participants. Manchester United's chance for victory is presumably
uncorrelated with either of those, so if you were a stock market participant
who also bet on Manchester, you were better off than if you were a stock
market participant who bet on CDOs.

~~~
BRadmin
I agree.

I think his point was pretty clear, but his subsequent conclusion regarding
the risk factor just seems completely nonsensical to me -- I mean, you could
bet on any not-correlated-to-the-stock-market-event, regardless of its
probability or odds factor, and it would have yielded less risk than holding
CDOs as per his assessment. He's just talking about diversifying, but with the
assumption that a stock market crash / economic crisis is imminent.

------
yangyang
Rather minimal "maths". There's no mention of the pricing models used for CDS
and CDOs. That would have been more interesting.

~~~
TriinT
I agree. And allow me to suggest this paper: <http://arxiv.org/abs/0809.1393>

It's not everyday that you see an algebraic geometer writing on CDOs ;-)

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initself
I love the candid bio at the end of the article.

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jswinghammer
The same thing happened to Long-Term Capital Management. You can read up on it
here:

<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.

~~~
mattyb
An excellent book on LTCM is 'When Genius Failed' (not an affil link):

[http://www.amazon.com/When-Genius-Failed-Long-Term-
Managemen...](http://www.amazon.com/When-Genius-Failed-Long-Term-
Management/dp/0375758259)

------
madair
Excellent article, but the notion that we should believe that idiocy was at
the heart of this seems quite wrong to me. At best, willful idiocy.

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.

