Spare the rod, spoil the child

I’m a little late commenting on it, but the official, court-ordered bankruptcy examiner’s report on Lehman Brothers came out last week. The report is extremely detailed (9 volumes!), and most commentators have focused on the shady Repo 105 deals that artificially hid Lehman’s real liabilities while boosting its assets.

I just want to take a minute to talk about basic incompetence, however. When a large proportion of Harvard’s graduating class goes into investment banking each year, what they’re mostly going into is ‘valuation’. It’s not a terribly difficult thing, but it is very time-consuming and requires attention to detail. You employ a standard set of models and theories to derive present value of various companies, assets, commodities, etc. Then you see if present-day prices are less than your calculated value. Buy low, sell high, and all that. One of the most basic concepts in valuation is the intertemporal discount rate. Having a dollar of income today is generally better than having that same dollar of income tomorrow, because with that dollar today I can invest and have more than a dollar tomorrow. So to calculate the net present value of an asset, an investment banker will discount future earnings by a given discount rate. This is Valuation 101, and the bread and butter of an investment banker’s job. If investment bankers ‘deserve’ their ridiculous compensation, then it’s most likely for their skill at valuation.

So it might surprise you to learn that Lehman Brothers was doing an absolutely terrible job of valuation. Frank Partnoy has a great summary of the bankruptcy examiner’s report’s section on valuation, where he finds this nugget in the report (page 556):

The discount rates used by Lehman’s Product Controllers were significantly understated. As stated, swap rates were used for the discount rate on the Ceago subordinate tranches. However, the resulting rates (approximately 3% to 4%) were significantly lower than the approximately 9% discount rate used to value the more senior S tranche. It is inappropriate to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche. [emphasis added]

That last sentence is a study in understatement. The ‘tranches’ they’re talking about are the way you slice and dice a pool of mortgages, with the “more senior S tranche” being a less risky pool of mortgages, and the “Ceago subordinate tranches” being a significantly more risky group of mortgages. Lehman’s quality control group operating above the trading desks created valuation models that get valuation completely wrong. When something is more risky, you use a larger discount rate to reflect net present value. The examiner’s report says, moderately, “It is inappropriate to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche.” Perhaps a more accurate reading would be, “It is completely fucking boneheaded and a breach of the most basic standards of professaionalism to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche.” This isn’t even an issue of the products being too complicated to value properly (though they were); it’s an issue of getting even the most basic parts of the model right.

Which leads me to the title of today’s post: “spare the rod, spoil the child.” We’ve all heard this from certain strict Christian parents who think that a child won’t learn unless you beat them senseless. I don’t personally sign up for that brand of parenting, but at some point there really do have to be consequences for misbehavior. I’m not advocating the US adopt the practice, but it is noteworthy that the North Korean government tried its lead financial and economic planner for incompetence and then executed him by firing squad a couple days ago. Sure, Kim is a dictatorial dickhead, and the poor schmuck was just a fall guy for Kim’s own policies. But say what you will about the DPRK, they don’t spare the rod.

Maybe we don’t need to go that far. Maybe all we need to do is limit the insane, unearned profitability of the financial sector so that incompetent i-bankers don’t get take-home pay that would make a Gilded Age tycoon blush.

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2 Responses to “Spare the rod, spoil the child”


  1. 1 JSC7 March 22, 2010 at 1:36 pm

    I never thought I could say with a straight face that valuations done at TSC were more reasonable than those of a major investment bank.


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This is a group blog. JSC5 currently writes from the US. JSC7 writes from behind the Great Firewall of China.

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