David Einhorn's 2007 presentation predicting the fall of Lehman Brothers

In yesterday's email, I gave a number of examples of "crime and (mostly lack of) punishment in the financial world" – but I left out a big one...

This one is important and interesting enough to warrant its own discussion: the collapse of investment bank Lehman Brothers in September 2008, which was at the time the largest corporate bankruptcy in history.

It was likely the largest spark that turned a somewhat contained financial crisis into the global financial crisis.

Nevertheless, you won't be surprised to hear that nobody was charged with a crime, much less went to jail, for this.

This is on my mind because an account on X called "Finding Compounders" posted something last week I had never seen before: an e-mail exchange on May 19 and 20, 2008 between my friend and legendary hedge fund manager David Einhorn of Greenlight Capital and then-chief financial officer of Lehman Brothers, Erin Callan.

At the time, Einhorn had already publicly disclosed his short position in Lehman's stock and was trying to get answers to a number of questions before his upcoming presentation at the Ira Sohn Investment Research Conference on May 21, 2008.

Rather than answering his questions, Callan instead wrote:

As I mentioned on [the] telephone, I come away from our conversation Friday and this e-mail below feeling you have been very disingenuous...

Unfortunately, it does not seem prudent on my part to engage in any further conversations with you going forward.

In his reply, Einhorn wrote:

Erin, the fact is that I believe your firm is doing an enormous disservice to our financial markets. Rather than follow the course of most of your peers and take your write-downs, acknowledge your capital hole and seek out a recapitalization – Lehman continues to insist that it is profitable, doesn't need to raise capital, has hedged etc.

In fact, you have aggressively added assets into the crisis (July – February) and diminished your capital through aggressive buybacks and dividend increases. It would be much better if you reduced your risk for yourself and the financial system at large.

You and your management seek and receive press for your expert crisis management skills – which from my perspective mostly means denying the reality of your balance sheet and calling for investigations of short-sellers who have the temerity to think for themselves.

Failing to listen to Einhorn was a mistake of epic proportions.

Had Callan listened, she would have recognized the need to raise capital to offset losses and write-downs (which was still possible, as Lehman's stock was at $39 per share), Lehman would likely have survived, and the global financial crisis might have been meaningfully less severe.

Instead, she, CEO Dick Fuld, and other senior managers circled the wagons, lied to investors, regulators, and themselves, and sunk their 158-year-old bank.

Einhorn's speech at the Ira Sohn Conference is the one everyone remembers because it was the last major one before the blow-up. But he actually first went public with his warnings six months earlier, on November 29, 2007, when Lehman's stock was $64 per share.

I know this because it was at my conference, the Value Investing Congress, and I was standing on stage next to him. I don't have a picture of us from that day, but here's what we looked like at my 2005 Congress:

I've never made public Einhorn's historic 35-slide presentation that day, but he gave me permission to do so today: you can see it right here.

It was so compelling that I shorted Lehman's stock not long thereafter – and made a fortune when it went to zero in September 2008.

I want to highlight a few key slides because Einhorn's analysis was so brilliant – and can be applied to analyzing any financial company...

Late in the presentation (page 26), he showed Lehman's balance sheet for the latest quarter (ending August 31, 2007) compared with the end of the previous fiscal year nine months earlier (ending November 30, 2006):

Two things jump out at me...

First, in a period when cracks were clearly emerging in the housing and debt markets, Lehman grew its balance sheet dramatically, with liabilities soaring 31.6%. Instead, it should have been shrinking its balance sheet so it could weather the coming storm.

Second, Lehman's equity base was dangerously low. Assets were 26.2 times equity at the end of the 2006 fiscal year – and this worsened to 30.3 times by the end of the third quarter of 2007.

Things are even worse when you look at Einhorn's next slide, which breaks down two items on the balance sheet – "Financial instruments and other inventory positions" on the assets (owned) side and the liabilities (shorted) side:

Unexploded bomb abound...

Let's start with the big increase in the first line, "Mortgages and mortgage-backed" debt – one of the riskiest areas in light of the collapsing housing market. Worse yet, you can see that it was almost completely unhedged.

Meanwhile, safer "Government and agencies" debt actually declined – and was more than fully hedged.

Risky "Derivatives and other contracts" grew 57% and wasn't fully hedged.

Lastly, risky "Real estate held for sale" more than doubled.

Note that some of these numbers might seem small in the context of a $659 billion asset base, but the number that really matters is the tiny $21.7 billion in equity from the first slide above.

Einhorn then showed (page 29) Lehman's "Lending-Related Commitments," which doesn't appear on the balance sheet, but reflects very real liabilities – the contractual commitment to lend cash:

Again, the largest increase is in the riskiest area: non-investment grade contingent acquisition facilities. That means Lehman wasn't just on the hook to lend cash – but to dicey companies or deals.

Finally, Einhorn's next slide showed the massive increase in "Derivative Contracts" to $768 billion in notional exposure:

It's hard to assess the risk here because some derivatives contracts are very safe – and, as Einhorn mentions in the footnote, the fair value of these contracts is "only" $11.1 billion. But the trend is certainly in the wrong direction...

To be clear, at this point – 10 months before Lehman filed for bankruptcy – Einhorn wasn't predicting a total collapse. Rather, he concluded (page 32) that Lehman would be forced to recognize losses:

In conclusion, Einhorn showed that Lehman was dangerously levered to the hilt at more than 30-to-1 assets to equity, all the trends were going in the wrong direction, and management was clearly failing to acknowledge losses all over its balance sheet.

That is a dangerous combination that every investor should always be on the lookout for. If you find it, it doesn't mean you should short the stock – that's risky – but for sure avoid it!

Best regards,

Whitney

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