As Lehman Brothers (NYSE:LEH) stares into the abyss, Martin Hutchinson says the company’s risk management strategy is to blame.

The company leveraged its assets far too much over the last few years, using ‘dozy’ risk metrics that forced little restraint on bankers. This meant even a small drop in asset values could wipe out the bank’s capital.

Martin says Lehman Bros was not the only big bank to follow this reckless strategy.

There could be more blood on Wall Street before this crisis is over.

This from Money Morning:

Of the five big investment banks that were in operation at the outset of this year, The Bear Stearns Cos. has already failed and been taken over and Lehman Brothers is trying to avoid a similar fate.

That leaves only three members of the original group - Goldman Sachs Group Inc. (NYSE:GS), Merrill Lynch & Co. Inc. (NYSE:MER) and Morgan Stanley (NYSE:MS) - a casualty rate as steep as the one experienced by second lieutenants on World War I’s Western Front.

Just where were all the risk-management experts who should have assessed the pitfalls these companies faced, and how could they have missed the massive risks that are now threatening to take this entire sector down?

The answer may be more than a minor exercise in financial irony. Lehman, the latest Wall Street investment bank forced to the brink of failure, may have put itself out on that precipice with its own risk-management strategies.

Let’s take a closer look.

In its 2008 Annual Report, Lehman boasted of having “a culture of risk management at every level of the firm.” That was written at the end of last year, when the global stock and credit markets had already been in turmoil for several months.

As an investor, one’s question here has to be: “If there was a culture of risk management at every level of the firm, how come you allowed the leverage ratio (total assets divided by stockholders equity) to rise from 26.2 to 1 in the tranquil bull market of 2006 to 30.7 to 1 in the troubled market of November 2007?”

Even more bothersome: There weren’t any losses that year that dinged stockholders’ equity - in fact, Lehman increased its stockholders’ equity by more than $3 billion.

Investment bankers love leverage. That’s because, the more assets you control, the more chance you have to make money from them - and the bigger the bonus you can hope for at the end of the year. However, 12 years of easy money - a run that started when then-U.S. Federal Reserve Chairman Alan Greenspan turned on the monetary spigots in March 1995 - seems to have made investment bankers greedy.

And reckless.

Yes, they had risk management, but it mostly used the “Value at Risk” system invented by JPMorgan in the early 1990s.

VAR appears to have been designed to let the traders get on with the business of making real money, while at the same time keeping the top brass from worrying too much about the risks traders were taking.

It makes a number of mathematical assumptions that are provably false in real life, then assesses the “99% confidence limit” of the loss that may be incurred by each trading position at most 1% of the time (this is usually done by modeling the price behavior of a particular security as a Gaussian normal curve - a “bell curve,” and then taking the point 2.36 standard deviations from the mean).

One big problem with this approach to managing risk is that it doesn’t tell you what can happen the other 1% of the time, when the VAR limit is exceeded.

But the top managers of the investment banks were lulled into believing that other 1% didn’t matter: After all, they came to believe, if it was only a 1% probability, how dangerous could it be? However, since VAR was calculated from daily price movements, that 1% actually was quite important.

Even if VAR is modeling monthly movements, an exceptionally conservative use of it recommended by international regulators for the Basel II bank regulating accords, 100 months is still only 8.33 years. Looking at the possibility of going bankrupt every 8.33 years and viewing that as an acceptable risk is absolutely not something that bankers should be doing.

The other problem with VAR is that, in most cases, it depends on an assessment of the “volatility” of the security concerned - how much that security bounces around. However, volatility is by definition low in quiet markets and much higher in turbulent markets. Hence, the system’s assessment of risk is low when markets are quiet, allowing traders to pile on positions like madmen, and then zooms upward when things go wrong. At that point positions cannot be unwound.

As you can see, “a culture of risk management at every level” is not a great deal of use if you’re using dozy metrics like VAR to measure risk. The problem is made worse if you indulge in excessive leverage.

Traditionally, the maximum leverage for Wall Street broker-dealers was held to be 20 to 1. That level was always fudged a bit, partly by pretending that so-called “subordinated” debt was the equivalent of equity, which it obviously isn’t.

So, while this 20-to-1 ratio is fine when your assets consist of commercial paper, bonds and shares that can be more-easily valued because they are more-liquid and trade every day, it is far too high when the asset mix has come to include investment real estate, private equity stakes, hedge fund positions, credit default swaps and other derivatives positions that do not even appear on the balance sheet.

Scaling up from 20 to 1 to 30 to 1 - as Lehman did - is asking for trouble.

Even if the off-balance-sheet credit default swaps (CDS) and other derivatives don’t give you trouble, and there are no assets parked in “structured investment vehicles,” or SIVs, that suddenly must be taken back onto the investment bank’s balance sheet. An institution that is levered 30 to 1 needs to see a decline of only 3.3% in the value of its assets before its capital is wiped out.

In a global credit crisis such as the one we’re navigating right now, even if some of the assets are rock-solid Treasuries and such, a 3.3% decline can happen frighteningly quickly: You only need to see a 10% decline in value of a third of your assets.

If that seems reckless to you, consider this: Lehman’s leverage is not exceptional among Wall Street investment banks. According to the most recent quarterly financial statements (focusing on the balance sheet as of May or June), while Lehman’s leverage had been brought down to 23.3 times through asset sales, Morgan Stanley’s was still 30.0 times, Goldman Sachs’s 24.3 times, and Merrill Lynch’s was an astounding 44.1 times.

Far be it from me to contribute further to Wall Street’s current gloom. So do the research and come to your own conclusions.

Source: How Lehman Brothers’ Own Risk Management Strategy May Cause it to Fail