The failure of Lehman Brothers and the ensuing fallout remain hot topics of conversation in the world of finance nine years after the investment bank came crashing down. The principals who decided to allow Lehman to fail have issued their respective memoirs, arguing their options were limited and awkwardly attempting to reconcile the decision on Lehman with their choice to bail out Bear Stearns and AIG.

Apart from the principals, analysts fall into two predominant camps on Lehman. One argues that allowing failure was the right call but the decision was part of such a confused and inconsistent policy approach that the subsequent decision to bail out AIG and other institutions wiped out any benefit derived from the Lehman failure in combating moral hazard. The other camp claims the government should have propped up Lehman like it did so many other large institutions, although in truth most in this camp did not come to that conclusion until after the key decisions were made in mid-September 2008.

Into this thicket, Oonagh McDonald enters to shed light on the failure, the fallout, and in particular the question of value of the Lehman asset portfolio. McDonald is a former member of the United Kingdom parliament and author of several books, including most recently Fannie Mae and Freddie Mac: Turning the American Dream into a Nightmare. I got a preview of Lehman Brothers: A Crisis of Value at a small gathering just before its release, during which she made herself available to discuss her research and respond to questions.

She really folds two books into one in Lehman Brothers. The initial chapters focus on the buildup in size of Lehman in the run-up to its ultimate failure, how Bear Stearns and Lehman shadowed each other operationally, the Securities and Exchange Commission’s efforts at applying a supervisory framework to the investment banks, and finally what McDonald calls the “Fateful Weekend” when Lehman Brothers unraveled. The second half of the book, with a few exceptions, focuses on matters of valuation: the so-called destruction of value that bankruptcy spawned, how Lehman internally valued its own assets, and the process of measuring and monitoring value. As promotional materials for Lehman Brothers gravely summarize it: “On September 12th, 2008, Lehman Brothers was valued at 639 billion US dollars. On Monday 15th September, it was worth nothing.”

To bail or not to bail / McDonald accepts the narrative that it was a big mistake to let Lehman fail, claiming, “It was the lack of understanding of the linkages which led to the calamitous decision to allow Lehman Brothers to fail.” She further notes:

The costs of “No bail-out” were far greater than [U.S. Treasury Secretary Henry] Paulson, [Federal Reserve Board Chairman Ben] Bernanke and [New York Federal Reserve Bank President Tim] Geithner could ever have envisaged for a single moment. If they had been aware, as they should have been, of at least some of the possible effects, then it is entirely possible that Lehman Brothers would have been rescued.

This quote, combined with her favorable quotation of a description of the aftermath of failure as “Armageddon,” makes clear that she would have sided with those who, mostly after the fact, argued that intervention would have been better than allowing Lehman to fail. McDonald does not trace in detail her “linkages” argument.

She makes a clearer argument when she enters the well-trodden ground of whether or not the Federal Reserve had legal authority to bail out Lehman. Bernanke, Paulson, and Geithner all contended that the Fed could not lend without a reasonable expectation of payment, and in the case of Lehman they could not reach that relatively low bar. McDonald favorably quotes Tom Russo, general counsel for Lehman Brothers, in this regard, “Any court would have deferred to the Federal Reserve on an interpretation of its statutory powers, especially given the unprecedented circumstances.” She then concludes that the argument on lack of powers “appears to be a post hoc view.” I would agree with that conclusion.

She also judges rather harshly Paulson’s zigging and zagging on whether to lend to AIG in comments made a few days after the fall of Lehman: “The rescue of AIG took place on 16 September, and made a nonsense of Paulson’s stand on moral hazard and no more government bailouts.” On point again.

McDonald dedicates quite a bit of ink to the March 2008 failure of Bear Stearns, noting that the expectations were that Lehman Brothers would likely be the next domino to fall as indicated by the 20% drop in its stock the day after the bailout of Bear Stearns. She is right that Bear Stearns should have been a red flag for Lehman and the market should not have been surprised by its failure. But she fails to point out that it was the contrasting and perplexing way that the financial authorities handled Bear and Lehman that threw the market into turmoil, not the fact that Lehman was some type of trigger in and of itself.

She makes a curious distinction at points throughout the book on this issue. She argues that Lehman Brothers was not the “cause” of the crisis but it was the “trigger.” This would have been more convincing with some evidence of a knock-on effect of Lehman Brothers’ failure in the form of financial institutions that failed as a result of its collapse, but McDonald does not provide such evidence.

Trimont and Repo 105 / The valuation chapters that take up much of the rest of the book are a focal point primarily because of the over-valuation of Lehman’s real estate–related assets. These chapters are a difficult read as McDonald goes into excruciating detail to explain various appraisal and valuation guidelines of the federal banking agencies and the Financial Accounting Standards Board Fair Value Measurement Standard. I admit that I had not previously given much thought to this aspect of Lehman’s failure. McDonald traces much of the problem with the valuation work to Trimont, Lehman’s real estate adviser, and their flawed methodology for determining the potential success of a project. The methodology did not take into account the overall deteriorating mortgage market.

McDonald also explains that the mysteriously named “Repo 105” was a technique that Lehman Brothers used to manipulate the extent of leverage reported in its financial statements. Unfortunately, she does so by jumping into the topic without much in the way of background, such as the fact that this method was specific to Lehman. I did find useful her comparison of Lehman’s calculated leverage as presented using Repo 105 and adjusted figures without. I should note that there didn’t seem to be that much difference. Unfortunately, she does not give an example of how the Repo 105 technique was used to dress up Lehman’s balance sheet, background that would have been a nice way to ease into the topic.

This is a problem throughout the book. There are almost no explanatory tables or charts, which would have been a nice way to break up the unending recitation of the issues. The only exception is an organogram of Lehman’s corporate structure at the very end of the book.

“Destruction of value” describes the value that Lehman’s creditors saw vanish because of the way the firm was unwound in bankruptcy, what McDonald and others have called a “disorderly” bankruptcy. This loss is estimated to have been $150 billion as compared to what would have been achieved in a more “orderly” bankruptcy. “That’s $150 billion of value out of pension funds and savings,” she writes. But this conclusion is problematic given the difficulty in picturing the perfect, orderly bankruptcy proceeding. As reform measures go, McDonald places a lot of hope in two Dodd-Frank provisions to improve the chances of retaining value in future bankruptcies of financial institutions, one on orderly liquidation authority and another on recovery and resolution plans.

Final thoughts / The last chapter of Lehman Brothers is a curious diatribe on the efficient market hypothesis, a chapter that seems entirely out of place in the progression of the book. McDonald relies on supporters of heavy-handed government intervention for this chapter. First, Joseph Stiglitz: “The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self-adjusting and the best role for government is to do nothing.” Second, George Soros: “On a deeper level, the demise of Lehman conclusively falsifies the efficient market hypothesis.”

The book does not break much ground in the way of original research that was not available for other books that addressed Lehman Brothers. McDonald relies most heavily for her source material on Anton Valukas, who was appointed by the Lehman bankruptcy court to report on the causes of filing. She cites his work dozens of times throughout the book.

The approach that McDonald pursues in blending the historical details on the failure of Lehman with a separate focus on valuation of assets was an ambitious effort. Unfortunately, it was not always executed very well.