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The Amazing Lehman Brothers!

FEATURE BY MAX NOBLE
06/10/2022

Reader!

Trust me like the Ghost of Christmas Past, and with your Scrooge mind-set aglow let us fly to the past to see if once more it can provide guiding lights to the future. Hang on to your nightshirt because here we go once more on a manic Pitpass flight of fancy. Our goal? To explore just why Inspector Hound and the FIA Forensic Bean Counters cannot confirm how many beans make five...

We start with a visit to The Amazing Lehman Brothers! No, not a trapeze act, rather an investment bank founded in Montgomery, Alabama in 1850, 172 years ago, by three brothers Henry, Emanuel, and Mayer. Prior to investing they plied a number of trades that over the course of a century saw them become a major investment firm employing more than 25,000 staff, handling massive amounts of money. This all ended in September 2008, 14 years ago, when the firm filed for chapter 11 bankruptcy. Their investments in the sub-prime mortgage domain, of highly questionable value, collapsed. The movie The Big Short tells the story in marvellous fashion, including some very amusing monologues to camera explaining all the financial instruments that (mostly) legally caused the American sub-prime mortgage crisis, tipping planet Earth into the Global Financial Crisis.

Allow me a touch more financial background dear reader, then we will swoop with our usual grace back into the F1 universe...

September 2007, and Lehman's post a modest $487 million quarter profit, while the two much larger banks, CitiGroup and Merrill Lynch, post $5.1 and $1.97 billion losses respectively for the quarter. Zip forward to June 2008, and Lehman's announce an unexpected $2.8 billion loss for the quarter, causing their share price to dive 75%. They quickly borrowed $6 billion (pocket money) while divesting assets to try and remain afloat.

August 2008 and Lehman's announce 1,500 staff have been released... September and a massive $3.9 billion dollar loss for the quarter signals Lehman's is cooked. Filing chapter 11 bankruptcy on Monday 15th September (which in the USA allows you under strict conditions to trade your way out of insolvency) Lehman's reveal $613 billion of bank debt, and $155 billion of bond debt. That's total debt of $768 billion US dollars! F1 budget cap, look at those numbers and weep!

On March 11 2010, nearly two years later, Anton R. Valukas, the court appointed forensic accountant (examiner) published their report. The report, among many dry facts, highlighted Lehman's had used a technique they called Repo 105 whereby assets were briefly sold for cash to inflate the books just prior to publishing the accounts in order to make the accounts look better. The amount they used for this activity? Usually around $50 billion US. Each quarter playing with $50 billion to look good! Goodness, by those standards a $145 million budget cap looks like an embarrassing drop of pocket change into a charity box.

In theory, if malpractice could be proven then former CEO Richard S. Fuld Jr. and the accountants for Lehman's, being Ernst and Young, were in deep water, looking at massive fines and jail time... Yet the SEC (Securities, and Exchange Commission) did not take the matter to court, because, as they said they could not prove any laws had been broken!

Thousands of staff losing their jobs, billions and billions being played with each quarter, a final debt edging towards one trillion dollars, yet the US Government (they are quite large, and well-resourced you know) did not believe they could get a conviction!! Wow. Breathe dear reader, the Ghost of Christmas Past has yet to glad hand you to the Ghost of Christmas Yet to Come.

Still here? Good!

Please... with drum roll, welcome to the high wire and trapeze, the arch joker of F1, Christian Horner! Toto, among others, have been real mean to him recently. Each time Christian pulls on his tights before his underpants and slides slowly, inch-by-inch across the F1 tight rope they howl with glee that he is about to fall, because they know he is going to fall. Gravity and all that.

Yet in the financial universe it is not Miss Physics and her tireless Quantum chums applying The Law without fear or favour. No, it is spreadsheets, calculators, ledger columns (well actually ERP systems these days but don't get me started) ... and... drum roll again please maestro... Accountants and accounting guidelines!

Last year (July, and August) I offered up Just Numbers in my Magic Square, and Cash on Delivery as two reasoned opinions on how the entire cost cap adventure was going to play out.

I've spent much of my career involved in accounting torture with various departments of defence around the planet. Large amounts of money, expensive shiny toys... The accounting is a nightmare. I've also been involved with confusing R&D tax off-set submissions to the Australian government. A process that can turn the hottest heart cold, blood to ice, and brains to cat food.

So, gentle reader, the US government could not get prosecutions against Lehman Brothers because it could not prove malpractice. Please recall the colossal amounts of money involved. Now as per A Christmas Carol the Ghost of Christmas Past will neatly high-five the Ghost of Christmas Yet to Come. Keep the Lehman Brothers front and centre as we fly into the possible future.

Toto has a huge multi-national organisation with dozens of global subsidiaries on which to call, while Christian only has a few corporate entities within which to hide hollow logs stuffed with cash. Toto is not stupid, he knows this. Christian is not stupid, he too knows this. Thus battle has been engaged in the universe of spreadsheets and the FIA accountants. These two being long time battlefield adversaries, as keen and cheerful as the Black Knight to unsheathe broadsword and stride into battle. This time on the far flank it is the phalanx of chartered accountants whom they wave forward into the melee.

To briefly recap concepts from my previous two articles; consider the following scenario... Read carefully, since there is a single exam question for you at the end of our night-flight with the Ghost of Things Yet to Come... (also, as a disclaimer, I'm not saying Red Bull has done any of this, it is simply a thought exercise between us, so whisper please dear reader, whisper).

The Ghost of Things Yet to Come sweeps us over Milton Keynes, and in our spectral form we witness a story unfold. Red Bull Racing requires a new turbo unit. They tell Red Bull Powertrains that to remain within the cost cap they can only pay $1,000 per turbo. Red Bull Powertrains tell them: "Not to worry, leave it with us."

Red Bull Powertrains promptly ask their Honda consultants for "some hours" of reflection on turbo units, but as they are only going to sell ten to Red Bull Racing over a season the total cost cannot exceed ten times $1,000, being $10,000 in total. "Not to worry, leave it with us," says Honda consulting.

Honda consulting ring Honda HQ Japan, explain the situation and ask how much turbo research they can have for less than $10,000. "Not to worry, leave it with us," says Honda HQ.

Honda HQ Japan ring HKS (top quality Japanese turbo manufacturer) and ask what goes for $10,000? HKS say (sing it with me): "Not to worry, leave it with us!"

HKS ring a leading Tokyo university, state the need for urgent PhD research on ceramic turbochargers, and say the folk performing the work can have one year placements in the company and that HKS will establish a $125,000 per year engineering research chair at the university as long as the university will co-fund. "Not a worry, leave it with us!" says the university.

The university calls the Tokyo city government and asks for co-funding of a research chair which will be part-matched by the HKS engineering company. "Not a worry, leave it with us!" chime the city officials, very much used to this sing-along.

The Tokyo city government respectfully calls the Japanese federal government requesting co-funding, and possible tax off-sets... to which the federal government bow, smile, and say... "Yes!"

Puff of smoke, wave of ghostly hand, rewind the line of action... So! The Japanese federal tax payer, the Tokyo city rate payer, Tokyo University, HKS engineering, Honda Corporate HQ, and Honda Consulting all tip-in a few dollars (cough), and a few months later present Honda consulting with a remarkable turbo solution. Honda consulting model it on a high-end super computer, tweak a decimal or two, then present a solution to Red Bull Powertrains, along with an invoice for $3,000 representing "consultancy services".

Red Bull Powertrains look at the pretty pictures on a large screen in 3D, agree it is clearly a turbocharger and purchase $5,000 of ceramic base material. Whizz-bang, build ten turbo units.

Red Bull Powertrains pop ten turbochargers, along with an invoice for $10,000, in the post to Red Bull racing. Said invoice clearly detailing "Consultancy services, workshops and material purchases". Ten turbochargers. One clear invoice. A clear single charge to Red Bull Racing.

Red Bull Racing carefully record the cost of the turbochargers in their accounts for the tax office and the FIA. $10,000 for ten turbos, as per tax invoice. All recorded at the boundary as per FIA direction.

Dearest reader, your exam question is this. What did each turbocharger really cost? Go on... what dollar figure would you print on the price tag? Seriously what is the real cost of each turbo, and what is the measured price of each turbo? Where do you place your measurement point?

As Miss Physics will tell you from lessons in her Quantum universe, measurement impacts behaviour. Trust me the ghosts of Christmas Past and Future are backslapping one another while chuckling away as they say in unison, "When will they ever learn?"

Trying to agree the correct unit cost of each turbo is impossible. The accountants at each level in our mighty pyramid of technology can "prove" the input and output costs of their business unit. I've not even touched on the world of setting up tax off-sets, formal government incentives to industry, reduced land tax for corporations, and other government supplied free gifts. You name it. So many ways the real cost of a produced unit can never be known. So we have definitions, bounds, taxation assumptions, and so much more. The accountants ensure the relevant guidelines, accounting practices and laws have all been applied for their legal region. Yet as none of this has the slightest to do with Miss Physics and her universal laws it is all open to interpretation, argument and ambiguity.

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READERS COMMENTS

 

1. Posted by Max Noble, 12/10/2022 10:52

"@ancient70! - Quite so! It is such a complex area… and your “Leave it with us.” Taking time gave me a modest laugh out loud moment… So true! Here in Australia our “Armed Reconnaissance Helicopter” program was coded as “Air87” - while the current project codes were in the 1,000’s! Turns out Army had been asking for a usable helicopter for over 25 years… Some of the people I worked with on that one had spent their *entire careers* trying to get that project over the line… Yup… “Leave it with us”… "

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2. Posted by ancient70!, 11/10/2022 10:22

"Another good one Max!
Having also worked in the hi tech arms industry, in a country desperate to develop it’s own, you quickly realise the benefits of cross subsidising between units in a big organisation. In my case it was basically the government. The benefit of scale is also very clear. The large organisation/companies do have one drawback, the “leave it with us” sometimes takes a while! "

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3. Posted by Stitch431, 11/10/2022 9:28

"Toto spending his vacation together with Domenicali and Briatore on a yacht comes to mind. Wonder what they have been "planning"? It seems to come out now bit by bit ..."

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4. Posted by Max Noble, 08/10/2022 2:03

"@Burton - Given we never used to measure what they all spent I feel the sudden zealotry in the application of brand new rules is remarkable. If everyone calmed down, and worked through for a few seasons (say three) while openly sharing confusions and complexities one would end up in season four with a reasonably sensible set of rules that could be policed.

Trying to balance the differing company structures against the tax rules in the UK, Germany, Italy, the US, Japan, and Austria must be mind-melting!

To my mind the FIA is trying to get a hamster to eat an elephant with chopsticks… but that’s just me…"

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5. Posted by Burton, 07/10/2022 17:28

"Funny and informative at the same time, good piece, Max.
Teams can legally minimise their expenses, like you say, but what exactly is written in the agreements signed by everyone? Spygate showed us how giddy and smug the FIA was in letting everyone (well, Ron) know they didn't have to follow the legal burden of proof before coming up with that monumental fine.

I wonder if the financial penalties went straight into the coffers of rival teams like the luxury tax in cost-capped America sports, would someone still try to push it over the limit? :p

As for my own take on penalties, Max has touched upon the examples of cycling and the vacated titles in the Tour de France...I am perfectly comfortable with that scenario, the governing body says "sorry everyone, it wasn't a proper fair competition this year, keep your monies teams 2nd to 10th, but no medal for no one"."

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6. Posted by Max Noble, 07/10/2022 12:57

"@Spindoctor - quite. I cry now… So true.
"

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7. Posted by Spindoctor, 07/10/2022 11:41

"The whole point of these huge Accountancy\Consultancy(!) empires is to obfuscate. In a previous incarnation I worked for some very "successful" Venture Capitalists (re-branded to Private Equity Investors these days...).

For a very substantial fee these companies would ensure that personal annual "income" of over 100m for some Partners became something untaxed & untaxable. It was perfectly "transparent" (if you know where & how to look), but that didn't change their ability to keep 100% (or close) without paying tax to any Government or Nation. Needless to say these Services weren't cheap.....

"

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8. Posted by Max Noble, 07/10/2022 3:20

"@Kenji - you’re making me dizzy! Yup - that’s exactly the sort of “How many beans make five? Oh, and is this a bean?” Parallel universe that the “Big Four” inhabit! The poor FIA have no chance of “proving” a definitive version of accounting reality!
…and as I noted in my earlier comment, Lewis asking for “full transparency” is making me cry! No one will know what they are looking at!"

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9. Posted by kenji, 07/10/2022 0:58

"@ Max...I rather wish that I hadn't read your latest contribution! It brought back vivid memories of personal losses in the high six figures, directly related to the GFC ,impossible to ever recover. What it does highlight is the differences that different members of the 'big four/three' have when applying the 'laws of the land'. One case in point was dealing with the [ at the time ] touchy subject of royalties. The Gov't. decided to tax them at a 20% level, unknown in the civilised world of creative pursuits and intellectual property. We fought these taxes under the guidance of our Auditors/Tax advisors to no avail, then along came another 'big four/three' tax advisor with a completely novel approach, which we had looked at, in a similar form but different and discarded it as being fanciful as it relied on changing the nominative categorisation. Would you believe it? The Gov't of the day bought it and WHOOSHKA many millions relief [ and retrospectivity] at the stroke of a pen and a leg up for the other Tax experts.Live and learn."

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10. Posted by Max Noble, 07/10/2022 0:32

"@yakker - In the two previous articles mentioned I muse on those topics. “Just Numbers in my Magic Square” muses around how Lance Stroll came up with his costs, while “Cash on Delivery” explores the Mercedes model in some detail. As per this article “Cash on Delivery” wishes to outline to the reader that the problem is not cheating. The problem is “What on earth are we measuring? At what point? In which country? Using what ruler…!?”

The Teams will have gone to great lengths to get written definitions from the FIA which support their accounts as presented.

One only has to look at the public wailing by Lewis which perfectly mirrors that by Toto to know this is a planned Mercedes off-track tactic. Lewis demanding severe penalties is no surprise. What is amusing is his demand for “complete transparency.” Given my three articles, does any PitPass reader think that a complete open book from each of the ten teams being dropped in their inbox would make them any the wiser on what things cost? Of course not! You would need to employ Ernst and Young, KPMG, or Deloitte to decode them for you, and each would provide you with *more* than one answer, and each of them would provide you *different* answers. So bring it on for Lewis! Let’s have “complete transparency”, and the entire planet can argue over who was, or was not within the cost cap! For seeing the figures will help you, Like Inspector Hound at the FIA, not one jot!

"

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11. Posted by yakker, 06/10/2022 16:14

"@Max Noble. Yes another brilliant article from you.
In your article RedBull (a drinks company) ends up using Honda to "offset" costs. But a car company (such as,say Mercedes) with subsidiaries in composites, batteries, electric motors, gearboxes etc would find this even easier to do.
Two years ago when visiting Williams (my employer was a sponsor at that time) I asked how the cost cap would affect them, the reply "we don't spend that much, so no problem", but was last in the championship. No way another 20 million would make the difference between 1st and last on the grid.
While you say no-one is cheating, as Toto would say "its against the spirit of the rules" unless of course its you that is bending the rules."

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12. Posted by Spindoctor, 06/10/2022 14:42

"@Max Noble
Brilliant piece which shines a lot of light into corners some in F1 probably wish remained a bit darker.
I think it's important to make it clear that all the Large Corporate Teams will be singing from a similar Accountancy Hymn Sheet. RBR's "problem", as you point-out is that they have fewer hidey-holes than (say) Mercedes. However, as the piece shows, a bit of ingenuity & help from Partners can go a long way to ameliorating that.

The crux of all this is that attempts artificially to "spice" or "level" up (or down) the competition are unlikely to gain universal success or approbation. DRS irritates the purists (not to mention many drivers) but is lauded by the Media parasites. The Financial Cap looks like an attempt to make things "Fair", while having little serious effect on the real pecking order.
Both of these examples are as much about PR and Appearances as they are about changing anything significantly; a kind of Picardesque order to "make it so" but lacking the wherewithal to actually make it happen.... "

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13. Posted by Superbird70, 06/10/2022 13:08

"What needs to be done is to limit the toys that each team can spend money on.
No wind tunnel testing during the racing season.
Cut the electronic umbilical cord to the respective mother-ship home bases during a race (think of the electrons saved!!).
Only allow updates to be added at specific times, 20%, 40% 60% etc through the season.

For curiosities sake, is it more cost effective/efficient to build 24 PU that last only one race or 6 PU that are supposed to last 4 races each? I always loved the sound of a turbo detonating (Montreal 85, Brabham BMW)."

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14. Posted by Chester, 06/10/2022 12:15

"Thanks, Max. Clearly shows how cost accounting can be manipulated, whether intentionally or by incompetence. Another example of a regulation that has failed.

"

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15. Posted by Greg, 06/10/2022 11:34

"Great story Max as always. One thinks why have the cost cap anyway. So much can really be hidden. Sorry for the smaller teams as they may abide by the rules but cannot mtch the big teams with their subsidiaries "

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