The massive report by Lehman Brothers bankruptcy examiner reveals that the investment bank did not collapse simply because of the economic climate, but also thanks to a lot of accounting chicanery.
The 2,200-page report from Jenner & Block chairman Anton Valukas shows that Lehman made extensive use of an accounting gimmick it called Repo 105 to shift $50 billion worth of assets off its balance sheet at the end of the first and second quarters of 2008 to make it seem to investors as though the bank had less debt than it actually had. The transactions should have been recorded as financings, but Lehman instead claimed them as sales by twisting accounting standards to its liking.
In an ordinary repo, Lehman raised cash by selling assets with a simultaneous obligation to repurchase them the next day or several days later; such transactions were accounted for as financings, and the assets remained on Lehmans balance sheet, wrote Valukas. In a Repo 105 transaction, Lehman did exactly the same thing, but because the assets were 105% or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financings, so that the assets could be removed from the balance sheet. With Repo 105 transactions, Lehmans reported net leverage was 12.1 at the end of the second quarter of 2008; but if Lehman had used ordinary repos, net leverage would have to have been reported at 13.9.
Another problem was that the bank ignored the gathering storm in the subprime mortgage business. Rather than pull back, Lehman made the conscious decision to double down, hoping to profit from a countercyclical strategy, wrote Valukas. As it did so, Lehman significantly and repeatedly exceeded its own internal risk limits and controls.
Some Lehman execs warned of repercussions from accounting maneuvers such as the Repo 105 transactions.
Contemporaneous Lehman e-mails describe the function called repo 105 whereby you can repo a position for a week and it is regarded as a true sale to get rid of net balance sheet, said the report, quoting internal Lehman e-mails. Lehman used Repo 105 for no articulated business purpose except to reduce balance sheet at the quarter-end. Rather than sell assets at a loss, [a] Repo 105 increase would help avoid this without negatively impacting our leverage ratios. Lehmans Global Financial Controller confirmed that the only purpose or motive for [Repo 105] transactions was reduction in the balance sheet and that there was no substance to the transactions.
The companys outside auditor Ernst & Young, was apparently aware of the problematic transactions as well. Lehman did not disclose its use or the significant magnitude of its use of Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board of Directors, wrote Valukas. Lehmans auditors, Ernst & Young, were aware of but did not question Lehmans use and nondisclosure of the Repo 105 accounting transactions.
However, in mid-March 2008, after the near collapse of Bear Stearns, teams of government monitors from the SEC and the Federal Reserve Bank of New York took up residence at Lehman, as Valukas describes it, to monitor the banks financial condition and liquidity. Lehman was less than forthcoming about its liquidity problems, though, and as late as September 2008 publicly insisted that it had a liquidity pool of about $40 billion, even though much of that was illiquid or encumbered. The pool actually contained less than $2 billion of readily monetizable assets.
Once the extent of Lehmans problems became clear, frantic meetings took place with the Treasury Department and the Federal Reserve to reach a deal with Barclays to rescue Lehman before its collapse, but U.K. financial regulators refused to waive shareholder approval requirements.
The report found that there were colorable causes of action that could allow investors to sue because of the accounting irregularities and other factors that contributed to the banks collapse.
Although Repo 105 transactions may not have been inherently improper, there is a colorable claim that their sole function as employed by Lehman was balance sheet manipulation, the report noted. Lehmans own accounting personnel described Repo 105 transactions as an accounting gimmick and a lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end.Lehman used Repo 105 to reduce balance sheet at the quarter-end.
That could mean trouble for whoever has been left with enough money for class-action attorneys to pursue.