The Southern District Court of Manhattan recently released a 2,200 page review of the Lehman Brothers bankruptcy. The review provides an in-depth look at the factors leading up to the bankruptcy that roiled world markets and brought on the worst financial crisis since the Great Depression. The entire document is available at this location.
While I have not yet made significant progress through the report (the contents table is 45 pages long!), the report does make for fascinating reading and does indeed read like a bestseller, as author Anton Valukas claims.
Of particular interest is Lehman’s use of accounting transactions dubbed "Repo 105". It’s been described as a “borderline criminal accounting gimmick” which allowed Lehman to improve their leverage ratios and thereby reduce implied risk.
I think the report itself explains these dubious transactions very well, and therefore I quote:
“Lehman employed off-balance sheet devices, known within Lehman as ‘Repo 105’ and ‘Repo 108’ transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008.”
“Repo 105 transactions were nearly identical to standard repurchase and resale (“repo”) transactions that Lehman (and other investment banks) used to secure short-term financing, with a critical difference: Lehman accounted for Repo 105 transactions as “sales” as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction. By re-characterizing the Repo 105 transaction as a “sale,” Lehman removed the inventory from its balance sheet.”
Lehman was using the transactions by classifying them as sales instead of what they really were, which is financing transactions. The report continues:
“Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet. Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt. Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios. Thus, Lehman’s Repo 105 practice consisted of a two-step process: (1) undertaking Repo 105 transactions followed by (2) the use of Repo 105 cash borrowings to pay down liabilities, thereby reducing leverage. A few days after the new quarter began, Lehman would borrow the necessary funds to repay the cash borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet.”
This is eerily similar to some accounting gimmicks Enron used, the most famous of which was selling and then buying back Nigerian barges to take these assets off the balance sheet during reporting periods. The sales also generated profits used to boost the pay of those “smart guys” at Enron. Sarbanes-Oxley was promogulated precisely because of lies like this – which is what they are: lies.
Post the laws mentioned above transparency increased exponentially and would have though such material transactions would be properly disclosed. However, they were not.
“Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio. According to former Global Financial Controller Martin Kelly, a careful review of Lehman’s Forms 10-K and 10-Q would not reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its Repo 105 practice even though Kelly believed “that the only purpose or motive for the transactions was reduction in balance sheet;” felt that “there was no substance to the transactions;” and expressed concerns with Lehman’s Repo 105 program to two consecutive Lehman Chief Financial Officers – Erin Callan and Ian Lowitt – advising them that the lack of economic substance to Repo 105 transactions meant “reputational risk” to Lehman if the firm’s use of the transactions became known to the public.”
The report goes on to state that Dick Fuld, former CEO of Lehman Brothers, did not have any knowledge on the transactions. It also says that given the preponderance of evidence, it’s likely that Fuld is lying. The transactions were brought to the attention of Fuld, Bart McDade (former Chief Operating Officer) by Martin Kelly, who said as much in the report. Kelly was Global Financial Controller for Lehman at the time.
As for the securities that were removed from the balance sheet, the report provides clear details of the intention to remove toxic assets off the balance sheet. “Most securities Lehman used in Repo 105 transactions were ‘governmental’ in nature, implying a certain level of liquidity”, the report says. “While representing a relatively small percentage of Lehman’s total Repo 105 assets/securities, at times the nominal amount of non-‘governmental’ securities Lehman used in Repo 105 transactions was quite large. For example, as of February 29, 2008 (the end of Lehman’s first quarter 2008), Lehman utilized over $1 billion of highly structured securities, i.e., CLOs and CDOs, private RMBS, CMBS and asset-backed securities, in Repo 105 transactions. In August 2008, just before it was over, the firm allowed $55 million, or seven securities, rated CCC to be included in a Repo 105 transaction.”
Auditor Ernst & Young is also getting into hot water, as per this New York Times article
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