The Lehman Report: What Went Wrong?

Ernst and Young (E&Y), the auditing firm responsible for Lehman, has been scrutinized as having been aware of these tactics and not reporting them to the proper authorities. With annual auditing bills generating E&Y $31mil in revenue from Lehman alone, we can clearly see the moral hazard in allowing firms like Lehman to pay the auditors that are supposed to be judging them. Much like the problems with ratings agencies, the fact that services intended to protect the common investor are being paid for by the corporations putting them in danger creates an adverse situation in which the greed and desire for revenue impede these ratings agencies and auditing firms from actually protecting and aiding the public. Also exposed in the report were Lehman’s executives, who not only purposefully deceived both investors and the public for years, but many of whom have since moved on to equivalent positions in other big financial institutions.

So what was Lehman doing to make everything seem so normal before its collapse? Amongst other tactics, the accounting manipulation that is facing the most scrutiny in the report is called Repo 105. Repo 105 is a type of repurchase agreement- a transaction in which a bank sells a certain asset (often bonds or securities) to a company with excess cash under the pretext that they will repurchase it a short period of time in the future. Lehman funded itself through the short‐term repo markets and had to borrow tens or hundreds of billions of dollars in those markets each day from counterparties to remain in operation. If the repo counterparties were to lose confidence in Lehman, it would be unable to fund itself and continue to operate. While accounting rules require that these assets be left on the balance sheet to avoid deception, there are certain circumstances in which the repo party can temporarily remove the assets from their balance sheet, thus seemingly reducing their leverage and appearing healthier to the general public. If the asset being repurchased is sold at a “haircut”- a discounted price- of more than 5%, it is considered a sale rather than financing and it can be removed from the balance sheet. So by taking less cash than their assets were actually worth, Lehman was able to hide their true leverage and deceive both the investors and the rating agencies into believing they were in better shape than they actually were. Days after filing their quarterly and yearly reports, they could then borrow more money to buy the assets back. Lehman’s aggressive growth strategy involved betting heavily on the subprime mortgage sector using substantial leverage. As the subprime mortgage crises accelerated in 2007 and 2008, it became obvious that Lehman’s bet was the wrong one and even the artificial confidence being pumped into its investors wasn’t enough to keep it afloat.

What did the executives have to say? A recent Wall Street Journal article attributes Dick Fuld, former Lehman CEO as claiming he had no knowledge of the transactions. How about the CFO, Chris O’Meara? He’s quoted as saying, “I’m just not close enough to it.” Seems a little suspicious that the two people required by the Sarbanes-Oxley Act to personally sign off on the accuracy of all financial reports that they would have “no knowledge” of the transactions that allowed them to move over $50bil worth of assets off of their balance sheet. I’ll let you be the judge…