Hot on the heels of the Madoff scandal we now have a damning report issued by the examiner of Lehman’s bankruptcy, and it does not make for bedtime reading. Lehman’s bankruptcy can best be described as the iconic event of this financial crisis just as Enron’s implosion defined the start of the dot.com meltdown. The history books tell us that it was in 1840 that Henry Lehman founded the business: It was then a modest operation starting as a dry goods store and then expanded its operations into cotton trading.
Without wanting to appear too cautious I can best describe the scandal by quoting Simon Maughan, analyst at MF Global in London. He coyly said: “Give bankers of any ilk an inch and they will take a mile.” In his view it appears that Lehman got greedy and might just have taken a couple of miles. It is a sad story when one tells how the 158-year-old bank became insolvent, shedding thousands of jobs and triggering the world’s worst recession. This US$600 billion black hole came to light on September 15, 2008.
Some are blaming HSBC, who has been smart enough to pull the plug from some serious Asian business which they were holding as collateral. HSBC may be blamed of helping precipitate the fall of Lehman Brothers by demanding billions of pounds in collateral days before its collapse. True, but then when the ship starts to sink everyone is left to his or her own destiny and only the smartest will survive. There are few life jackets onboard and the first to grab them, swim for safety. Last week a deluge of bad publicity on the Lehman’s demise was top dollar in the media. This was the result of the publication of a 2,200 page report compiled by Anton Valukas, the examiner appointed by a US court in the bankruptcy proceedings. The long-awaited report is a monumental task having cost US$38 million to produce. It reveals a sober picture of the bank’s failure and some alleged misgivings from its top management. As we can see later, ex Lehman officers reading over the Valukas’s report have been alarmed by how much the management knew about what was going wrong. According to Larry MacDonald a former bond trader: “We’re shocked by how much they knew but disgusted that they did nothing with it.” In fact the examiner’s report has revealed how window dressing in financial terms was stretched to the full although prima facie audit requirements were followed. In fact, auditors Ernst & Young reject any responsibility for its fall in grace. The examiner criticised Ernst & Young for among other things “its failure to question and challenge improper or inadequate disclosure in those financial statements.”
He said the accountancy firm “was professionally negligent in allowing those [Repo 105] reports to go unchallenged.” But Ernst & Young rebutted the claim against them. It said: “Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles [GAAP], and we remain of that view.” On the management side, we see how Dick Fuld, the CEO and some of his colleagues are also facing legal claims for breach of fiduciary duty after using the “lazy accounting gimmick” to hide the fact that the bank was insolvent.
Matthew Lee, a Senior Vice-President at Lehman Brothers acted as a whistle blower when he discovered that things were not above board. In an email, he warned that the bank had “tens of billion of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities.”
His advice fell on deaf ears and the stark truth was that the rot was so pervasive that internal staff did not have sufficient time to straighten all the twists and contortions. This prediction was of such a potential magnitude but unfortunately came too late with only three months before the Lehman ‘s collapse was announced. As usually happens in similar cases of gargantuan financial mishaps the virus had penetrated deep in the system such that not enough time was in hand to apply surgery on the patient. The main culprit was the alleged abusive use of Repro schemes that were too aggressive.
Ironically, Lehman initially had sought legal clearance from an American law firm to permit a Repo 105 transaction but this was denied. It then sought advice from giant law firm Linklaters in London, which said that the deals were possible under English law. In one particular instance named Repro 105 the assets were transferred through Lehman’s London operations compliant to English law. In 2008, just before Lehman filed for bankruptcy, it transferred US$50.38 billion in a Repo 105 arrangement, thereby conveniently reducing its leverage. For the sake of readers who may not be conversant with such schemes let us explain how the use of such schemes helped built up a distorted picture of the true liabilities of the bank. As a matter of comfort it is on record that the technicalities of the alleged Repro transactions were approved by London law firm Linklaters before the accounts were signed off.
In plain terms, the repo markets act as a facilitator which smoothes the path for financial transactions. It oils the gears of the derivative machinery that is so beneficial to creative accounting provided the laws of the country allow it. Simply explained they work like a pawnbroker’s shop: a bank that wants access to cash agrees to sell a portfolio of high-grade securities, to one of its rivals for a fixed period of perhaps usually over night. During the halcyon days in the booming markets of three or four years ago, banks pawn such securities for cash and then repurchase them. The name “repo” comes from the “repurchase” of the securities that takes place at the end of the deal. Typically a bank pledges collateral to another in exchange for cash and promises to return the funds with interest. It is one of the most common means by which banks lend money to one another, allowing billions of euros to flow around the world every day between companies and individuals. For the technically minded it is correct to expect a typical repo transaction would show up on both sides of the balance sheet. The cash received from the transaction would show up as an asset, while the obligation to buy back the assets would show up as a liability. This is plain simple accounting and obviously fully legit. However, Lehman found a loophole that, in effect, allowed it to show the asset without recognising the liability. The magnitude of the trick or “window dressing” hinged on the amount of collateral it manages to post. A wonderful twist to the saga shows how for example if Lehman pawns securities worth €105, in order to get €100 of cash, the system allows under certain circumstances to treat the transaction as a sale rather than a loan deal. The fact it was obliged to buy back the assets a few days later was ignored and thus it will boost the assets side without the corresponding liability. In layman‘s terms this is having the cake and eating it. Lehman’s trick was to use a clause in the accounting rules to classify the deal as a sale, even though it was still obliged to repurchase the assets at a later date. Once discovered, it came to no surprise that US regulators wanted to ensure that Repo 105, which enabled Lehman to move some US$50bn off its balance sheet was not a widespread practice. No doubt more will be revealed in the next chapter when lawsuits may be opened against some of the top management. To conclude whether Lehman Brothers succumbed to temptation, made forgivable errors or deliberately committed acts of fraud will be a matter for courts to decide. The ghost of Enron lives on…………….
George Mangion [email protected] The writer is a partner in PKF Malta ,an audit and business advisory firm.
