Lehman Brothers was playing loose with its accounting even before the financial crisis put the investment bank under intense pressure to reassure its investors, according a report this week from a court-appointed examiner.
The report details how Lehman regalarly used an unusual accounting gimmick at the end of each quarter to make its finances appear less shaky than they really were.
The practice was called Repo 105, a type of repurchase agreement (or "repo" deal) that temporarily removed securities from Lehman's balance sheet. Unlike typical agreements for a repurchase, a Repo 105 deal would be characterized by Lehman as an outright sale of securities. This, according to the examiner's report, created "a materially misleading picture of the firm’s financial condition in late 2007 and 2008."
And it used the ploy well before then.
"Lehman first introduced its Repo 105 program in approximately 2001," the report says. "Unable to find a United States law firm that would provide it with an opinion letter permitting the true sale accounting treatment under United States law, Lehman conducted its Repo 105 program under the aegis of an opinion letter [by a British law firm] ... under English law."
New legal liability for Lehman officers?
The examiner's report – part of Lehman's ongoing bankrtupcty case – could result in new legal liability for former officials at the firm, but it's not clear that will happen. The examiner who wrote the report, Anton Valukas, simply labeled certain actions he reviewed as "colorable," meaning he believes the evidence would "support a finding by a trier of fact."
Mr. Valukas found colorable claims against former Lehman chief executive officer Richard Fuld, three former Lehman chief financial officers (Christopher O'Meara, Erin Callan, and Ian Lowitt), and the firm's external auditor (Ernst & Young).
The report shines fresh light on how Lehman Brothers failed 18 months ago – in a collapse that shook financial markets worldwide and precipated the worst stage of the financial crisis. The firm was rapidly losing the confidence of clients and investors, and the Repo 105 deals are one new piece of evidence that those parties had good reason to be concerned.
The report also puts fresh focus on a broader issue: Wall Street's culture of risk and sometimes-shoddy accounting. It comes amid debate over where financial stocks are headed. Many investment strategists predict that these stocks will continue to climb from lows reached a year ago, but some argue that the industry's recovery is built on fuzzy accounting for still-troubled real estate portfolios.
Lehman's Repo 105 ramped up in volume as the firm became more desperate during the crisis. According to the report, then-Treasury Secretary Henry Paulson "urged Fuld to find a buyer" after the collapse of Lehman rival Bear Stearns and Lehman's own reporting of a large second-quarter loss in 2008.
Fuld failed to cut a deal before its third-quarter report in 2008. That was followed by a September weekend of last-minute efforts by other bankers and US officials to avoid a chaotic collapse by the firm. The Lehman bankruptcy was followed by panic in financial markets, the controversial federal rescue of insurance firm AIG, and an extraordinary range of Federal Reserve efforts to prop up the banking system.
'Another drug we r on'
Lehman's use of Repo 105 earlier in the decade signals that it was not merely the crisis itself that prompted the reach into creative bookkeeping. In good times, Wall Street firms can reap big profits by having high leverage – putting money to work that's many times their underlying capital.
The report, released Thursday, quotes one Lehman official in an April 2008 e-mail referring to the deals as "another drug we r on." In interviews, other Lehman employees called the Repo 105 transactions an "“accounting gimmick” and a “lazy way of managing the balance sheet."
Not every financial firm is a lemon, or a Lehman. But since the financial crisis erupted, questions about accounting have resulted in sharp debate over how severe the banking-sector troubles are. Although confidence seems to have returned to financial markets over the past year, it remains more fragile than before the crisis.
"Bad data lead to bad decisions," says William Black, a financial expert at the University of Missouri in Kansas City. Despite the crisis, the US government isn't putting enough resources into pursuing accounting fraud, argues Mr. Black, who led prosecutions during the 1980s savings-and-loan crisis.