Report escalates Lehman ineptitude to new level

March 12, 2010

The forensic autopsy of Lehman Brothers appears to have found the many causes of death. The examiner for the bankruptcy court, Anton Valukas, portrays the investment bank’s chief Dick Fuld and his lieutenants as more hubristic and inept than first thought. The scathing report also details a series of balance-sheet shenanigans that could land the former top brass and their auditor, Ernst & Young, in court.
Among the toxins discovered was something called Repo 105. This accounting gimmickry masked the size of Lehman’s balance sheet as the pressure grew for investment banks to reduce their leverage at the end of 2007 — which Lehman also was doing at the time.

Even if Repo 105 wasn’t lethal it was certainly poisonous. Lehman had been abusing it as far back as 2001, using repurchase agreements to finance assets but, unlike with typical repo transactions, treating them for accounting purposes as sold. This enabled Lehman to cover up its true leverage, making it seem lower than it actually was. Lehman even needed its overseas subsidiary to make it work sometimes. Bart McDade, the Lehman executive in charge of shrinking the balance sheet disparagingly referred to Repo 105 as “another drug we r on.”

That sounds like a breach of fiduciary duty — although Valukas doesn’t think it was. He does, however, reckon there is a strong case — or a “colorable claim” as he calls it — against Fuld and the firm’s three finance chiefs in its final 12 months: Chris O’Meara, Erin Callan and Ian Lowitt. What’s more, Ernst & Young could be on the hook for professional negligence for allowing the trades to pass muster. Through his lawyer, Fuld has disavowed knowledge of Repo 105 or how it worked.

The 2,292-page report is a page-turner even without this damning revelation. It paints a far more detailed picture than previously available of senior management believing their own hype, ignoring growing risks, and their deputies’ concerns, as they built up bigger positions in illiquid assets like commercial real estate and private equity. They overrode the bank’s own risk limits on a regular basis and didn’t include these positions in stress test scenarios.
Whether or not Fuld and his associates end up on trial, Valukas has at least drafted a fantastic management guide. It’s the best document yet from this crisis on how to prevent future failures. It should be mandatory reading for current and would-be bank chiefs — and their regulators.

CONTEXT NEWS
— The findings of court-appointed examiner, Anton Valukas, chairman of law firm Jenner & Block, charged with investigating the collapse of Lehman Brothers in September 2008, were unsealed on March 11. The report is 2,200 pages long.

— Among the findings, the report details Lehman’s use of an accounting device, known as “Repo 105,” to temporarily remove $50 billion of assets from the firm’s balance sheet in 2008. The device lowered Lehman’s net leverage — a measure closely monitored by rating agencies — to 12.1 from 13.9 in the second quarter of 2008.

— The examiner said there were “colorable claims” against bank executives Richard Fuld, Christopher O’Meara, Erin Callan, and Ian Lowitt “in connection with their failure to disclose the use of the practice” as well as against the firm’s auditors “Ernst & Young for its failure to meet professional standards in connection with that lack of disclosure.”

— Examiner’s report: http://r.reuters.com/vyq73j

13 comments

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It seems to me that the GAAP needs to me addressed and that REPO 105 should no longer be considered an acceptable practice. Any “rule” or “acceptable practice” that can be so twisted and cause so much damage needs to be refined or just plain expunged.

Posted by jrct | Report as abusive

Why on earth do we persist in using these polite terms like “accounting gimmickry?” This isn’t gimmickry, it’s FRAUD. The fact that it is legal doesn’t suddenly turn a lie into the truth, does it? No, it does not. This is FRAUD. FRAUD. This is FRAUD. If I swindled someone out of $5,000, I would go to jail, and rightly so.

Why is it legal for large corporations to commit fraud? Why? There is no innocent explanation for this.

Posted by JackMack | Report as abusive

I know so many people that lost fortunes from the Bear and Lehman collapses and most of them will never recover

Posted by STORY-BURN | Report as abusive

The sad thing is that They’re allowed to call this “accounting gimmickry” because some of these accounting principles, such as claiming “agreements” as “sold” and write it as revenue.

“Even if Repo 105 wasn’t lethal it was certainly poisonous. Lehman had been abusing it as far back as 2001, using repurchase agreements to finance assets but, unlike with typical repo transactions, treating them for accounting purposes as sold.”

Enron used a similar accounting practice, where they would claim future tender agreements as revenue. It’s a shame that these practices aren’t completely outlawed. MORE TRANSPARENCY IN THE WHITE HOUSE! MORE TRANSPARENCY ON WALL STREET!

Posted by toneloco64 | Report as abusive

After the last set of enormous financial scandals, the U.S. implemented Sarbanes-Oxley. I certainly hope that, as the evidence is fully collected, that those responsible for this enormous fraud will be prosecuted.

Posted by ExtremeCentrist | Report as abusive

It’s not fraud because they didn’t steal any money. They sold something to someone else, then bought it back at a loss. There’s nothing illegal about it.

The questionable part comes because they were only selling it to get rid of it when the reports were done. They used accounting gimmicks to turn a normal transaction into something tricky.

They have names for those crimes and it’s things like “breach of fiduciary duty”.

Posted by Jarlent | Report as abusive

How many large investment banks would look good with their kimonos wide open like Lehman’s? There, but for the grace of God…

Posted by igiveup | Report as abusive

How come big companies with aid of their auditors can get away with such massive FRAUD. They should be held liable for their actions like anybody else. Come on E & Y are you only interested in your audit fees, where does your loyalty lie.

Posted by HiHo | Report as abusive

[…] Andersen” over Lehmann? Felix Salmon rounds up some evidence, pointing particularly to this analysis. […]

Posted by Odds and ends | Ben Schiller | Report as abusive

It what way are they considered inept? :-)

Posted by The1eyedman | Report as abusive

“It’s the best document yet from this crisis on how to prevent future failures. It should be mandatory reading for current and would-be bank chiefs — and their regulators.” Well, if the biggest financial system on the planet had such dumb rules that allow so much flexibility for false reporting, how are the regulators going to regulate? Lehman has been doing this since 2001?
Gimme a break!!!

Posted by doctorjay317 | Report as abusive

Corporations are certainly not inept at fleecing investors.

What they are doing is a crime. Call it a crime. Prosecute the bastards and punish them in a very painful and memorable way.

If our financial system does any less than that, we are tacitly approving of their behavior.

Posted by breezinthru | Report as abusive

Please don’t trivialize the severity of what’s at issue here by calling it ineptitude. Ineptitude is somebody not knowing what the heck they’re doing.

The Lehman situation’s in an entirely different category, properly referred to as serial felony accounting fraud, to an extent impossible without the complicity of major “bipartisan” insiders at the New York Fed.

Posted by HBC | Report as abusive

“Mar 12, 2010
9:31 pm ESTIt’s not fraud because they didn’t steal any money. They sold something to someone else, then bought it back at a loss. There’s nothing illegal about it.”
-So you are saying that if you invested $100,000 with my investment firm and I used it to buy shares in another company and I turned around and sold them for $25,000, that there is nothing wrong with that? Do I have a great deal for you!

Posted by jfz50 | Report as abusive

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