Rolfe Winkler

The just-released examiner’s report of the Lehman collapse reads like the financial crisis equivalent of the 9/11 Commission Report.

WSJ has hosted the 2,200 page document in 9 parts on Scribd.

Right up top it shows how, to inflate the “net leverage” figure on which ratings agencies were focused, Lehman actively manipulated its balance sheet.

Lehman did not disclose…that it had been using an accounting device (known within Lehman as “Repo 105”) to manage its balance sheet – by temporarily removing approximately $50 billion of assets from the balance sheet at the end of the first and second quarters of 2008.

In an ordinary repo, Lehman raised cash by selling assets with a simultaneous obligation to repurchase them the next day or several days later; such transactions were accounted for as financings, and the assets remained on Lehman’s balance sheet.

In a Repo 105 transaction, Lehman did exactly the same thing, but because the assets were 105% or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financings, so that the assets could be removed from the balance sheet. With Repo 105 transactions, Lehman’s reported net leverage was 12.1 at the end of the second quarter of 2008; but if Lehman had used ordinary repos, net leverage would have to have been reported at 13.9.

Lehman employees themselves referred to the maneuver as an “accounting gimmick” according to the report.

Here’s a simpler way to look at it:

The report also says they misled the market about their available liquidity, much of which was, er, illiquid.

There is much, MUCH more.

Regular readers know how pessimistic I am about the economy. The “recovery” is little more than a government-financed credit bubble and it’s back to risky business as usual for much of the banking sector.

But that doesn’t mean there isn’t good news to report.

For instance, less credit coursing through the economy means deflation, and deflation means stuff is cheaper.

Start with the cost of necessities, like shelter. House prices are down 31 percent, according to the latest Case-Shiller data.

That may wreak havoc with bank balance sheets, but it’s great for buyers. Rents are down, too. I was thrilled to get two months free when I signed my new lease. Such terms were unimaginable just two years ago.

Energy isn’t cheap, but thanks to reduced demand it’s cheaper. Oil is down to around $70 per barrel after reaching $147 14 months ago.

Deflation can improve an economy’s competitive position, too. In the short run, it means higher unemployment, but in the long run it means improved productivity.

If, for instance, blue-collar workers can afford to work more cheaply America may stop bleeding manufacturing jobs.

A big reason we have deflationary pressures is that banks are lending less. Yes, that’s good news. It means excessive levels of credit are being wrung out of the system. Credit isn’t a bad thing, but too much of it inflates unsustainable asset bubbles.

On an individual level, this means keeping up with the Joneses no longer requires maxing out your credit cards and taking out a home equity loan. Sure enough, statistics suggest people are borrowing less and saving more. As of July, consumer credit had fallen 4.2 percent over the previous 12 months — the fastest rate since 1991 — while the personal savings rate reached 5 percent in the second quarter.

Banks are socking away more cash too. The biggest ones have raised tens of billions of new equity since the stress tests, giving them thicker cushions to absorb future losses.

And some of the government bailouts are going away on schedule. The Fed will soon stop printing money to buy Treasury securities, and FDIC’s debt guarantee program is being wound down, as is Treasury’s backstop for money-market funds.

For their part, state and local governments are facing up to budget realities, making cuts and raising taxes to put themselves back on a sustainable path.

A good example is Flint, Michigan, where city planners are now “planning shrinkage.” This reduces the city’s operating costs: There are fewer abandoned streets to police, fewer sidewalks to repair and shorter routes for trash collectors.

And who doesn’t love the occasional shot of schadenfreude that downturns deliver? Bernie Madoff got 150 years in prison. Lehman, Bear Stearns, Merrill Lynch, Wachovia, and WaMu are all gone, victims of their own hubris.

These are the kinds of adjustments that dynamic economies have to make in order to flourish over time. Higher unemployment is an unfortunate consequence early in the process — I should know, I lost my job at an internet company earlier this year as a result of the recession — but in the long run many people end up more gainfully employed.

Think of the thousands of investment bankers that lost jobs last year. Was that a bad thing in the long run? Think of all the talent that’s no longer wasted generating vigorish for banks.

We need more creative destruction, not less. It will make the economy more productive. And higher productivity is the magical ingredient that enables sustainable growth.

The Year Since Lehman — related columns:

Securitization survives the fall

Banking? Keep it simple, stupid

A year on, it’s still a housing story

I’m sorry I missed this CNBC interview last week with Robert Wolf, chief of UBS Investment Bank in the U.S.  There’s a remarkably eye-opening sound bite.   (hat tip M. Mayer)

…there were no discussions on AIG during that three day period [the weekend Lehman failed].

Wait, really?  Does this mean the Fed had no idea AIG was about to collapse when it was working to resolve Lehman?  Two days later it threw $85 billion at them with completely insufficient security, a package that later expanded to $150 billion.

Clearly there needs to be some mechanism to receive the assets of failed systemically-important companies.  FDIC has its hands full with insured depository institutions.  It has no mandate, much less the capability to handle a behemoth like AIG.

But should we be giving more authority to the Fed to handle this?  There is a singular explanation for the financial bubble and ensuing collapse: leverage.  The Fed has ultimate control over leverage via the reserve requirements it is supposed to impose on banks.  Taken in by mathematicians whose models explained that leverage could be made riskless via complicated hedges, Greenspan/Bernanke/et al totally abdicated their responsibility to enforce sensible reserve requirements.

Yet Obama thinks they can handle a bigger book of business?