The fallout from the biggest bankruptcy in history is still being felt nearly two years on, but how was everyone led into believing the solvency of the firm for weeks, perhaps months before its crash?
Since Lehman Brothers crashed on September 15, 2008, many have been blamed for the demise and fallout. The ratings agencies were attacked for allowing the investment bank to continue to have AAA status until days before its demise. Structured product providers and IFAs have been criticised for the continued sale of structured products underpinned by Lehman Brothers right up until its collapse.
But should the blame fall on those who helped present Lehman Brothers as a solvent firm?
By the time Bear Stearns had collapsed, the report says Lehman had amassed $175bn of illiquid assets made of commercial and residential sub-prime loans after “significantly and repeatedly exceeding” risk limits in an attempt to make profits.
If this had been made clear, rating agencies and investors may have been more cautious when investing in the firm. Lehman knew this, and the report says chief executive Dick Fuld had stressed the importance of keeping up the AAA rating on which Lehman relied. So the firm did all it can to hide its appalling assets.
At its zenith, Valukas says the investment bank was reporting a liquidity pool of $41bn but in fact it only had $2bn of monetisable assets. This allowed it to retain its AAA status and IFAs continued to sell Lehman-underpinned structured products unabashed.
But how did it do it?
Lehman Brothers employed an accounting trick known as “Repo 105” to hide its bad assets and lower its leverage.
Most investment banks employ the use of ‘repos’ to raise short-term money. The bank sells an asset to a lender in exchange for a slightly cheaper fixed interest loan with an agreement to buy it back at a later date, with interest. These are not recorded as a ’sale’ because the buyer does not legally own the asset.
The report says: “Repo 105 transactions were nearly identical to standard ‘repo’ transactions with a critical difference: Lehman accounted for these transactions as “sales” as opposed to financing transactions. By recharacterising the Repo 105 transaction as a sale Lehman removed the inventory from its balance sheet.”
Because the haircut in the Repo 105 deals were higher, Lehman argued that this meant it had ceded “control” of the asset, which it said was a sale. But US lawyers disagreed, so Lehman used its London office and British lawyer Linklaters to execute the Repo 105s instead.
Days before reporting periods, Lehman would use the “gimmick” to remove illiquid assets from its books and would then use the proceeds to pay down other liabilities. This would lower its leverage ratios and keep investors and ratings agencies happy. A few days later it would borrow more money and return the bad assets to the balance sheet.
“Lehman never publicly disclosed its use of Repo 105 transactions and its accounting treatment for these transactions,” says the report. In Q2 2008, Lehman had moved $50.5bn of bad assets from its balance sheet.
But the bluff wasn’t enough. Even though it raised $6bn from a rights issue in June 2008, Lehman could not raise sufficient cash it needed to survive. By the time it was made insolvent in September 2008, the report says it had $25bn of capital supporting $700bn of assets and liabilities.
Lehman’s accountants Ernst & Young signed off on its Repo 105 deals. Replying to Valukas’ report, it says it continues to believe that Lehman’s accounts were “fairly presented”. Fuld’s lawyers told the Financial Times that he knew nothing about Repo 105. Linklaters says there are no facts within the report which would “justify criticism” of its practices.
The report found that while the “serious” errors of Lehman executives were “non-culpable”, they may face legal action, as could E&Y for “professional malpractice”.
The failure of Lehman Brothers will reverberate through the financial sector for years to come but this report has shed a little more light on how and why everyone trusted in Lehman until the very end.