The debacle that Lehman Brothers found themselves in because
of the subprime mortgage crisis led to a period of substantial losses that
pushed the firm into the brink. A $2.8billion loss was announced on 9th
June in the 2nd quarter report of 2008 which was the first reported
loss during Fuld’s tenure as chairman.
The figures quoted on Lehman’s balance sheet were supposed
assets of $700billion maintained with only a reported $25billion of equity. If
these values were ever true, Lehman Bros had an extremely high leverage ratio
of around 30-1, when commercial banks were restricted to a ratio of 15-1. In
this position Lehman had to borrow billions of dollars each day to continue its
operations. Whilst interest rates are low, a higher leverage ratio like that of
Lehman’s can be profitable and manageable. When the decisions to undertake
leverage were first made, the market reflected this and general conditions were
favourable with a strong housing market and low interest rate, Zingales (2008).
However, the financial markets changed, as we all know, and an unstable market
with uncertain outcomes introduces instability in highly leveraged models. Risk
managers within the company recognised that this leverage could become an
insurmountable problem as the USA’s economy took a nosedive.
As a direct result of the 9th June announcement,
a process began to try to reduce the leverage ratio used by the firm. Some
assets on the balance sheet are written down and whilst some others were
reduced through fire-sales to improve overall liquidity. The publication of the
financial figures consequently led to a reduced revenue stream and losses on
hedge funds. All-in-all it seemed that assets fell by $60billion so Lehman
reported their leverage ratio was now somewhere in the region of 12.5-1.
However, the balance sheet was hiding a few details that actually shed a little
light on how much trouble the firm was actually in.
The report from Valukas (2010) indicated that Lehman’s
accounting department had been implementing a practice codenamed “Repo 105”
within the firm. There is a slight difference between this and the standard
repo operation of corporate firms. When an ordinary repo is performed, assets
are sold to raise quick, liquid cash but it also comes with a concurrent
obligation to repurchase the same assets within a very short period of time
since the original transfer of funds. Repo 105 is performed in the same way but
the assets are repurchased at 105% of the value that was paid for them
originally. However, the main difference between these is how they are
classified when publishing the quarterly returns. The assets transferred in a
normal repo procedure remain on the firm’s balance sheet and are explained as
“financings”. Repo 105 assets can be included on the balance sheet in the same
way but it is no compulsory to do so. Accounting regulations allow for these
particular assets to be treated as sales and, consequently, removed from the balance
sheet. This procedure is an accounting manipulation that reduces net leverage
on paper but not in reality.
Accounting trickery had taken place over a period of years.
But it was during the final 3 quarterly reports that Lehman produced before
bankruptcy that this procedure became of prime importance. At this stage as
much as $50billion in the form of assets were being temporarily removed from
the balance sheet to make their leverage appear lower than it actually was. It
is evident that the only purpose of Repo 105 was to buy Lehman time with
misleading information to continue operating in the hope that the situation
could be rescued. The managers were fully aware that the firm was in trouble. Leverage
and liquidity were recognised as the key factors. Continually, Lehman announced
that they had enough liquid cash reserves to allow them to weather the financial
storm and cover their liabilities, which was a lie because the majority of
their reserves were illiquid. They wanted to the rating agencies to maintain
their confidence in the firm, which in return will continue to be classified
with the top security rating. In turn, this would encourage more buyers as
Lehman would still be an attractive option.
Lehman didn’t disclose the use of Repo 105 to any other
financial institutions, let alone the public. In fact, it was unclear who
inside Lehman even knew of the “numbers massaging”. Richard Fuld himself
overtly claimed that he wasn’t aware of the codename Repo 105, not to mention
what the term referred to. Evidence found during Valukas’ investigation
suggests otherwise. The Wall Street Journal, issued on March 11th
2010, made clear that the executives at the top of Lehman had hidden the truth
from their own board of directors, who would surely have objected to it.
In the aftermath it has become clear that the auditors of
Lehman at the time, Ernst & Young, were fully aware of the implementation
of Repo 105. They took no action upon discovering this. Ernst & Young were
judged not to have met the professional standards expected of them. The
Financial Times confirmed in December 2010 that Ernst & Young would face a
lawsuit for their negligence and fraud. With 47 other complaints officially
lodged against the accountancy firm at the time and several court cases already
lost, this showed that they had previous form.
Accounting gimmicks, Repo 105 included, posed a serious risk
to Lehman’s public image and overall professional reputation. Plain and simple,
this was lazy banking. If anything, Repo 105 only exacerbated their problems in
the long-term, plunging Lehman further into debt. When considering that the
other option was to actually sell assets, reduce debt and meet leverage
targets, Repo 105 was the easy way out on the short term loan market.
No comments:
Post a Comment