Lehman Mess: Bad Intent, or Just Bad GAAP?

Lehman Brothers’ collapse into bankruptcy—finally exposed for all to see in a 2,200-page report released earlier this month—is quickly becoming the textbook tale of how mysterious and opaque the U.S. financial system and its accounting have become.

The report, compiled by Anton Valukas, chairman of law firm Jenner & Block and the court-appointed examiner in Lehman’s bankruptcy proceedings, says Lehman management essentially tossed good judgment to the wind two years ago in a desperate, trans-national accounting stunt designed to hide piles of mounting debt that were quickly crushing the legendary Wall Street bank. Lehman ultimately filed for bankruptcy in September 2008, triggering the financial crisis.

Lawmakers, regulators, plaintiff lawyers, and many others are now poring over the Valukas report to see whether Lehman executives or the firm’s external auditors, Ernst & Young, should face any legal action. Neither the Securities and Exchange Commission nor the Justice Department have taken any action against any involved parties yet, but the Valukus report makes it clear that the SEC did scrutinize Lehman’s valuation estimates in the months preceding its collapse, but provided the bankruptcy court with no definitive conclusions about whether it sensed any wrongdoing.

The report focuses on Lehman’s internally dubbed “Repo 105” and “Repo 108” maneuvers—transactions that moved securities off the balance sheet for seven to 10 days at a time in late 2007 and in 2008, to make the balance sheet appear stronger than it actually was. Lehman relied on a thin interpretation of Financial Accounting Standard No. 140, Accounting for Transfers of Financial Assets, which at the time governed when a transaction can be treated as a sale (which moves it off the balance sheet) and when it should be treated as a short-term lending arrangement (which keeps it on).

Turner

Financial institutions do routinely transfer securities under short-term arrangements to finance immediate liquidity needs, says Lynn Turner, former chief accountant for the SEC and now a forensic accountant for consulting firm LECG. Under FAS 140, companies are instructed to focus on who controls the asset to determine whether the transaction is a financing arrangement or an actual sale.

If the institution that transferred the asset to another party has an obligation to take it back under a short-term liquidity arrangement, then it’s a financing transaction—which carries a liability with it, which must be reported on the balance sheet. If the institution really has sold the asset, and has no further involvement with what happens to the asset after that, the company records an influx of cash on the balance sheet. The key question is who has de facto control of the asset’s fate. “If you never give up control of the asset, you typically don’t treat it as a sale,” Turner says.

According to the Valukus report, Lehman began its Repo 105 approach in 2001, soon after FAS 140 took effect and long before trouble surfaced in 2007 and 2008. In a typical Repo 105 transaction, Lehman would transfer securities to a repurchase lender in return for cash, and then Lehman would repay the cash plus interest in the return transaction. Lehman’s internal accounting policy manual specified the “haircut,” or the cost to Lehman for the short-term liquidity, had to be at least 5 percent for a Repo 105 transaction or 8 percent for a Repo 108 transaction; hence the names.

Since Lehman’s maneuvers in 2007 and 2008, the Financial Accounting Standards Board has modified FAS 140 to seal up various exceptions that permitted some assets to be squirreled away off the balance sheet when they had not legitimately been removed from a company’s control or risk profile. But by exploiting FAS 140 at the time and booking transactions as asset sales, the examiner’s report says, Lehman temporarily reduce its net balance sheet by $38.6 billion in the fourth quarter of 2007, by $49.1 billion in the first quarter of 2008, and by $50.38 billion in the second quarter of 2008.

Lehman scoured the United States for a law firm that would support its interpretation of FAS 140, couldn’t find one, and ultimately tapped the British law firm Linklaters in London. Interpreting U.S. Generally Accepted Accounting Principles under British law, Linklaters provided an opinion letter supporting the practice, and the transactions were carried out through Lehman’s European broker-dealer in London.

“It’s a little like cleaning up a kid for a school picture. The snapshot of the balance sheet at the end of the reporting period showed this lower level of debt, but it never looked that good before or after the snapshot was taken.”

—Bruce Pounder,

President,

Leveraged Logic

The Valukus report cites numerous Lehman management communiqués suggesting the executives knew they were stretching FAS 140 to its limits and possibly beyond—with e-mail messages calling the tactic “another drug” Lehman was on, “window dressing,” and an approach “based on legal technicalities.”

Calculations

Pounder

Bruce Pounder, president of accounting education firm Leveraged Logic, says the report shows Lehman used the cash from the security transfers to pay down other debt, which artificially polished Lehman’s balance sheet all the more. “It’s a little like cleaning up a kid for a school picture,” he explains. “The snapshot of the balance sheet at the end of the reporting period showed this lower level of debt, but it never looked that good before or after the snapshot was taken.”

Ernst & Young knew about and supported Lehman’s position, according to the examiner’s report, and that has led many to wonder whether E&Y has any complicity in the fiasco. The firm issued a statement through spokesman Charlie Perkins saying it stands by its audit opinions.

“Our last audit of the company was for the fiscal year ending Nov. 30, 2007,” the statement said. “Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with GAAP, and we remain of that view. After an exhaustive investigation, the examiner made no findings in his report that Lehman’s assets or liabilities were improperly valued or accounted for incorrectly in Lehman’s Nov. 30, 2007, financial statements.”

Sherman

David Sherman, professor of accounting at Northeastern University, says the real effect of Lehman’s accounting interpretation—that is, the tens of billions moved off its balance sheet—still amounted to only a modest impact on Lehman’s total leverage during the periods in question. Even under various methods of calculating leverage ratios, it only changed by relatively small amounts that probably wouldn’t alarm investors, he says, “and that’s the difference that this whole thing hinges on.”

ORDINARY REPO FLOW DIAGRAM

The chart below explains Lehman’s accounting treatment of Repo 105 transactions versus ordinary Repo transactions:

Generally, “[r]epurchase Agreements, or repos, are the primary instruments used

by [United States] broker-dealers to finance their inventory positions.” Repo transactions consist of two legs. In the first leg, Lehman would transfer securities

inventory to a repo lender in return for cash. In the second leg, Lehman would repay

the cash amount plus interest, and the repo lender would return the securities

inventory. The difference between the value of the securities inventory transferred

and the cash received is referred to as the “haircut” on the repo transaction.

[I]n an ordinary repo transaction involving liquid securities

during the late 2007 and 2008 time period, the haircut third parties typically required

was approximately 2 percent while in a Repo 105 or Repo 108 transaction, the haircut

involved was required to be at least five percent or eight percent, respectively, and was

often more.

Anton Valukas Examiner Report on Lehman (March 11, 2010)

Sherman says there’s much more that should be explored before investors or regulators can conclude Lehman was being deceptive. “If Lehman touted the lower ratio as a sign of strength after having managed the ratio, that is misleading and that is really a serious issue,” he says.

“In short, many companies have had major adjustments to cash from operations and balance sheet adjustments that have not affected earnings, and none of these have been big scandals,” Sherman says. “Many have been allowed to be treated as simple adjustments to a clarification of how to apply GAAP.”

Gazzaway

Trent Gazzaway, national managing partner of audit services for Grant Thornton, says the bankruptcy examiner’s report doesn’t provide enough evidence to conclude deception or wrongdoing. It does, however, underscore the importance of getting away from a highly prescriptive, rules-based system such as GAAP, he says, where a strict adherence to the precise boundaries of rules can sometimes lead to an unintended result.

“Maybe when this is all said and done we will find out that they did comply with the rules exactly as written,” he says. “It’s too early to say whether the company violated the accounting standards, but it’s not too early to draw a link between the rules-based standards that get more and more complex and cumbersome every year, versus principles, where the only thing that matters is whether the principle was adhered to.”