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We're 'Shocked, Shocked': There Was Gambling Going On at Lehman Brothers

1 year ago

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Why does Wall Street's reaction to the report that Lehman Brothers used questionable accounting tricks to hide its shaky financial position remind me of Captain Renault in "Casablanca," who is "shocked, shocked to find that gambling is going on" in Rick's Café Américain?

Wall Street and the blogging community are acting outraged that Lehman Brothers used a crafty accounting technique to make its financial situation appear better than it was. Excuse me? Aren't accounting gimmicks the oldest trick in the book in that regard? Despite their image of precision, accounting rules grant companies wide discretion in how they report a transaction, and companies are adept at figuring out legal ways to exploit that discretion to their financial advantage. In this case, Lehman treated a transaction as a sale when it arguably should have treated it as a loan. But, although the accounting maneuvers may have been "materially misleading," they weren't illegal, said Anton R. Valukas, the court-appointed lawyer who conducted the investigation. (Valukas released a nine-volume, 2,200-page report on the case, the largest bankruptcy in U.S. history, on March 12.)

What, exactly, was Lehman Brothers, a 158-year-old investment bank that borrowed hundreds of billions of dollars to finance its risky derivatives business, doing that caused such outrage?

It engaged in a nifty maneuver called Repo 105 to make the company look like it wasn't as deep in debt as it actually was. Accountants generally need to approve these techniques. When Lehman couldn't obtain approval under U.S. rules, it ran the maneuver through its U.K.-based offices after the London law firm Linkaters attested that the technique met accounting rules there. Lehman's U.S. accounting firm, Ernst & Young, asserts that it is not at fault, stating that its 2007 audit of Lehman's financial statements met U.S. accounting standards. In any case, the Repo 105 technique kept Lehman afloat for a while, but in the end, such maneuvers were futile, and Lehman Brothers collapsed on Sept. 15, 2008.

Wall Street firms have long used repurchase agreements ("repos"), which are short-term sales of securities with a promise to repurchase them at a slightly higher price, in order to obtain short-term financing. In 2007, for example, Goldman Sachs, which was then an investment bank (it's now a bank holding company), had sold more than $159 billion in financial instruments under repurchase agreements. (Goldman Sachs says that it did not use the Repo 105 maneuver.) And JPMorgan Chase says that from 2001 through 2004, its New York office classified some if its repo trades as sales. Unlike Lehman, however, JPMorgan did not use the trades to make its balance sheet appear stronger than it was.

Repo 105 was not a new trick that Lehman invented to keep itself afloat during 2008. Lehman had been using this method to shift assets to off-balance-sheet entities since 2001. That period covers the period post-Enron and post-WorldCom, when regulators were supposed to keep a closer eye on companies than they had in the past. This latest scandal shows that little seems to have changed. Lehman's $691 billion bankruptcy dwarfs Enron's $65.5 billion and WorldCom's $103.9 billion bankruptcies. Congress was so outraged following the Enron and WorldCom disasters that it passed stiff new reporting rules, known as Sarbanes-Oxley, requiring senior executives to sign the financial statements, attesting that they were accurate. Executives could face criminal action if they knowingly or willfully certified materially false statements. These rules were designed to ensure that such accounting gimmickry never happened again. Yet, it appears that Sarbanes-Oxley became largely a bookkeeping chore.

Despite the outcry over Lehman's widespread use of techniques allegedly designed to mislead investors, the new report does not charge anyone at Lehman with criminal wrongdoing. It merely says that Richard S. Fuld Jr., Lehman's former CEO, was "grossly negligent" and that three former senior executives -- Christopher O'Meara, Erin Callan and Ian Lowitt -- might have breached their fiduciary duties.

The SEC admits that it did not know what Lehman was up to. In a significant understatement, SEC chief Mary Schapiro, whose agency is charged with monitoring these firms, testified before the House Appropriations Committee on March 17 that her agency's oversight "may have been inadequate" during the period when Lehman was dressing up its financial statements. Seeking, perhaps, to preserve her agency's reputation, Schapiro now warns that the SEC is investigating other unnamed firms that might also have engaged in financial shenanigans in the months leading up to the worst financial crisis since the Great Depression.

The aspect of this situation that most reminds me of the gambling in Rick's café is that it was taking place right under the regulators' eyes. Following the near-collapse of Bear Stearns in March 2008, the SEC and the Federal Reserve Bank of New York began daily on-site monitoring of Lehman. The New York Fed conducted "stress tests" to gauge Lehman's financial viability, and Lehman failed both tests. Yet, the report says that there is no indication that any agency required Lehman to do anything after failing its stress tests.

One public official seems determined to do something. In responding to the Lehman report, Sen. Ted Kaufman (D-Del.) said, "That report has put in sharp relief what many of us have expected all along: that fraud and potential criminal conduct were at the heart of the financial crisis." Kaufman, who is on the Senate Judiciary Committee, has called on the president to "pursue a thorough investigation, both civil and criminal, to identify every last person who had knowledge that Lehman was misleading the public about its troubled balance sheet -- and that means everyone from the Lehman executives to its board of directors to its accounting firm, Ernst & Young."

Investigators for the Financial Crisis Inquiry Commission are also looking into how widespread the accounting tricks are at other Wall Street firms. And regulators in the United Kingdom are examining how Lehman Brothers Holdings Inc. accounted for the repo transactions there.

Filed Under: Economy, Investigations, Culture, Wall Street, Ethics

Tagged: bankruptcy, lehman brothers, LehmanBrothers, repo 105, Repo105

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