Lehman's Drug-like Addiction

Supposedly, Lehman Brothers was trading toxic assets back and forth with other respectable Wall Street fixtures to produce cleaner balance sheets and healthier periodic reports for their shareholders.  How were they doing this?  Through a legitimate accounting procedure called Repo 105 transactions, which we will get to in a second. 

Data was manipulated, top executives reportedly closed a blind eye and lawsuits may be looming.  Before we get to all that though, let’s talk about what a Repo 105 transaction is and how they are tainting the reputation of top Wall Street executives.

What is a Repo 105 Transaction?

A Repurchasing agreement (the Repo standing for Repurchasing) is a type of transaction that allows one company to use an asset as collateral for a cash loan.  The company will pay back the cash loan plus interest within a given amount of time and buy back the collateral. 

The difference between regular Repurchasing agreements and a Repo 105 transaction is that the borrower provides assets worth 105 per cent of the loan value, rather than the typical 100 per cent.  For example, a bank would temporarily sell $105 of assets to another entity for $100 with a guarantee that it would buy back the toxic assets within a given time span. 

The additional 5 percent included in the transaction (the 105 in a Repo 105 transaction) allows the transaction to be seen as a sale rather than a financial agreement.   In this light, the sale can be removed from balance sheets. 

How did Lehman Brothers Use Repo 105 Transactions?

Lehman Brothers was heavily invested in Mortgage Backed Securities and we all know how toxic those assets were.   During auditing periods, Lehman Brothers would supposedly “sell” toxic assets to respectable banks like Barclays Capital or UBS for a cash loan with a fixed interest rate.  They would use this loan to pay off other debt they had incurred making their balance sheets look healthier for investors.  Another white-collar crime comes to mind starting with the letter E and ending with Nron

At the height of their Repo 105 activity, Lehman removed $50 billion dollars in toxic assets from their balance sheets.  Reports indicated that the company depended on these transactions as if it was a drug to get them through the day. 

After a few days, the company would borrow funds to pay back the cash loan plus interest and buy back the toxic assets.

According to the Financial Times, since the transaction was seen as a sale, “the assets can be removed from balance sheets while the cash received is used to pay off other liabilities reducing (exposure to risk) at critical moments.”

It is important to note that Repo 105 transactions are legitimate accounting tools.  The problem is that Lehman Brothers failed to report these transactions.  Not only was the sale of the financial asset not reported but the received funds to pay off other debts was left off balance sheets as well.

Who Actually Knew About This?

In a 2,200 page report prepared by appointed lawyer, Anton R. Valukas, it is mentioned that Bart McDade, then COO at Lehman, wrote an email to CEO Richard Fuld inviting him to a meeting on March 28, 2008.  Fuld did not make the meeting in which the use of Repo 105 transactions were discussed however, McDade admits that he eventually talked to Fuld about the Repurchasing agreements.

The report also notes that the transactions were done through their European branch and legally approved as sales by the UK based law firm Linklaters.  This was because a U.S. legal entity would not approve them.  How was this not a huge red flag!?

And what about Ernst & Young who was auditing Lehman’s books?  Valukas’ report says that they “didn’t approve repos but became comfortable with the policy for purposes of auditing financial statements.” 

Valukas also talked to Treasury Secretary Timothy Geithner and it is reported that Geithner said that he did not know about the use of Repo 105 transactions.   He told Valukas that if this type of activity were taking place at a bank he was supervising, this would be a real concern. 

But weren’t Geithner, who was the president of the Federal Reserve Bank at the time, and then-Treasury Secretary Hank Paulson monitoring Lehman Brothers?  They were creating a Bear Stearns-type bail out while all of this was going on to help the failing firm.  So how did they not know there were gaps in the balance sheets?

What Is Next For Involved Parties?

Valuka’s report is a colorful damnation of many of the top Wall Street firms and professionals.  The Financial Times reported that someone close to the SEC believes Valuka’s investigation will speed up the SEC’s internal investigation because his documents are so thorough.

The report finds “credible evidence” that top executives approved misleading financial records and used “accounting gimmicks” to make the reports look better than they were.  Valukas also says that there is enough evidence to say that Ernst & Young failed to “question and challenge improper or inadequate disclosures.”

Another Notch On An Already Dirty Bed Post

Some of the most respectable entities on Wall Street were essentially trading bad assets back and forth to make balance sheets healthier than they appeared.  Who exactly knew about this and what consequences their actions carry is still to be determined however, the report has tainted the reputation of top executives and firms in the industry.

Only a portion of Valukas’ report was released to the public.  I wonder what else the investigator had to say….