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The collapse of Lehman Brothers (OTC:LEHMQ) in September 2008 was a watershed, and in its wake, our financial system was thrown headlong into a tailspin. Lehman’s stock tanked, and so did market sentiment. The Lehman Brothers failure was the largest bankruptcy in U.S. history; and the examiner’s report filed this month sheds light on the circumstances of that historic failure, and may pave the way for legal claims against the firm’s former executives and auditors.

Lehman Brothers Holdings

Source: Yahoo Finance

The document detailing the demise of Lehman Brothers runs 2,200 pages. That’s 2,200 pages of allegations of deceptive accounting practices and off-balance-sheet maneuvers. But more than that, it is a 2,200 page story of how investors end up on the losing side of a conflict of interest, and how corporate malfeasance leads to ruin.

At the heart of the examiner’s report is Lehman Brothers' use of off-balance-sheet transactions to adjust their financial statements (these accelerated in the months leading up to the collapse). The firm employed repurchase agreements referred to as "Repo 105"; a repurchase agreement is basically a secured loan, and is a common way for investment banks to get short term financing. In a repo, a firm will transfer assets to a separate party in exchange for cash, agreeing to repurchase the asset at a later date. Normally, this transaction would reflect an increase in both assets and liabilities on a firm’s balance sheet. But Lehman Brothers found a way around that.

"Repo 105" got its name because Lehman Brothers would transfer assets that were worth 105% of the cash they received. Because of that, accounting rules allowed the firm to treat the transaction as a sale, even though it wasn’t. What does this mean? It means that Lehman Brothers still had to repurchase the assets, but that was not reflected on their balance sheet. Instead, the balance sheet showed that the assets were sold, and the firm then used the cash to pay down other liabilities. The result: Lehman Brothers looked healthier than it really was... it looked like it had much less debt.

In the third quarter of 2008, just before the collapse, Lehman moved $50 billion off their balance sheet using "Repo 105" (according to the examiner’s report).

While Lehman Brothers worked behind closed doors to create the image of a strong balance sheet, some people inside those doors saw the writing on the wall. According to the report, company emails show that some staff members began to question the firm’s actions. Who didn’t ask questions? The firm’s auditors, Ernst & Young. As a spokesman said, "Our opinions indicated that Lehman’s financial statements for that year were fairly presented". The failure to challenge those statements may result in malpractice claims against the auditor, according to the bankruptcy examiner. But Ernst & Young was not alone in their apparent complicity. Several brokerage firms might find themselves facing claims. There’s more: ratings agencies didn’t downgrade Lehman; the firm faced bankruptcy with its investment grade rating intact. Why? According to Moody’s (NYSE:MCO), it was assumed that the firm would be rescued by the government (given that Bear Stearns had been bailed out earlier in the year). Well…hindsight is always 20/20, as they say.

While the bankruptcy examiner’s report does not contain any language suggesting that the conduct of Lehman Brothers management was criminal, it was certainly negligent. While their use of "Repo 105" to manipulate the balance sheet wasn’t illegal, it was certainly misleading. The bottom line: that is neither here nor there to investors who lost their money. And when something like the Lehman Brothers collapse happens, the lesson isn’t just about money lost. It’s about confidence destroyed.

Even as Lehman Brothers was spiraling out of control and headed for bankruptcy, investors were being sold "structured products" that they thought were sound but wound up a loss. In the weeks (even days) before the collapse, brokers continued to sell securities offered by Lehman Brothers (principle protected notes), and investors were led to believe they were guaranteed, that the principle value could not decline. What these investors learned was that a guarantee is only as solid as the company that makes it.

How could this happen to an investor? When a brokerage firm has a product to sell, the brokers working for that firm will sell that product, even if it is not in the best interest of the investor. Why? Because that investment carries a commission. And what happens when that risky investment turns out to be a mistake? Nothing. It is a broker’s job to sell investments, not to monitor the product’s performance.

The lesson: don’t count on government regulators, rating agencies, or even your broker to make sure that your best interests are met. This is how the story of Lehman Brothers ends: investors found themselves counting their losses because they were on the losing side of a conflict of interest.

Disclosure: No positions

Source: Lehman Brothers Collapse: A Lesson in Conflicts of Interest