Lehman Perfidy: Everybody Does It

Includes: IYF, KBE, LEHMQ
by: John Lounsbury

I have reported previously about the accounting shenanigans at Lehman Brothers (OTC:LEHMQ) prior to their collapse in September, 2008. The earlier reports discussed the official report of the court examiner, Anton Valukas. Mr. Valukas' official report revealed that Lehman's executives were involved in a scheme to hold assets off the balance sheet, at key accounting times, in order to conceal the firm's extreme use of leverage. The Valukas report also faulted the bank's accountant, Ernst & Young, for defective audit processes.

Repo 105

One of the accounting procedures that has received a great deal of publicity is known as Repo 105. Repos are shorthand for repurchase agreements, whereby one party makes a sale of a security or asset for a specified time to a second party with a specified higher repurchase price. The end effect is the same as would be achieved through a secured loan, with the lender holding the security. The higher repurchase price covers the "interest" costs for the "secured loan."

The Repo 105 process is an arcane maneuver where the sale of the asset is at a higher value than it actually has. In the case of 105, the value is 105% of its actual value. The effect is that the bank removes an amount, say $100 billion from its invested assets and shows $105 billion in cash on its books.

A Simplified Hypothetical

To help explain how these tricks are used, the following hypothetical example has been developed. Note: This example is an oversimplification of the actual processes employed in the scandal.

A bank has actual assets of $1 trillion, supported by cash and equivalents of $50 billion. The leverage is 20/1. After a Repo 105 is arranged, just in time for an accounting check, the assets are temporarily reduced by $100 billion and cash or equivalents are increased by $105 billion. The temporary leverage appears as $900 billion divided by $155 billion, or about 6/1.

If the repo is recognized by accounting, the leverage ratio should not be affected. The cash from the repo and the liability to repurchase should self cancel. However, here is where the 105% subterfuge is used. If accounting is sloppy, the 5% ($2.5 billion in the case of $50 billion) can magically appear on the bank's books long enough to pass the audit date. This produces a smaller, but still positive affect on leverage: $1 trillion divided by $52.5 billion, or about 19/1.

New Details

A recent article by Louise Story and Eric Dash in The New York Times gives new details on how Lehman operated the repo subterfuge. It seems that they set up a company by the name of Hudson Castle, with which to engage in hiding assets. On the record, Lehman was a minority owner (25%) of Hudson Castle. Actually, Lehman controlled the board and staffed the company with former Lehman employees. This allowed Lehman to control the day to day actions of Hudson Castle, while maintaining the subterfuge that dealings between the two companies were at an arm's length.

Story and Dash state that Lehman disclosed none of this arrangement. They also say that this deception is not limited to Lehman:

Entities like Hudson Castle are part of a vast financial system that operates in the shadows of Wall Street, largely beyond the reach of banking regulators. These entities enable banks to exchange investments for cash to finance their operations and, at times, make their finances look stronger than they are.

Critics say that such deals helped Lehman and other banks temporarily transfer their exposure to the risky investments tied to subprime mortgages and commercial real estate. Even now, a year and a half after Lehman’s collapse, major banks still undertake such transactions with businesses whose names, like Hudson Castle’s, are rarely mentioned outside of footnotes in financial statements, if at all.

A Second Use for Repos

The next item reminds me of the child's argument: "But Mom, everybody does it. It must be okay."

Last week Kate Kelly, Tom MCGinty and Dan Fitzpatrick had a report in The Wall Street Journal showing how all banks manipulate their balance sheet to accommodate the accounting cycle. In this case, banks use repos to raise cash for trading during the quarter and then close out the positions in time for the quarterly accounting date.

According to the WSJ article, the total of repos in banks averages 42% higher at the highest point in the quarter compared to the accounting date. The following graph shows the total repo activity by banks, plotted weekly.

(Click to enlarge)

It's Okay Mom, It's Not Illegal

There is apparently nothing illegal about all of this. If that is the case, then the term "a nation of laws" is itself a deception. It should not be legal to hide assest off the books by maneuvers such as Repo 105. It should not be legal to hide the fact that excess leverage is used every month for trading, hidden from the official balance sheet.

Disclosure: No positions