Lehman Brothers & Repo 105 On September 15th 2008, the fourth largest U.S investment bank, Lehman Brothers, filed for chapter 11 bankruptcy. With revenues peaking at $19.2 billion in 2007 and over $600 billion in assets, the collapse of Lehman became the largest bankruptcy in history. Lehman’s demise was attributed to their aggressive investment strategy and significant exposure to the subprime mortgage market. As the housing bubble grew, Lehman Brothers acquired several mortgage lenders, some of the acquired firms frequently made loans to home buyers without full documentation (Jeffers 2011). When consumers began defaulting on mortgages and market conditions began to unravel, Lehman as well as many other banks faced huge losses. The write down of debt securities had significant adverse effects on Lehman’s balance sheet. Furthermore, credit rating agencies began focusing more on leverage ratios of investments banks. Lehman’s leverage ratios were already extremely high. A downgrade on Lehman’s credit rating would have sent Lehman’s share price on a downward spiral and hinder their ability to receive financing. In order to prevent these occurrences Lehman would have to sell some of its assets or raise capital. Lehman was unable to sell any of its assets or raise any capital because no one knew what the value of their complex mortgage securities were. In response to deteriorating economic conditions the investment bank used a very aggressive accounting maneuver called “Repo 105”, its name derived from repurchase agreements, which temporarily improved Lehman’s financial condition just before financial statements were released. In 2007 and 2008, Lehman was able to move up to $50 billion off their balance sheet by recording repurchase agreements as sales.

Repurchase agreements are frequently used in the banking industry. In a typical repurchase agreement one party sells securities to another party with the promise of repurchasing those assets for a higher price at a later date. In this transaction, the borrower’s cash account increases, the securities remain on their balance sheet and a liability is recorded for the repurchase agreement. Instead of treating these transactions as short-term borrowings, Lehman Brothers was able to record the exchange of assets as a sale. Lehman was able to book these transactions as sales by exploiting a loophole in the accounting standards regarding repurchase agreements. By employing this tactic, Lehman was able to remove assets from the balance sheet and omit recording the liability to repay the short-term loan. Lehman then used the cash received from the repurchase agreement to pay down liabilities, which ultimately improved its leverage ratios.

Under the Statement of Financial Accounting Standards No.140, in order for transfers of assets to be considered sales three conditions must be met: 1) the transferred assets need to be isolated from the transferor, 2) the transferee can pledge or exchange the assets, and 3) the transferor does not maintain effective control (Whitehouse 2011). Lehman easily met the first two conditions but circumventing the third condition required Lehman’s creative accounting since effective control is defined as follows:

“Effective control is maintained only if the transferor has the ability to repurchase substantial amounts of the transferred assets. To demonstrate the ability to repurchase transferred assets, the transferor, must maintain sufficient cash or other collateral to fund substantially all of the cost of repurchasing the transferred assets at all times during the repurchase contract term. Thus if a company can attest that the cash holdings are insufficient for the repurchase of the transferred assets during the contract period it would have exhibited a lack of ability to repurchase the assets, and therefore would not maintain effective control over the transferred assets. The firm has then met the third criteria of a sale by not maintain effective control” (Whitehouse 2011).

To sidestep the “effective control” condition Lehman had to circumvent the accounting rule that states, the transferor’s (the transferor of assets) repurchasing right is only assured when the repurchase price is between 98% and 102% of the cash received from the lender. In response to this clause, Lehman set the repurchase price at 105% and then claimed that it did not have enough cash to repurchase the assets (Whitehouse 2011). Since there was no assurance for repurchase Lehman lost effective control and consequently reported the purchase agreement as a sale. After the reporting period, Lehman would retrieve the assets through forward contracts, which were included on the balance sheet at very low values (Valukas 2010). According to the Bankruptcy Examiner’s report, Lehman had been using this strategy since 2001 but as the company began to unravel they increased the use of Repo 105. In the fourth quarter of 2007, $39 billion were removed, in the first quarter of 2008, $49 billion of assets were removed, and in the second quarter of 2008, $50 billion of assets were removed.

Internally, some members of the investment bank knew of the use of Repo 105. In June of 2008, Michael McGarvey, a finance controller, sent an email to another Lehman employee describing Repo 105 as “basically window dressing” (Sorkin 2010). He went on to say, “We are calling repos true sales based on legal technicalities” (Sorkin 2010). Bart McDade, the President and COO of Lehman Brothers up until its collapse, was also well aware of the accounting scheme. In an email conversation between McDade and Hyung Lee, the global head of fixed income, Lee stated, “Not sure you are familiar with Repo 105” (Sorkin 2010). Mcdade responded, “I am very aware…It is another drug we r on” (Sorkin 2010). Matthew Lee, a senior vice president, tried to bring the issue to his superiors to no avail. Eventually, he wrote a letter directly to senior management regarding the accounting issues. In his letter Lee described Repo 105 as “accounting improprieties” that were in violation of the firms code of ethics (Sorkin 2010). In June 2008, Lee met with two audit partners of Ernst and Young, William Schlich and Hillary Hansen. He clearly told the firm’s auditors that $50 billion had been removed from the balance sheet to make the leverage ratio appear lower (Jennings 2011). After the meeting, Schlich wrote an email to his colleagues that stated, “also dealing with a whistle-blower letter, that is on face pretty ugly and will take us significant time to get through” which implies he understood Lehman’s financial statements could have been materially misstated (Jennings 2011). Lee was let go and was given a $300,000 severance package. He agreed to refrain from making “any remarks at any time of in the future to any third party, such as a client, a competitor, or the media, that could be detrimental or adverse in anyway to Lehman” (Sorkin 2010). During the bankruptcy examination, William Schlich would not discuss the materiality of the Repo 105 transactions. The Bankruptcy Examiner’s report also states that partners Hansen and Schlich pointed fingers at one another and most of their responses to the Examiner’s questions were, “I don’t recall” and “that was not a part of our audit scope” (Valukas 2010).

In December 2010, the New York Attorney General sued Ernst & Young for assisting Lehman Brothers with disguising its financial condition from 2001 to 2008. The New York Attorney General, Andrew Cuomo, hinted at an auditor-client conflict of interest in his 32-page civil fraud lawsuit. Ernst and Young earned more than $185 million dollars in audit fees from 2001 to 2008. Lynn Turner of the SEC said that when clients generate such large fees partners “get extremely scared to death about losing a major client” (Rappaport 2010). Lehman was Ernst and Young’s 8th largest client and former Ernst and Young employees served as chief financial officers for the investment bank (Rappaport 2010). Perhaps Ernst and Young’s biggest blunder was its failure to review the legal opinion provided by a U.K law firm, which blessed Repo 105 transactions because it would have revealed Lehman was manipulating repurchase agreements and misstating short-term loans as sales. The fact that Lehman used a law firm based in the U.K should have raised a red flag for the auditors. Ernst & Young inexcusably took no action after the Matthew Lee blew the whistle on Lehman’s accounting practices. The information that Lee provided was relevant and material to current and prior financial statements as there were neither disclosures regarding Repo 105 transactions, nor efforts to restate financial statements. Furthermore, Ernst & Young failed to inform regulators about Lehman’s accounting shenanigans after they met with Lee. Ernst and Young’s most recent statement regarding Repo 105 is as follows:

“Lehman’s bankruptcy occurred in the midst of a global financial crisis triggered by dramatic increases mortgage defaults associated in mortgage and real estate portfolios, and a severe tightening of liquidity. We firmly believe that our work met all applicable professional standards, applying the rules that existed at the time. Lehman’s demise was caused by the global financial crisis that impacted the entire financial sector, not by accounting or financial reporting issues” (Kroft, 2010).

In response to Repo 105, the FASB amended SFAS 140 with SFAS 166, which now provides more clarity on the definition of “effective controls.” Even though the amendment improves reporting of repurchase transactions, it does not eradicate all the issues of repurchase agreements and loopholes in the accounting standard for repurchase agreements still exist (Chang 2011).

In the case of the Lehman Brothers and Ernst & Young, the rules were not broken instead they were circumvented. In a very literal interpretation of U.S GAAP the repo transactions were in compliance with financial accounting standards. However, the auditors at Ernst & Young did not exercise professional judgment even though the accounting profession has repeatedly emphasized the principle of “substance over form.” Furthermore, the very basic financial reporting principal of faithful representation was clearly violated. Unfortunately, Lehman was not the only bank on Wall Street recording repurchase agreements as sales. Citigroup and Bank of America classified repo transactions as sales with amounts ranging from $573 million to $10.7 billion. Similar to Enron and Worldcom, the financial reporting of Lehman Brothers indicates that high ethical standards are necessary in order to provide financial statements that faithfully represent firms’ financial positions. Investors rely on auditors to be independent “watchdogs” and when transactions like Repo 105 are ignored by auditors the accounting profession loses its credibility and, more importantly, the trust of investors.

Bibliography:

Chang, C. (., Duke, J., & Hsieh, S. (2011). A loophole in financial accounting: A detailed analysis of repo 105. Journal of Applied Business Research, 27(5), 33-39. http://ezproxy.clarkson.edu/login?url=http://search.proquest.com/docview/889140206?accountid=37646

Craig, S., & Spector, M. (2010, Mar 13). Repos played a key role in lehmans demise; report exposes lack of information and confusing pacts with lenders. Wall Street Journal (Online), pp. n/a-n/a. http://ezproxy.clarkson.edu/login?url=http://search.proquest.com/docview/237968953?accountid=37646

Jeffers, A. E. (2011). How lehman brothers used repo 105 to manipulate their financial statements. Journal of Leadership, Accountability and Ethics, 8(5), 44-55. http://ezproxy.clarkson.edu/login?url=http://search.proquest.com/docview/909486602?accountid=37646

Jennings, M. M. (2011). The irony of complicity: Lehman brothers, ernst & young, and repo 105. Corporate Finance Review,15(6), 36-38,40-41. http://ezproxy.clarkson.edu/login?url=http://search.proquest.com/docview/875636189?accountid=37646

Rappaport, L., & Rapoport, M. (2010, Dec 22). Ernst accused of lehman whitewash --- new york sues the accounting firm, alleging a 7-year fraud as it made $150 million in fees. Wall Street Journal, pp. C.1-C.1. http://ezproxy.clarkson.edu/login?url=http://search.proquest.com/docview/819616401?accountid=37646

Whitehouse, T. (2011). FASB closes lehman repo 105 loophole. Compliance Week, 8(89), 6-6. http://ezproxy.clarkson.edu/login?url=http://search.proquest.com/docview/870841297?accountid=37646

Sorkin, A. (2010). Too Big to Fail. New York, New York: Viking Penguin.

Valukas, A. (2010). LEHMAN BROTHERS HOLDINGS INC. CHAPTER 11 PROCEEDINGS EXAMINER REPORT. Chicago: Jenner & Block.