Tuesday, March 16, 2010

Summary: Valukas Report

¹²A Short Summary Of What We Have Mined From Anton Valukas' Report, So Far:

Repo 105
Posted by Tracy Alloway on Mar 12, 2010.

Think window-dressing on a massive, and possibly misleading, scale. Much of the 2,200-page Examiner's report into the Lehman Brothers bankruptcy centres around an "accounting gimmick" used by the bank, and signed off by auditors Ernst & Young, to [[apparently but NOT actually: normxxx]] reduce leverage. That would be Repo 105 and Repo 108— or Repo 105 for short.

And it/they worked like this, according to Volume III of the report:

Lehman employed off-balance sheet devices, known within Lehman as "Repo 105" and "Repo 108" transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm's financial condition in late 2007 and 2008.

Repo 105 transactions were nearly identical to standard repurchase and resale ("repo") transactions that Lehman (and other investment banks) used to secure short-term financing, with a critical difference: Lehman accounted for Repo 105 transactions as
"sales" as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction. By recharacterizing the Repo 105 transaction as a "sale," Lehman removed the inventory from its balance sheet.

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet. Lehman's periodic reports did not disclose the cash borrowing from the Repo 105 transaction— i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851 Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios. Thus, Lehman's Repo 105 practice consisted of a two-step process: (1) undertaking Repo 105 transactions followed by (2) the use of Repo 105 cash borrowings to pay down liabilities, thereby reducing leverage. A few days after the new quarter began, Lehman would borrow the necessary funds to repay the cash borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet.

Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions.

You can see why Repo 105 would be a tempting thing in the midst of a brewing financial crisis. Leverage had become a focus of the ratings agencies and was widely thought to be an indicator of bank risk, which meant Lehman would have been hell-bent on reducing its leverage— at least publicly. At the same time prices for things like CMBS and subprime loans were falling and/or illiquid— Lehman could not have reduced its balance sheet simply by selling things off without incurring large losses.

Hence the Repo, which the bank increasingly used between 2007 and 2008— even breaching its own internal cap on the Repo's use (about $22bn as of summer 2006). And the effect is pretty clear. From the report:

Hence the Examiner's conclusion:

The Examiner concludes that there is sufficient evidence to support a colorable [[ie, legally actionable: normxxx]] claim that: (1) certain of Lehman's officers breached their fiduciary duties by exposing Lehman to potential liability for filing materially misleading periodic reports and (2) Ernst & Young, the firm's outside auditor, was professionally negligent in allowing those reports to go unchallenged. The Examiner concludes that colorable claims of breach of fiduciary duty exist against [former CEO/CFOs] Richard Fuld, Chris O'Meara, Erin Callan, and Ian Lowitt, and that a colorable claim of professional malpractice exists against Ernst & Young.

And the response, as reported by the FT:

In a statement, Mr Fuld's lawyer wrote: "Mr Fuld did not know what those transactions were— he didn't structure or negotiate them, nor was he aware of their accounting treatment," his attorney wrote in a statement.

"Furthermore, the evidence available to the examiner shows that the Repo 105 transactions were done in accordance with an internal accounting policy, supported the legal opinions and approved by Ernst & Young, Lehman's independent outside auditor".

E&Y said in a statement:
"Our opinion indicated that Lehman's financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view".

Mr Lowitt's attorney said in a statement:
"In the three months during which he held the job, Mr Lowitt worked diligently and faithfully to discharge all of his duties as Lehman's CFO. Any suggestion that Mr Lowitt breached his fiduciary duties is baseless".

Mr O'Meara could not be reached for comment. A lawyer representing Ms Callan declined comment



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