Friday, March 12, 2010

Examiner: Lehman Torpedoed Lehman

A scathing report by a U.S. bankruptcy-court examiner investigating the collapse of Lehman Brothers Holdings Inc. blames senior executives and auditor Ernst & Young for serious lapses that led to the largest bankruptcy in U.S. history and the worst financial crisis since the Great Depression. In the works for more than a year, and costing more than $30 million, the report by court-appointed examiner Anton Valukas paints the most complete picture yet of the free-wheeling culture inside the 158 year-old firm, whose chief executive Richard S. Fuld Jr. prided himself on his ability to manage market risk.

Fuld's arrogance was boundless. He even told a House member to let him finish, when the politician had the temerity to interrupt his testimony before a Congressional committee. Fuld was used to such deference.

The document runs thousands of pages and contains fresh allegations. In particular, it alleges that Lehman executives manipulated its balance sheet, withheld information from the board, and inflated the value of toxic real estate assets. Lehman chose to "disregard or overrule the firm's risk controls on a regular basis,'' even as the credit and real-estate markets were showing signs of strain, the report said.

Getty Images - Lehman's top executives, including CEO Richard Fuld, were aware of accounting chicanery and failed to disclose it, the report said. Above, Fuld testifies before the House Oversight and Government Reform Committee in October 2008.

Mr. Valukas, chairman of law firm Jenner & Block, devoted more than 300 pages alone to balance-sheet manipulation, accusing Lehman of using accounting methods to move assets off its books.

Coincidentally, the firm is domicilied at 919 Third Avenue.

The examiner said that Lehman—anxious to maintain favorable credit ratings—engaged in an accounting device known within the firm as "Repo 105" to essentially park about $50 billion of assets away from Lehman's balance sheet. The move helped Lehman look like it had less debt on its books.

Seems misleading, to say the least.

In an ordinary repo transaction, Lehman would raise cash by selling assets with a simultaneous obligation to buy them back within days, according to the report. The transactions would be accounted for as financings, and the assets would remain on Lehman's balance sheet. In a Repo 105 transaction, Lehman did the same thing. But because the moved assets represented 105% or more of the cash it received in return, accounting rules allowed the transactions to be treated as "sales" rather than financings. The result: Assets shifted away from Lehman's balance sheet, reducing the amount of debt it showed to investors.

Misleading, and allowed. Nice.

"In this way, unbeknownst to the investing public, rating agencies, Government regulators, and Lehman's Board of Directors, Lehman reverse engineered the firm's net leverage ratio for public consumption," says the report.

Bloomberg News - Erin Callan, Lehman's former financial chief, in an April 2008 interview.

Lehman's own global financial controller, Martin Kelly, told the examiner that "the only purpose or motive for the transactions was reduction in balance sheet" and "there was no substance to the transactions." Mr. Kelly said he warned former Lehman finance chiefs Erin Callan and Ian Lowitt about the maneuver, saying the transactions posed "reputational risk" to Lehman if their use became publicly known.

In a November 2009 interview with the examiner, Mr. Fuld said he had no recollection of Lehman's use of Repo 105 transactions but that if he had known about them he would have been concerned, according to the report.

Plausible deniability?

One party singled out in the report is Lehman's audit firm, Ernst & Young, which allegedly didn't raise concerns with Lehman's board about the frequent use of the repo transactions. E&Y met with Lehman's Board Audit Committee on June 13, one day after Lehman senior vice president Matthew Lee raised questions about the frequent use of the transactions.

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

Difficult to believe that such a hands-on CEo didn't know a blessed thing about such an important matter. And if true, then he wasn't awatre of a very important matter.

As Lehman began to unravel in mid-2008, investors began to focus their attention on the billions of dollars in commercial real estate and private-equity loans on Lehman's books. The report said that while Lehman was required to report its inventory "at fair value," a price it would receive if the asset were hypothetically sold, Lehman "progressively relied on its judgment to determine the fair value of such assets."

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