“Our enemies are innovative and resourceful, and so are we. They never stop thinking about new ways to harm our country and our people, and neither do we.”
Number 42, August 5, 2004
What a mess. Before the most recent giant sucking sounds you all heard, the two largest bankruptcies in the U.S. were Enron and Worldcom, and they were largely the result of corporate accounting scandals.
Those numbers games gave rise to some considerable prison time, what is now known as Sarbanes-Oxley, as well as a whole host of new GAAP accounting literature designed to prevent a repeat of that deception.
Given the considerable efforts of Mssrs. Sarbanes and Oxley to drum creative types completely out of the accounting profession, you may wonder how Lehman managed to make nearly $50 billion of debt disappear from its balance sheet quarter after quarter. Surprisingly, the answer is that they were able to combine a little bit of good old fashioned jurisdiction shopping with some pretty stale, nearly 20 year old accounting guidelines to create a technical asset sale, even though the substance of the transaction amounted to no more than a five day loan. Of course, Lehman would have gladly sold all of this stuff permanently if it could have, but no reasonable investor would touch it.
During Lehman’s final months, the independent examiner (the reports are linked here) confirms that there was an almost constant scramble for liquidity, and that despite this, some senior managers – including Dick Fuld – suffered from considerable delusion over the value and marketability of the firm’s massive real estate portolio.
Nevertheless, as Lehman’s balance sheet froze up and the hunt for liquidity grew more desperate, the firm began selling chunks of its illiquid loan book to anyone it could, including long-time clients and even its own employees:
While REPO 105 was simply the result of a conflict between U.S. and U.K. accounting guidelines, the deal outlined above was the result of a more fundamental conflict between large Wall Street firms and their own clients (and in this case, large Wall Street firms and their own employees). If you ever had doubts about that, all you need to do is take a quick peak at the disclaimer on the target return analysis for the above $3 billion loan “opportunity” fund:
“This model makes a significant number of assumptions, including the general assumption that investing conditions will not deteriorate.”
Huh??
If your job is to throw assets assets over the side like so many seat cushions on the Titanic, I suppose you’d need a fair bit of optimism just to make it through the day. But under the circumstances, peddling a 21% gross IRR on an illiquid, 2006 vintage senior secured loan book seems just a tad exuberant. Nevertheless, this loan opportunity fund closed nearly fully subscribed, even though “investing conditions” were deteriorating by the minute. Sold to you my friend!
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It’s hard to fault Lehman for taking advantage of SFAS 140 loopholes. True, the disclosure in the MD&A was limited and failed to disclose that a material amount of liquidity was being generated via noneconomic repurchase arrangements. Still, the market had every opportunity to punish Lehman’s stock price for its opaque and complex financials and chose to remain blissfully ignorant. I really don’t fault Lehman too much for the Repo 105 transactions.
Hi Patrick – I have to disagree. Clearly, FIN 46 was meant to end this sort of thing once and for all. LEH was playing by the letter of the law, not the spirit. This is the kind of thing that convinced me to abandon my career as a banker.
Although the Examiner’s Report expressly declined to take a position on the issue, it seems quite unlikely that Lehman’s repo 105 program in fact met the standards required by FAS 140 for off-balance sheet treatment. In particular, LBIE (Lehman’s UK entity) apparently repo’d two different “buckets” of securities in the UK: (i) securities that were already owned LBIE, and (ii) securities transferred to LBIE from U.S. Lehman entities. With respect to the second category, the means of transfer was a repo between the U.S. Lehman entity and LBIE. That repo between the U.S. Lehman entity and LBIE, however, would not be characterized as a true sale for U.S. bankruptcy law purposes; indeed, the very impetus for the repo 105 structure was Lehman’s inability to obtain a true sale opinion from a U.S. law firm for repos transacted by U.S. Lehman entities. And there lies the problem: the transfer of securities from U.S. Lehman entities to LBIE, and the characterization of such transfer for U.S. bankruptcy law purposes, were not addressed in the Linklaters UK legal opinion upon which Lehman depended for FAS 140 purposes (and one might conjecture that Lehman probably never informed Linklaters of the specific providence of the securities). Instead, the Linklaters UK legal opinion simply included an express assumption that there were no provisions of foreign law that would have any effect on the opinion. Accordingly, it is hard to imagine that Linklaters would still have been able to provide its UK legal opinion if there had been an explicit statement of the fact that certain of the securities that were repo’d in the UK by LBIE were first acquired by LBIE from U.S. Lehman entities in repo transactions that did not constitute true sales for U.S. bankruptcy law purposes.