The huge task of analysing and investigating why Lehman Brothers failed fell to Anton Valukas, an experienced and highly respected Chicago lawyer. The investigation which spanned 350bn pages of documents as well as over 200 interviews has attracted praise for its narrative style. Moreover the findings open up a Pandora’s Box of legal and accounting issues.
The main issue here is risk: the continual increase of Lehman’s risk-ceiling led the firm down a very dangerous path. One example of this was its move into the housing market, even though it was already overheating and about to collapse – the risks were high but the rewards were huge. This was a gamble which did not pay off.
To accentuate the problem their own stress tests of risk were manipulated to not include data on their investment in the housing market and so appeared healthier than they really were. As a result they were far more sensitive to fluctuations in capital markets.
Moreover ratings agencies and investors needed the bank to reduce its balance sheet to become more manageable and so the manipulative balance sheet technique, known as ‘Repo 105’ was used; in fact this has been reported to have been used since 2001.
Repo 105 is a technique which allows the bank to transfer its assets to a counterparty in return for cash. This cash will be subject to interest and the assets will be transferred again at a specified time. However this transaction is described as a sale rather than as issues of finance which means the assets can be removed from the balance sheet, while the cash collected can be used to pay off liabilities. This makes the firm look far less risky giving it leverage at specific times.
Lehman Brothers had not reported these transactions and can therefore be described as misleading and deceiving. The more trouble they got into with spiralling, uncontrollable risk meant the more they would fall back on Repo 105. And it was the same story every quarter. In 2008 the amount of assets transferred under this technique was over $50bn.
This raises the question of risk and exactly how big your contingency fund is. Transparency is the key – there needs to be a mechanism in place stopping firms from hiding such practices. However as the issue was that such transactions could not be described as a true sale in the US, it was in the UK – hence the use of accountancy over here. Therefore the only answer can be standardisation of terminology and practice.
Repo 105 became the drug of choice for traders at Lehman Brothers; it would have a lasting impact on not only the financial world but society as a whole.