Lehman’s Funny Accounting: Who Knew?

It looks very much as if the report issued today by the investigators examining Lehman’s last days will roil the waters somewhat. There seems to have been some funny accounting going on in a deliberate attempt to mislead investors and counter-parties.

Who knew?

The accounting in question relates to the way on which repurchase agreements – ‘repos’ – are reported on the books. A repo is an exchange where one party hands over assets, such as a wad of government bonds, to another party in return for cash. This is not a sale because there is a second part to the agreement: the first party agrees to buy the assets back at a set future date for a premium. Repos are very common in finance and are an excellent way to raise short term cash. All large banks use them as do many other finance companies. The repo market was one of the first victims of the crisis: it froze up because no one could place a good value on the assets being exchanged and without a reliable price for the underlying collateral the risk of being a counter-party rose to unacceptable limits.

So far so good.

By mid 2008 many of the most aggressive players on Wall Street were extensive repo users. They used the market as a key source of liquidity. So when the market dried up the panic was severe: everyone had to scurry to locate other sources of liquidity. The atmosphere was akin to a gigantic game of musical chairs. When the music stopped Bear Stearns and Lehman were left standing and thus collapsed.

Lehman’s problems apparently go further: they were using repos very heavily, but they were using an aggressive accounting ploy called repo 105 transactions. There is an accounting rule – FAS 140 – that allows sellers of repos to account for the transaction as an outright sale even though there is a contract for repurchase. This is bizarre, but true. The technicality that allows such an oddity is the level of collateral. If the seller hands over assets in excess of the cash value received, in this case 105% or more, then it is allowed to book the transaction not as a pure repo, but as a sale. This has a dramatic effect on the balance sheet. Instead of continuing to despite the fact that it still has an agreement to repurchase the assets in the future.

Why would you do this?

To make your balance sheet look smaller than it actually is. The entire transaction is designed to create the impression that you have sold, rather than repo’d, the assets. Your balance sheet is thus smaller, and in Lehman’s case a smaller balance sheet was one way in which they could present themselves as being less risky as they sought to borrow in the market. Lehman was deliberately misleading its counter-parties, its shareholders, and the regulators about the actual amount of risk on its balance sheet. But it was doing nothing illegal because it was simply applying FAS 140, a legitimate Financial Accounting Standard as promulgated by the accounting profession through its FASB rule setting system.

The fact that no law was broken is why we will be reading bemused statements by accountants that they knew of on wrongdoing. They are correct. But clearly this is an example of an organization abusing an accounting rule. It is common knowledge that accounting rules are being subverted all the time. Corporate reporting is an arms race between internal financial people who want to distort a company’s reports for various reasons, and the accounting profession who are constantly trying to plug holes in reporting methods and establish guidelines so that the public has the ability to extract sensible and consistent information from those reports. FAS 140 must exist for some purpose – I have no idea what that purpose is – but it surely was not to deceive investors, regulators and counter-parties.

What seems to have happened is that as the stress built on Lehman some bright soul came across FAS 140 and realized that it provided a way for the company to appear less risky than it was. Presumably the plan was to survive long enough for real risk reduction efforts to catch up with the funny accounting.

As we know that effort failed, and what we have left is the troubling remains of a concerted deception.

The next step is for the usual suspects to gather around and start the inevitable legal challenges to recoup damages: they have a very strong case that without the deception they would not have entered into business with Lehman and thus would not have lost their investment. Watch the law suits fly. And watch for the ex-executives who signed off on the accounting to lawyer up quickly. This has all the makings of a mess.

Parenthetically: issues such as this are always going to pop up after the implosion of a risk driven organization like Lehman. This is a salutary example of how difficult it is to wind down a complex financial business. Any meaningful financial reform has to concern itself with such complex bankruptcies and the endless repercussions that seem to ripple on for years afterwards. How Lehman’s auditors and regulators allowed it to use FAS 140 in this way is also open to strong criticism. Laxity was endemic. Everyone was to blame for the collapse, but Lehman’s executives hold the ultimate responsibility. No one asked them to cheat, but that’s what they did. I can guarantee you that every Wall Street firm is busy making sure it cleans up its own FAS 140 transactions before the regulators come knocking – already Goldman and JP Morgan Chase have issued statements denying any such behavior.

But that’s today. What were they doing back in 2008?

Who knew?