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The Feds Knew About Lehman’s Repo 105 Transactions March 16, 2010

Chris Cox

It is difficult to be shocked about new revelations stemming from the financial crisis, but today’s DealBook column by Andrew Ross Sorkin was a real revelation.  S.E.C. examiners, working during the watch of Christopher Cox as S.E.C. commissioner, apparently saw nothing wrong with Repo 105.  Here are a few excerpts:

“Even though Lehman dressed up its accounts for the great unwashed public, it did not try to fool the authorities,” Yves Smith, the author of “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism,” wrote on her blog last week. “Its game-playing was in full view.”

Indeed, it now appears that the federal government itself either didn’t appreciate the significance of what it saw (we’ve seen that movie before with regulators waving off tips about Bernard L. Madoff). Or perhaps they did appreciate the significance and blessed the now-suspect accounting anyway.

Oddly, when the bankruptcy examiner asked Matthew Eichner of the S.E.C., who was involved with supervising firms like Lehman, whether the agency focused on leverage levels, he answered that “knowledge of the volumes of Repo 105 transactions would not have signaled to them ‘that something was terribly wrong,’ ” according to the examiner’s report.

There is plenty of blame to go around.  Lehman’s CEO Richard Fuld was criminally negligent, shockingly incompetent, or both.  Ernst & Young, the firm’s auditors, concluded that Repo 105 was acceptable under generally accepted accounting principles but obviously failed in their larger responsibility to users of Lehman’s financial statements.  Now we find that the S.E.C. and other government regulators were fully aware of the Repo 105 shenanigans for nearly six months prior to Lehman’s collapse.

Click on this link to read the full DealBook Column

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A Modest Proposal for Audit Reform March 15, 2010

Ernst & Young

Attempting to understand the sequence of events that led to the downfall of Lehman Brothers is normally a mind numbing process, but occasionally an obvious outrage is discovered such as Lehman’s use of “Repo 105” transactions.  While we have not perused the 2,200 page bankruptcy examiner’s report, enough information has been reported to draw some conclusions.  While Lehman’s top management deserves much criticism and blame, the firm’s auditors were derelict in their responsibilities as well.  Whether Ernst & Young is legally culpable is an open question.  However, it is obvious that the firm acted as an “enabler” to Lehman’s management when it came to the use of Repo 105.

“Lehman Complied with GAAP”

The Wall Street Journal provides the following quote from an unnamed source at Ernst & Young who commented on the use of Repo 105 transactions at Lehman:

The firm’s auditor, Ernst & Young LLP, on Friday said it reviewed the accounting for Lehman repo deals under scrutiny by the examiner “on a number of occasions. Our view was, and continues to be, that Lehman’s accounting policy for these repo transactions complied with generally accepted accounting principles. The examiner has not concluded otherwise.”

Let us carefully consider what this statement implies.  Based on the bankruptcy examiner’s report and quotes found in multiple sources such as the Wall Street Journal and The Financial Times, top managers at Lehman specifically state that they were relying on Repo 105 at the end of reporting periods in order to move tens of billions of dollars off Lehman’s balance sheet in an attempt to create the illusion of lower leverage.  The firms auditor, Ernst & Young is now stating that they reviewed the repo transactions on a number of occasions and they complied with GAAP.  However, can anyone believe that the auditors did not understand the nature of the transactions or the illusion it was intended to create?  That is highly doubtful.

Principle vs. Rule Based Accounting

Generally Accepted Accounting Principles, or GAAP, present general principles and rules under which companies are supposed to report their business activity to investors and other interested parties.  At its very basic level, GAAP is supposed to ensure that management is accurately matching costs with revenue, recognizing revenue at the appropriate time, using consistent standards across accounting periods, and can substantiate financial statements based on evidence.  GAAP is considered a “rule based” accounting standard.  In contrast, International Financial Reporting Standards (IFRS) is “principle based”. The United States is moving toward convergence with IFRS. (It should be noted that we are not aware of whether Repo 105 would have passed scrutiny under IFRS.)

While GAAP is considered to be “rule based”, it does not follow that auditors should turn a blind eye toward obvious manipulation of accounting by management which is intended to mislead users of financial statements.  Perhaps there was no explicit rule in GAAP that prohibited the Repo 105 transactions or required disclosure of the transactions.  However, this fact alone does not mean that auditors should sign off on financial statements when such material misstatements have taken place.

Every public company files audited financial statements in which the audit firm makes a statement similar to the following:

“In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of [Company Name] and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and cash flows for each of the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.”

The last point in italics is the key problem.  If we examine the quote from the Ernst & Young official provided earlier, we can see that he or she did not claim that the Repo 105 transactions were not designed to mislead financial statement users or that they fairly represented Lehman’s financial condition.  The statement is qualified by a reference to GAAP.

A Modest Proposal

A modest proposal for audit reform would add the following statement to the auditor’s report immediately following the statement above:

“Furthermore, we are not aware of any material transactions or off balance sheet entities, even if in compliance with GAAP, that in our judgment have been designed to mislead users of the company’s financial statements.”

Would the auditors like to see such language added?  Obviously not because it would add an element of professional and perhaps legal liability that does not exist today.  Should auditors accept this additional responsibility?  It would seem that if your business is to examine the accuracy of financial statements and provide your seal of approval to the public, such responsibility goes with the territory, even if your motto is not “Quality in Everything We Do”.

Intelligent investors should always approach financial statements with a healthy level of skepticism, but at the very least is it too much to ask to be alerted when the firm’s auditor knows of material attempts to distort reality, whether or not the deception runs afoul of GAAP or not?

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Was Lehman’s CEO Criminally Negligent or Merely Incompetent? March 13, 2010

Dick Fuld

In a pattern that would be amusing if it was not so disturbing, we are again witnessing the spectacle of lawyers for a disgraced CEO who claim that their client was “unaware” of key risks that led to the downfall of their firm.  The Lehman Brothers bankruptcy examiners report has been widely covered in the business media over the past few days and, at a minimum, paints a picture of shocking incompetence and an intent to mislead among Lehman’s senior management team.  It is the type of scenario in which a former CEO’s only defense appears to rest on claims that he was incompetent rather than criminally negligent.

Repo 105 Transactions

The Wall Street Journal reports that Lehman management routinely engaged in “Repo 105” transactions in an attempt to dress up the balance sheet prior to the end of financial reporting periods.  In a normal repurchase agreement, a borrower uses a financial security as collateral for a cash loan.  The agreement generally involves the sale of the collateral combined with a commitment to repurchase the same security at a point in the future at a higher price.  In a “Repo 105” transaction, Lehman was able to book the transaction as if it was an outright sale rather than an ordinary repo transaction because the assets the firm moved were worth 105% or more of the cash it received in return.

Through this accounting maneuver, Lehman was able to appear less leveraged than it really was.  According to the Wall Street Journal, no United States based law firm would sanction this accounting treatment so Lehman secured an opinion letter from a London law firm named Linklaters.  If a U.S. based Lehman entity needed to engage in a Repo 105 transaction, it would have to move the security to a European division to execute the transaction.

Lehman executives are on record acknowledging the necessity of such transactions as the following quote from a Wall Street Journal article clearly demonstrates:

Four days prior to the close of the 2007 fiscal year, Jerry Rizzieri, a member of Lehman’s fixed-income division, was searching for a way to meet his balance-sheet target, according to the report. He wrote in an email: “Can you imagine what this would be like without 105?”

A day before the close of Lehman’s first quarter in 2008, other employees scrambled to make balance-sheet reductions, the report said. Kaushik Amin, then-head of Liquid Markets, wrote to a colleague: “We have a desperate situation, and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it.”

Grossly Negligent, Criminally Responsible, or Merely Incompetent?

Lehman’s CEO Dick Fuld is cited in the bankruptcy examiner’s report as being “at least grossly negligent” regarding the Repo 105 transactions:

The examiner wrote there was “sufficient evidence” to support a legal claim that Mr. Fuld was “at least grossly negligent for failing to ensure” Lehman filed proper financial statements about its accounting for the transactions, and that a key former executive of the firm, the chief operating officer, personally briefed him on the matter.

Of course, Mr. Fuld’s attorneys have decided to pursue the “incompetent” defense as opposed to taking any responsibility for the situation:

Mr. Fuld’s lawyer said on Thursday that Mr. Fuld “did not know what those transactions were” and wasn’t “aware of their accounting treatment.”

It is unclear what is more shocking:  The prospect of a CEO of a major financial institution willfully pursuing financial transactions designed specifically to mislead investors and counterparties into thinking that the firm was less leveraged than it really was or the idea that the CEO really had no idea that these maneuvers were taking place at all.

Buffett’s Decision on a Lehman Investment

The bankruptcy report also contains some interesting information regarding Lehman’s attempts to have Warren Buffett invest $2 billion in the company as a “stamp of approval”.  Of course, Mr. Buffett decided against doing so when he found problems in Lehman’s 10-K as well as negative signals from Lehman executives who were unwilling to invest in the firm on the same terms he was offered.

As is often the case, we can also look at Mr. Buffett’s statements regarding corporate governance to understand what went wrong at Lehman:

“In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.”

— Warren Buffett’s 2009 Letter to Shareholders.

If Lehman’s story can be distilled down to its core problem, it seems to be that the company’s CEO did not regard himself as the Chief Risk Officer.  Based on Mr. Fuld’s own admission (if we are to believe him), he was not aware of critical accounting policies that misled investors and counterparties who were using Lehman’s financial statements to judge the health of the business.  Of course, the Repo 105 maneuver was only necessary because of other failures to control risk at the firm.

It would be a refreshing change if at least one CEO involved in the demise of a major financial institution would step up and admit that the responsibility was his rather than hiding behind the “incompetence” defense.

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Book Review: Lessons From Andrew Ross Sorkin’s “Too Big To Fail” January 5, 2010

Too Big To Fail

Most outside observers had difficulty keeping up with the momentous events of the weekend of September 14-15, 2008 with all of the twists and turns that finally led to Lehman Brothers’ historic bankruptcy filing, Bank of America’s purchase of Merrill Lynch, and AIG’s bailout only a few days later. Ever since that tumultuous period, there has been a need for a comprehensive book covering the behind the scenes events.  Andrew Ross Sorkin’s Too Big To Fail has succeeded in delivering exactly what is needed to gain a better understanding of these historic events.

If newspapers are the “first draft of history”, Andrew Ross Sorkin played a major role with his New York Times coverage of the financial crisis in 2008.  Although Mr. Sorkin is only 32 years old, he has obviously been able to build up a massive network of contacts on Wall Street and in Washington. Mr. Sorkin’s coverage spans the timeframe from the failure of Bear Stearns up to the passage of the TARP legislation, but the narrative really shines when it comes to the events of a September weekend when the financial system came much closer to total collapse than anyone on the outside could have realized at the time.

Mr. Sorkin’s book has received a great deal of media attention and book reviews, but there is also a need to step back and think about the lessons that must be learned if future crises are to be avoided.  The inability of Washington to come to any agreements on financial system reform was a significant failure in 2009, but one that received little attention outside the financial press.  With each passing week of relative “calm”, chances grow greater than another crisis may be required to prompt reforms.

Greed and Fear

The old adage that a balance between greed and fear creates equilibrium on Wall Street seems hopelessly out of date in light of the revelations in this book.  In the “text book world”, investors and other players in a market system need to be driven by the profit motive (“greed”) but decisions are tempered by a desire for safety (“fear”).  For many decades on Wall Street, the partnership model in investment banking seemed to keep the level of risk aversion high enough to prevent overreaching (for a great book on the old  model at Goldman Sachs, for example, see Charles D. Ellis’ The Partnership).

One can argue that many leading Wall Street players lost huge sums of money in the 2008 crash, so the absence of more “fear” in the system cannot be explained merely by a change in the ownership models of the investment banks. Indeed, an absence of adequate levels of risk aversion extended to Main Street and Washington as well.  Rep. Barney Frank’s famous declaration in favor of “rolling the dice” with softer underwriting standards for mortgage lending as well as the reckless disregard of financial prudence by many subprime borrowers cannot be ignored.

False Illusions and Egos

From the outside looking in, Wall Street and Washington are populated by highly confident, assertive, and competent individuals who seem equipped to carry out their responsibilities in a capable manner.  While there are many individuals who fit this description well, some of whom appear in Mr. Sorkin’s book, many others appear to suffer from the human defects that affect everyone else.  At several points in the book, we can see cases where ego prevented otherwise intelligent actions from being taken.

For example, why did Lehman Brothers’ CEO Dick Fuld, shocking even his own team, attempt to abruptly change the terms of a nearly sealed deal with Korea Development Bank in early August that would have valued Lehman at a premium and likely saved the firm?  Was it a matter of seeking better terms for his shareholders, a question of ego, or confidence that a government bailout would be a backstop if all else failed?

There are countless other situations in the book where the reader, with the benefit of hindsight, asks:  Why?

Government Saviors?

Government players hardly come out of the story looking like heroes either, with the possible exception of Treasury Secretary Hank Paulson who had the unenviable task of coming up with solutions for the crisis without appearing to favor a bailout of his former colleagues at Goldman Sachs.  Throughout Mr. Sorkin’s account of the events, it becomes quite apparent that helping Goldman was probably the last thing on Mr. Paulson’s mind.

Timothy Geithner, the current Treasury Secretary, was President of the Federal Reserve Bank of New York during the crisis.  Mr. Geithner comes across as the main deal maker for the Fed while Chairman Ben Bernanke takes a much lower profile role.  While there is no doubt that Mr. Geithner played a critical role, he often comes across as authoritarian in terms of his tactics.  For example, at several points, he makes threats or orders bank CEOs to take action during meetings and simply leaves the room asking to be notified when a solution is in place.  Whether this was necessary or not during these remarkable times is an open question, but this is not how we should want government officials to behave in normal times.

President Bush hardly appears in the narrative and seems quite detached in the few occasions where he is being briefed on the crisis.  For all practical purposes, Secretary Paulson was calling the shots for the Executive branch of the Federal Government throughout this process.  Sen. Barack Obama made a few appearances in the book (as well as on Secretary Paulson’s calendar) but Sen. John McCain hardly appears at all which is surprising given that he famously suspended his campaign in order to return to Washington and work on a solution for the crisis.

Financial Regulatory Reform

One of the interesting aspects of the book is the degree to which government officials pushed to “marry” commercial banks and investment banks during the height of the crisis in September.  It seems like every possible permutation was considered, to the point where Mr. Geithner was referred to mockingly as “E Harmony” in a reference to the online dating site.  At the same time, many in government blame the 1999 repeal of the Glass-Steagall Act, which prohibited the union of commercial and investment banks, for precipitating the crisis.

While the idea of giving investment banks access to stable deposits through commercial banks had a great deal of merit during the crisis, such mergers also created ever larger institutions, many of which are considered “too big to fail”.  It seems that society must decide which is the lesser of two evils:  Government regulations that seek to keep financial institutions small such that none can become “too big to fail” or heavy handed regulations that properly govern mammoth institutions that are obviously “too big to fail”.

Wall Street:  Pick Your Regulatory “Poison”

Wall Street cannot have it both ways:  If regulations are repealed that then allow financial institutions to grow so large that a failure would have systemic impacts, then regulations governing the conduct of these institutions is essential to avoid future crises from developing.  On the other hand, if we accept regulations that prohibit mergers that will result in massive institutions, Wall Street firms should have more flexibility to conduct their ongoing affairs without as much regulatory scrutiny since the failure of any one institution will not be systemically important.

It seems preferable to have “blocking” regulations such as Glass-Steagall rather than “operational” regulations required to govern massive financial institutions that are of systemic importance.  A “blocking” regulation is not as intrusive into the day to day operation of firms and is less likely to throw sand in the gears of capitalism.  In contrast, the regulatory regime required to monitor massive systemically important institutions will, of necessity, be intrusive and bureaucratic.

“Too Big To Fail:  The Sequel”?

There are many potential solutions that should lead to a more stable financial system going forward, but each passing week makes it less likely that reforms will be made.  As the economy recovers and “business as usual” returns to Wall Street, the seeds are now being planted for the next crisis.  While no doubt capable of the task, we should hope that Mr. Sorkin does not have the opportunity to write a sequel to Too Big To Fail.  The consequences could be even more severe.

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Warren Buffett’s Patience Paid Off in 2008 December 12, 2009

Warren Buffett has often said that there are no called strikes in the field of investing.  Investors are presented with a series of “pitches” every business day by the market but there are no penalties for failing to swing other than the potential to miss out on interesting opportunities.

Of course, Warren Buffett gets many more “pitches” than ordinary investors.  Berkshire Hathaway’s huge cash balance in 2008 created many situations where Mr. Buffett  was offered unique investment opportunities but he passed on the vast majority of them.  The Wall Street Journal has published a detailed account of the many offers made to Mr. Buffett  in 2008 including some details that were previously not known.

One of the early “pitches” came from the CEO of Lehman Brothers on March 28, 2008.  According to the article, Mr. Buffett spent the evening of March 28 reviewing Lehman’s latest 10-K  report and jotted down the number of pages where he found troubling information.  By the time he finished the report, there were too many problems and he passed.  Click on this link for a copy of the 10-K cover provided by the  Wall Street Journal.

In the video below, the author of the Wall Street Journal article provides some additional background information and commentary:

For RSS Feed Subscribers, please click on this link to view the video.

The Wall Street Journal also made available a letter that Mr. Buffett sent to Treasury Secretary Hank Paulson on October 6, 2008 proposing a public-private investment fund.

When Mr. Buffett finally swung on the Goldman Sachs and General Electric pitches in October 2008, he was able to secure investments that have already proven to be very profitable for Berkshire Hathaway.  While he could have achieved even better results by waiting for the March 2009 lows, there was no realistic way to forecast the exact low or to time the market to produce an “optimal” result.

The author owns shares of Berkshire Hathaway.

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