Repo Lehman Brothers

1) Over the period 2000-2008, Lehman Brothers switched from a low-risk brokerage model to a higher-risk banking model, expanding its portfolio to include more risky products than just fixed income securities. Following the early-2000s housing boom, the bank acquired various mortgage lenders and began originating subprime loans (i.e. loans to financially risky individuals or entities). When banks give subprime loans, they mitigate their risk by turning the loans into securities which are then bought by investors: mortgage-backed securities allowed Leman to move mortgages off the books, freeing up room for more lending capital.

As an investor, evaluating the risk related to such business model requires some digging. Rating agencies and auditors did not do what they are designed for, which is helping investors: the former failed to assess the true risk of mortgage-backed securities, the latter failed to uncover the Repo practices that were leading to lower net leverage ratios. Despite this, just looking at the financial statements and the activities of the bank should have raised doubts: Lehman had an insignificant book level of equity compared to liabilities, had huge cash flows provided by financing activities needed to cover its cash needs for operational activities, and was heavily committed in long-term investments in the real estate market, basically locking up working capital. Safe to say that all of this contributes to increasing operating, credit and liquidity risk, and ultimately default risk.

2) Lehman employed Repo transactions to borrow cash using assets on its own balance sheet as collateral and pay down other liabilities on its balance sheet.

Usually in Repo transactions, the collateralized assets remain on the banks’ balance sheet. What made such practice by Lehman fraudulent was the fact that the bank recorded the transactions as sales rather than financing by taking higher haircuts of 5% (i.e. Repo 105), thereby taking the transactions off the balance sheet and decreasing the net leverage ratio, and did so explicitly the days prior to the publishing of the financial statement. The manipulation of the balance sheet was neither made public to shareholders nor included in the financial report’s footnotes. For these reasons, I obviously disagree with how Lehman accounted for these transactions: though not necessarily illegal – Lehman abused an accounting rule that was prone to manipulation – such practice was certainly unethical.

3) Three institutions are to blame for Lehman’s use of Repo 105.

The first is Ernst & Young. E&Y was the accounting firm that oversaw the auditing of Lehman Brothers’ financial reports. E&Y approved Lehman’s use of Repo 105 transactions and was also aware of their use to manage the bank’s balance sheet. It is important to note that E&Y was committed to report to the Lehman Audit Committee