The Lehman report
Posted by Christie Malry on March 12, 2010 at 11:10 pm
The report into Lehmans was published today. It's nine volumes and over 2,000 pages long.
Some of the papers have referred to how Lehmans used "accounting gimmickry" to massage its balance sheet so its main banking ratios would look better. At the heart of the matter is the enigmatically named Repo 105.
Repo 105
Repo 105, so named because it involves providing $105 of assets for each $100 of cash (not because it was preceded by 104 failed accounting gimmicks), was designed to switch illiquid assets for cash at key balance sheet dates. The basic idea is this: Lehmans sells some assets to someone else for cash, but signs a contract to buy them back later. The buyer makes a standard interest return on the cash.
Key to how this should be accounted for is how genuine the sale really was. Imagine a pawnbrokers. Is it a real sale followed by repurchase, or is it really just a standard loan that happens to be secured against something you value?
Accounting standards tend to assume that it's almost always the latter. Companies that sell things and buy them back probably wanted them all along. They were just using them to convince a third party to loan them money.
And, as the Lehmans report makes clear, Lehmans asked several US law firms to sign an opinion saying that Repo 105 was a genuine sale and buyback. They couldn't find a single one. In the end they got a UK firm, Linklaters, to sign an opinion saying that they believed Repo 105 was a valid sale under UK company law. Lehmans then used that opinion to justify wholesale window-dressing of their balance sheet, at one point by as much as $50 billion.
Where were the auditors?
Now, I used to be an auditor. I never audited banks, but I am familiar with the sorts of games companies can play to massage their balance sheets. My firm was keen to train us to be watchful to trickery. They showed us auditing horror stories, such as ZZZZ Best. I bought and read Terry Smith's Accounting for Growth
What on earth were Ernst & Young thinking? Because the US law firms wouldn't touch Repo 105, Lehmans could only rely on the Linklaters UK opinion, which meant all Repo 105 transactions had to be routed through the UK. The UK auditors should, in my view, have picked up the transactions and reported it back to their parent company auditors in New York. They should have basically ignored the legal opinion. Had I been in their place, I would have told the client that the legal opinion is interesting but not binding on me. Linklaters are lawyers and accordingly are expert in law, not financial reporting.
Secondly, the parent company auditors should have picked them up too. The report is pretty damning about the conduct of the head office audit team, who were notified by a whistleblower of some serious concerns but appear to have failed to follow up on those concerns with the audit committee. This is despite being asked specifically by the audit committee to report on the whistleblower's concerns! The repos were referred to as one of the items.
Colorable claims
The Lehmans report uses the quaint term "colorable claim", which is legalese for "it's a claim that is pretty convincing". It concludes that there is a colorable claim that Ernst and Young were negligent in their audit of Lehmans. Based on what's in the report, I agree. There will be some very nervous risk partners at Ernst and Young tonight.
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