There are two ways to react to the biblically proportioned report that Lehman Brothers’ bankruptcy examiner released last Friday, which over its 2,209 pages (not counting appendices) has echoes of Grisham, Orwell and Ayn Rand.
The first is to lose faith in man. As it reveals, Lehman turns out to have used a secretive and dazzling accounting trick to fluff up appearances as it tumbled toward a violent end in September 2008. That month’s gruesomeness still reverberates: Moody’s not only warned this week that it may downgrade the American government’s triple-A credit rating, but it said that maintaining it will require “adjustments of a magnitude that, in some cases, will test social cohesion.”
The second reaction is to shrug.
Two former senior Lehman executives did just that this week, telling The Observer that the examiner’s autopsy, especially its news that about $50 billion was quietly scooted off the firm’s balance sheet for each of the first two quarters of 2008, was simply not a big deal. “If Valukas went into Goldman Sachs, what do you think the report would look like?” the first asked, referring to the court-appointed examiner, Chicago attorney Anton Valukas. “This would be a fairy tale compared to that.”
“It’s just not that big of an event. But that’s not what people want it to be, so they’ll make it not that way if they can,” said the other. “They just want to be mad and don’t know what they’re talking about and want to be outraged.” After an interview, that executive sent a follow-up email comparing the widespread furor over Lehman Brothers to the groupthink that sent America into Iraq after Sept. 11.
The idea, a year and a half after the biggest bankruptcy in American history began, is that criticism of the firm is the domain of unsophisticates. “When I read this, I giggle a little bit. Because $50 billion is a shitload of money, but in the grand scheme of things,” said a third source, a former managing director in England—where the accounting gimmick, named Repo 105, was given a legal endorsement that it couldn’t get here, “$50 billion is a drop in the ocean.”
“THIS IS EVERYONE’S worst nightmare,” Lehman CEO Dick Fuld said in Davos in January 2008, after a Société Générale trader lost a few billion dollars on rogue trades at his French bank. That month, Lehman’s stock was above $65. By mid-September, his firm began its historic bankruptcy.
According to Mr. Valukas’ yearlong investigation, the 158-year-old firm collapsed because of an investment banking model that rewarded excessive leveraging and risk, failed government oversight and Lehman leadership whose conduct ranged from negligence to active manipulation.
In Mr. Valukas’ dry, good-postured, starched-collar prose, the entire third volume, the report’s most entertaining section, focuses on that manipulation. “Starting in mid-2007,” the opening explains, “Lehman faced a crisis.” Investment banks had to reduce their leverage—dependence on borrowed money—or face ratings downgrades, not to mention the market’s discontent. But because it was difficult to raise equity, and to sell inventory without steep losses, Lehman’s response was to increasingly rely on a sleight of hand it had invented earlier in the decade. It’s all very Lex Luthor.
The trick was to make Lehman look healthier than it was. It started with a repurchasing agreement—normally a humdrum tool to raise money by selling assets that are quickly bought back. Under accounting rules, the temporarily sold assets stay on a firm’s books. But because Lehman arranged to be paid about $100 for every $105 of assets, thus its name, it counted Repo 105 as a true sale. That meant it could shovel off billions from its balance sheet.
In the report, Lehman’s former global financial controller confirms that its only purpose was to artificially and momentarily spiff Lehman up for its end-of-quarter earnings reports. There was “no substance to the transactions,” he said.
They weren’t disclosed to the government, the rating agencies or Lehman’s own board. “If you do something legal, are you supposed to say, ‘I’m doing this perfectly legal transaction’—do I tell you about that? And what about the other 10,000 legal issues I’m doing?” the first senior Lehman executive said. “Now, if it’s, from what I’ve read, legal in the jurisdiction in which the transaction was made, then that is what it is. It’s a legal transaction.”
Indeed, the problem when Lehman invented Repo 105 early last decade was that it couldn’t get an American law firm to sign off on it. It finally got the O.K. from Linklaters, a member of the small group of top British firms called the Magic Circle. So Lehman would send over its Repo 105 assets to England, where its European wing handled them. “These firms clearly shop jurisdictions all the time for the most favorable rule set, and there’s nothing wrong with that,” the second executive said.
Not everyone agrees. Lynn Turner, a senior adviser in the forensic accounting practice at LECG, and the S.E.C.’s former chief accountant, said that courts have found that technically complying with Generally Accepted Accounting Principles doesn’t matter if there’s deception, as with the case against Continental Vending Machine Corporation.
The Court of Appeals referred to the same case in its decision against Bernie Ebbers, saying that accounting rule-following is not a shield when it’s done to intentionally misstate results. And the S.E.C., as the examiner points out, says that “compliance does not excuse a misleading or less than full disclosure regarding a transaction.” The truth isn’t the truth if it’s not really the truth. “It doesn’t matter,” Mr. Turner said, “what the hell they were saying over in the U.K.”
MR. FULD’S LAWYER, Patricia Hynes, has said he didn’t know about Repo 105. As for presentations about it that were emailed to his office before an executive committee meeting, she explained that he doesn’t use a computer, and isn’t able to open attachments on his BlackBerry.
The former managing director in London said that Repo 105 was an open secret there, if it was a secret at all. “Yeah, yeah, yeah. In Europe, people just generically talk about it. It’s funny, for nonprofessionals, you can try to make it a smoking gun,” the source said, “I’m like, whatever.”
“People use different ways of lowering their balance sheet at quarter end, and almost all financial firms do it,” the second senior executive said. “The market understands it, and they don’t really care.”
The examiner paints a different picture. “So it’s legally doable but doesn’t look good when we actually do it? Does the rest of the street do it?” one Lehman employee asks another in emails included in the report. The answers, respectively, are yes and no, followed by a smiley face.
More than anything else, the three sources wondered why Repo 105—which was used to shuffle $38.6 billion at the end of 2007, $49.1 billion in the beginning of 2008 and $50.3 billion for its second quarter—could make a difference when dealing with a behemoth whose balance sheet totaled something like $700 billion. “If you’re going to center on $50 billion [and] letting the goddamn firm go and almost destroying the financial system, one is, I don’t want to say a pimple, but one is a lot smaller,” the first senior executive said.
The only people who would worry about using an old trick to reduce leverage from 13.9 to 12.1, the second executive said, are “yappers who don’t know anything.”
Again, the examiner’s report takes pains to show otherwise. It quotes a senior vice president calling Lehman’s leverage targets “a very hot topic.” The firm’s own definition of a material leverage shift was one-tenth of a point.
Both executives think of Repo 105 as a minor detail that was played up by a lawyer who needed to justify a report whose cost had run to $38.4 million. “When you spend what you did on this report, and you go through a firm for a year, and this is all you find? That’s amazing,” the first said.
And both spoke with sighs about what they feel is the impossibility of their side of the story being listened to. “It would be like telling people in 2005 that real estate prices are going to collapse,” the second said. “People wouldn’t believe you, no matter what you said.”
“Quite frankly, I think that is the heart of the issue on Wall Street,” Mr. Turner said. “They honestly think that. But it also turns around and tells you how big the problem is. It’s one thing to write a financial reform bill. It’s another thing to change the culture on Wall Street.”