How and Why Lehman Brothers Collapsed ?

Lehman Brothers was once considered as the darling of Wall Street and an institution that was incapable of falling, often regarded as the numero uno investment banking institution in the world. In September 2008, the story of Lehman’s demise unfolded itself leading the world to a financial turmoil.

At the heart of Lehman’s practice was a tool that they used over and over again to reduce its financial leverage and mislead investors. The tool that is known as Repo 105. The lid off this practice was blown by Mathew Lee, Vice-President of the Finance division in May 2008 who raised serious concern over the existing accounting practice as a result of which he was dismissed two weeks later, though the official reason was that of firm downsizing. The article focuses on the origins of Repo 105 and how Lehman used it.

Repo 105 had its origin in a rule called FAS 140, approved by the Financial Accounting Standards Board in 2000- so it was well within GAAP (Generally Accepted Accounting Principles) of that time. It modified earlier rules that allow companies to "securitize" debts such as mortgages, bundling them into packages and selling bond-like shares to investors, thereby improving the degree of financial leverage. As the pooled securities were moved off the issuing firm's balance sheet, it protected investors who bought the securities in case the issuer faced financial trouble. Thus it implied a win-win situation for both. The rule contained a provision saying the assets involved would remain on the firm's books so long as the firm agreed to buy them back for a price between 98% and 102% of what it had received for them, often referred as Repo 102.

In a traditional repo transaction, Lehman would give securities, typically Treasuries, worth $102 to its repo counterparty for cash of $100, with an agreement to repurchase the securities back at a later maturity date. At maturity, the transaction is reversed for Lehman. However, it is here that Lehman did one of the greatest financial manipulations. It increased the collateralization from 102 to 105 in the case of interest rate products and to 108 in the case of equity products and there would be no assurance of Lehman repurchasing the assets effectively making it a sale. We can actually look at the scenario with a small example.

Thus in case of accounting for loan the leverage ratios before and after remain the same. However in case of accounting for sale, the practice that Lehman used, things change drastically.

The percentage of equity in the capital structure increased from 25% in the first case to 33.33% in second case thereby reducing the degree of financial leverage.

However, despite being able to circumvent legal issues to make Repo 105 and 108 a technical “True Sale”, it was actually illegal in the US that time as technically complying with accounting rules is not a shield against litigation when it is done to intentionally misstate results and Lehman feared lawsuits if this became known. Lehman was able only to get a “True Sale” opinion, covering Repo and Reverse Repo trades executed in London, from the U.K. solicitors, Linklaters as a result most of these sales took place through its UK office. In fact Lehman considered the discount that was given as an option price to repurchase the asset at a later date, thereby leading to no reduction in assets due to discount.

Given the two-fold benefits of increasing accounting revenues while reducing accounting liabilities, Repo 105 saw increased usage from $38.6 billion in Q4 2007 to $50.38 billion Q1 2008. The increased usage was especially prominent before accounting periods and had the effect of understating the net leverage by about 9% to 13% from Q4 2007 to Q2 2008, meaning the ‘real’ net leverage at Q2 2008 was 13.9 instead of 12.1. The main motivation behind using Repo 105 was to mislead the credit rating agencies by lowering net leverages from the period from March to September 2008, the rating agencies took turns to downgrade Lehman’s credit outlook and credit rating. In fact, the management estimated that a loss in confidence due to rating downgrades could result in Lehman having to post additional collateral of around $1.1 billion to $3.9 billion. 

On Sept. 14, 2008, the investment bank announced that it would file for liquidation after huge losses in the mortgage market and a loss of investor confidence crippled it and it was unable to find a buyer. Its collapse sent global financial markets into a panic and brought credit markets worldwide to the edge of a meltdown. Job losses soared as the recession that had begun in late 2007 turned into the steepest downturn since the Great Depression. In March 2012, Lehman Brothers emerged from bankruptcy, becoming a liquidating company whose primary business in the years to come will be paying back its creditors and investors. 

Food for thought : Could this have been prevented ?

[Disclaimer: The views reflected above are personal and does not reflect any organization or entity.]