Lehman Gets in Trouble

Lehman Brothers had a storied history. For starters, it was 158 years old. During that time it had left its mark on many well-known companies. Lehman had raised debt and equity for Campbell Soup, BF Goodrich, RKO, 20th Century Fox and RCA. Its partners had helped develop such retail giants as Gimbels, Woolworth’s and Macy’s, plus airlines like American, TWA and Pan American. During its heroic age it had produced one partner, Herbert Lehman, who became Governor of New York and later on a Senator.² Another, Robert Lehman, became an investment banking legend. Unfortunately for the Firm, those days were now far in the past. As 2007 turned into 2008, Lehman Brothers was in trouble. In the bars and restaurants around Manhattan, whispered voices slotted Lehman right behind Bear Stearns as the bank facing the greatest financial difficulties.

Lehman’s path to this plight was long and convoluted. Like other banks, it suffered from the commoditization of its underwriting franchise. During the 1970–80s, it merged first with Kuhn Loeb, then with Shearson, before falling into the arms of American Express. Some thought the legendary Lehman name would disappear. It didn’t. A dedicated core group believed the “Firm” could make it as a stand-alone investment bank. By 1994, Lehman was independent again. With the Lehman family no longer involved, the Firm was headed by Dick Fuld, a former bond trader. Its new focus would be financing takeovers and leveraged buyouts, securitizing asset-backed products, mortgage finance, and proprietary trading.

For some years things went well. Its M&A and LBO businesses produced solid results. Lehman was also an early entrant into the mortgage securitization game. It was one of three banks that pioneered “warehouse” credit lines for mortgage originators.³ This gave Lehman a secure pipeline of mortgages which it duly carved into asset-backed securities and sold globally to investors. This business proved hugely profitable. It also helped develop a savvy trading team. These traders generated large profits by shorting problematic deals, buying securities at distressed prices, and understanding how to value the complex instruments that Wall Street brought to market. Attachment 2 shows Lehman’s performance for 1999–2004.

By 2006, however, problems were on the horizon. The mortgage securitization business began to turn. Underwriting standards decayed. More and more mortgage securities were backed by problematic collateral. Lehman and other Wall Street firms had been bringing subprime securities to market without any government guarantee. This meant that Lehman would bear subprime credit risk on any securities retained on its balance sheet. In Lehman’s case that meant billions of dollars in exposure. Lehman was thus very exposed to a downturn in the mortgage market. By late 2006, that downturn was at hand. For the first time in decades, nationwide housing prices sputtered, then declined.

With its mortgage securitization engine beginning to falter, CEO Fuld and his deputy, Joe Gregory, faced a choice. They could see the problems and put the Firm into a defensive posture. This would mean deleveraging the balance sheet, selling off risky assets at a loss, and accepting lower profits. The Firm, however, would be buttressed to ride out a storm. Instead, Fuld and Gregory decided to grow Lehman’s other businesses to compensate for the lost momentum in mortgage finance.

Fuld unleashed Lehman’s balance sheet to fund new deals. The Firm participated in takeover deals for Claire’s Stores, TXU, Applebee’s and First Data. Lehman joined other banks in lending with the expectation that the Firm would sell the loans later as high-yield bonds. Next, Lehman began buying hedge funds. It also bought some companies, like Eagle Energy Partners, as merchant investments. Finally, Fuld spurred massive investments in commercial real estate. The capstone of this move came when Lehman bought Archstone-Smith, the owner-manager of some 360 luxury apartment complexes. Lehman and its partner, Tishman-Speyer, outbid Goldman Sachs, paying $22.2 billion. Observers guessed Lehman had bought at the peak of the price cycle, overpaying by $3 billion.⁴

As a result of this acquisition binge, Lehman became vulnerable financially. Its balance sheet leverage was huge. Some observers estimated that net assets exceeded capital by more than 40 times. With this capital structure, it wouldn’t take much to pitch the Firm into a financing crisis. A mere 1% decline in Lehman’s asset values would wipe out over 40% of its capital.

Analysts and the rating agencies noticed. Fuld and CFO Erin Callan found themselves besieged with questions about the Firm’s risky balance sheet. Lehman’s leadership began to look for ways to present a less worrisome profile to the outside world. It was then that it turned to “Repo 105.”

Repo 105 to the Rescue

Over the course of 2007, Callan told Lehman’s creditors and the rating agencies that the firm was committed to reducing “Net Asset Leverage.” This ratio, closely watched by credit analysts, measures net effective leverage. Net Asset Leverage is computed by first deducting cash and cash equivalents from assets. The resulting “net assets” are then divided by the firm’s capital. As noted, Lehman’s had moved toward net assets being over 40 × Firm capital.

To improve this ratio, firms can raise new capital or sell off assets. Raising new capital is time consuming and expensive. It also tends to depress the firm’s stock price. Selling off assets can also raise cash. However, if markets have turned, asset sales can be painful. Wall Street traders quickly detect distress sales and exact their pound of flesh. Asset sales can then reveal big disparities between the prices at which firms are carrying securities and where they can actually sell them. This can result in “fire-sale” prices on divested securities AND the need to mark down remaining securities still on the balance sheet. This combination can result in very large reported losses which do little to bolster creditor confidence. As 2007 progressed, Lehman increasingly faced this difficult choice.

Repo 105, a variation on Wall Street’s standard repurchase agreement, seemed to offer an easier way forward. Repurchase transactions are a common means by which Wall Street firms raise cash. The borrowing firm “sells” securities to a lending firm, and immediately enters into a contract to repurchase the same securities at a stated price. The timing involved is typically short, often overnight. The difference between the sale and repurchase prices represents the borrower’s interest cost. The securities provide the loan’s collateral. If the borrowing firm should fail to repurchase, the lending firm can sell the securities to recover its cash. Usually the securities used for collateral are of very high quality, often U.S. Treasuries.

Some years before, Linklaters, a U.K. law firm, had given Lehman an opinion that if an asset was sold at a price 5% or more below what it was worth, the transaction could be treated as a “true sale.” This opinion opened the door for Lehman to construct “repurchase” transactions that were loans in substance but treated as sales for accounting purposes. By doing such “Repo 105” transactions at quarter end, Lehman could remove billions in assets from its balance sheet but not surrender control of the assets.⁵

Lehman structured its Repo 105 transactions as follows. Since the legal opinion only pertained to the U.K., Lehman initiated transactions by transferring securities to its London office, Lehman Brothers International Europe (LBIE). LBIE would then sell the securities to a European counterparty for 5% less than their fair market value. Simultaneously, it would agree to repurchase the same securities for slightly more than its sale price (and still almost 5% below market value). Lehman would increase its cash and decrease its securities holdings for the duration of the transaction. If it wished, Lehman could also use the cash to repay other debt. When done at the end of an accounting quarter, the Repo 105 deals reduced both Lehman’s reported net assets and its debts. To the outside world, it would look as if Lehman was successfully shrinking its balance sheet. Attachment 3 illustrates how Repo 105 worked.⁶

Lehman began intensifying its use of Repo 105 in 2007. Transaction sizes increased as the year progressed. At the end of first quarter 2008, Lehman used Repo 105 to remove $50 billion from reported assets. Lehman’s public accountant, Ernst & Young, found the practice technically in compliance with the rules. Lead auditor William J. Schlich took the view that if an accounting practice was technically compliant, it was not the concern of the auditor whether its purpose was to manipulate reported results.⁷ Schlich also opined that he did not consider Lehman’s Repo 105 usage to have a material effect on its reported results.

Not everyone within Lehman’s senior management was happy with this practice. Several Controllers executives voiced opposition. A more powerful opponent was Bart McDade, Lehman’s head of equities. McDade was appointed Lehman’s balance sheet czar in March 2008, and immediately began to call Repo 105 “another drug we’re addicted to.” McDade had asked the Firm’s executive committee to impose a cap on its use. Because of Lehman’s perilous financial posture, no such action was taken.⁸

Outside observers were voicing growing skepticism. On April 8, David Einhorn, the widely followed president of the Greenlight Capital hedge fund, gave a speech at an investment conference. He focused on Lehman, accusing the Firm of poor financial transparency. Einhorn noted that 30–50% of Lehman’s profits came from mortgage financing. That business was now widely understood to be in big trouble. Yet, Lehman had booked no losses. Einhorn went on to describe the risky Archstone-Smith purchase and concluded that Lehman was “dangerously exposed.”⁹ Some weeks later, Einhorn returned to Lehman’s situation in his monthly newsletter. He estimated Lehman’s net assets-to-capital ratio at 44×, based on $748 billion in assets and only $17 billion in equity capital. Einhorn then accused Lehman of hiding big losses. He said Lehman accepted demands for more transparency “only grudgingly” and if they eventually did respond, Einhorn opined that “I suspect it would not inspire market confidence.”¹⁰ Whatever magic Repo 105 was supposed to work was clearly wearing off.

Repo 105 was also in Matthew Lee’s mind as he drafted his letter to management. The investigation he was trying to prompt would certainly lead to an interview. Lee would then bring up Repo 105 as yet another example of Lehman misrepresenting its balance sheet and violating its Code of Ethics. At that time he would also point out that U.S. law firms had unanimously refused to provide similar advice to that given by Linklaters.

That discussion was for later. Right now Matthew Lee had a more pressing problem. Did he want to send his letter at all?

Weighing Ethics, Career and Courses of Action

As he reread his draft, Lee was bothered by several things. For starters, it was a somewhat technical, accounting-oriented letter. In normal times, he would have sent this type of letter to the Controller for handling. This draft was directed to higher levels of management, including the CFO and Chief Risk Officer. With Lehman in trouble, would they share his level of concern over accounting problems and Ethics Code violations?

Lee also wondered if sending a letter “out of channels” would prove effective tactically. Was this the way to address staffing and systems concerns? Was he overreacting to problems that others would consider far down Lehman’s list of priorities? High-level opposition to Repo 105 now existed within the Firm. Should he plug into that resistance rather than stepping forward alone? As Lee mused on these points, he also remembered the stony reactions his previous warnings had elicited. Nobody seemed to have time for taking care of back-office problems. Perhaps these issues would be taken seriously only when someone went on record advising that the Firm was getting into legal trouble.

As Lee pondered these dilemmas, alternative courses of action came into view. One involved feeding someone like David Einhorn with the specific information to confirm his suspicions. Doing so would probably put a stop to the, now useless, balance sheet manipulations. Done right, it might force Lehman’s Board of Directors to act. This could lead to improvements in staffing, systems, and accounting processes.

Such a leak, however, would certainly prompt an internal investigation to identify the leaker. Lee was already nervous about his job situation. Rumors were rampant that a major downsizing was coming. Lee had already received indications that he might be offered a severance package. Was this the time to leak information to the Firm’s leading critic?

A second, less obvious external option was available. In recent years watchdog blogs had developed in different fields. As one example, Francine McKenna, a former Price Waterhouse CPA, was writing a blog entitled “re: The Auditors.” Lee could provide her with the specifics about Repo 105 and its usage. McKenna could then write something of a semi-technical nature, one criticizing Linklaters opinion and Lehman’s use of same. The piece could cite “sources in the U.K.” Initially it would be read by the accounting community; however, Lehman was such a hot topic that inevitably the news would be picked up by the financial press and the hedge fund/short seller community. The posting might even go viral among investors. Tremendous pressure could come down on Lehman to respond. A major housecleaning might then ensue.

There was no riskless course of action. Any move Lee made could end up costing him his career. On the other hand, his employment at Lehman was in jeopardy in the base case. If he was at risk for going down with the ship, why not do something to try to save the ship?

Lee put his letter in his desk drawer. Next he secured contact information for David Einhorn and Francine McKenna. Finally, he secured Bart McDade’s cell phone number from the Firm’s directory and wrote it on a yellow sticky note. Then he locked the drawer and headed home to sleep on his choices.

Attachment 3

Lehman’s Repo 105 Transaction

Source: dealbook.nytimes.com/…/the-british-origins-of-lehmans-accounting-, March 12, 2010

Author’s Note

This case presents some familiar issues: accounting manipulations, senior management complicity, and highly accommodating CPA behavior. It also depicts the anguishing choices facing potential whistleblowers. What is new in this case are some of the choices. Matthew Lee can consider serious outside options for dealing with Repo 105. This case highlights the emergence of hedge fund managers and “watchdog” blog writer as potential resistance options.

Of course, the case is also about Lehman Brothers, whose failure almost brought down the U.S. banking system’s house of cards. In addition to addressing Lee’s predicament, students get to reconsider Lehman’s reckless course and how it might have been altered.

Several aspects of the case need elaboration. For one thing, there is no evidence that Matthew Lee considered any alternatives to sending his letter. Since being fired by Lehman, Lee has been mum about what happened. He broke his silence in August, 2012, in a CBS 60 Minutes interview, but did not discuss his alternatives. This case uses Lee’s predicament to pose choices which existed even if Lee did not choose to consider them. Students can then think about these options and incorporate them into their tactical toolkits. David Einhorn did play a very public role criticizing Lehman in spring 2008, and Francine McKenna’s blog should be on every corporate accountant and CPAs watch list.

The nature of Lee’s letter should be pondered. As justified as it may have been substantively, and as courageous as Lee proved to be, the letter is curiously insensitive to Lehman’s bigger issues. There is also little in the way of the constructive solutions similar to those offered by Sherron Watkins in her memos to Ken Lay. Students should ponder the tactically efficacy of Lee’s text.

Attachment 1’s text is that of Lee’s actual letter. It appears here as a draft, consistent with Lee mulling over his options.

This case is based upon reports of Lee’s firing in the Wall Street Journal and various finance blogs. Specific information about Lehman’s history and reckless late-day strategies comes from A Colossal Failure of Common Sense penned by ex-Lehman trader Lawrence G. McDonald. This book also provides information about David Einhorn’s criticisms of Lehman. Information about Bart McDade’s role and the attitude of William Schlich, the Ernst & Young engagement partner, comes from the report of Anton Valukas, Lehman’s Bankruptcy Examiner.

Lee’s story is in some ways a sad one. He did lose his job and as of 2013 has not found similar employment. Lehman, of course, ignored his warnings, didn’t or couldn’t change course, and went down in flames. Students should ponder the extent to which a more tactically nuanced course by Matthew Lee might have made a difference.

The story also continued for Ernst & Young. New York State’s Attorney General sued the firm over its role in assisting Lehman to misrepresent its financial situation. The suit, seeking recovery of EY’s auditing fees from Lehman, was settled in 2015 with E&Y paying a $10 million fine.