The implosion of Lehman Brothers in September 2008 led to the worst financial crisis since the Great Depression.
When the bankruptcy was announced, I pitched the notion that Lehman and its top execs, including CEO Dick Fuld, had been cooking the books. Unfortunately, at the time, there was no hard evidence to support this conclusion.
As the events in September began to unfold, it was tough for me or anyone else watching this historic financial meltdown to imagine how a 158-year-old Wall Street giant that had never had a losing quarter suddenly became insolvent. Now a recent report by an independent U.S. Bankruptcy Court examiner investigating the colossal collapse of Lehman Brothers sheds new light on this mystery.
According to Anton Valukas, the investigator retained by the Court, there were serious accounting lapses not just by Lehman executives but by its auditor, Ernst & Young. The multi-volume report, which is several thousand pages long and cost $38 million to produce, alleges that Lehman executives manipulated its balance sheet, withheld information from its board and inflated the value of toxic real estate assets. All of these shenanigans occurred under the complicit gaze of the firm’s auditor, Ernst & Young.
Although the report stopped short of concluding that there was outright fraud by Fuld and his cohorts, it underscores a repeated disregard for the truth. The examination also reveals the cavalier sleight-of-hand in financial reporting that had become standard operating procedure for Lehman as well as other Wall Street banks.
Probing Misleading Statements
In his report, Valukas documented several instances where Lehman chose to “disregard or overrule” its own internal risk controls, even as the real estate markets were starting to show strain. In one example during May 2008, a Lehman senior vice president alerted management to potential accounting irregularities. But the warning was ignored by Lehman auditors Ernst & Young and never raised with the firm's board.
As the clock ticked during the final months of the Lehman saga, the investigation exposes how Fuld and many of his chief lieutenants repeatedly certified misleading statements about the firm’s finances. While Valukas may not have found clear evidence of fraud, he concludes that Fuld was “at least gross negligent.”
The court-ordered report also determined that collateral demands by JP Morgan Chase and Citigroup – the nation’s second and third largest banks – helped push Lehman over the edge. Both were key lenders to Lehman.
As redemption demands on the billions of dollars worth of the credit default swaps Lehman had underwritten started to pile up, the firm became desperate to find additional liquidity through the short term lines of credit it held with JP Morgan and Chase. Internal documents show that both lenders knew that the collateral Lehman had posted was either overvalued or functionally worthless.
Instead of disclosing this information to regulators, JP Morgan and Chase relentlessly pressed Lehman to provide additional collateral to cover their continued short term loansIn the end, their pressure resulted in a chain reaction that panicked and nearly destroyed the nation’s money market mutual funds, an investment sector that has long been considered to be stable and low risk.
Whatever It Takes
To prevent a worldwide panic and the failure of the money market, the federal government intervened. The result was a multi-billion dollar bailout of banks such as JP Morgan and Chase, and a liquidity crisis that rocked the global economy.
Lehman was apparently prepared to do anything to retain its favorable credit rating. In one example detailed by the Bankruptcy Court report, Lehman used an accounting device it dubbed “Repo 105.” Through the use of blue smoke and mirrors, Lehman parked about $50 billion in assets away from its balance sheet. The move made Lehman look as if it had less debt on its books.
In an ordinary repo transaction, Lehman would raise cash by selling assets with a simultaneous obligation to buy them back within days, according to the report. The transactions would be accounted for as financings, and the assets would remain on Lehman's balance sheet.
For the Repo 105 transaction, Lehman did the same thing. But because the moved assets represented 105 percent or more of the cash it received in return, accounting rules allowed the transactions to be treated as “sales” rather than financings. As a result, the assets shifted away from Lehman's balance sheet reduced the amount of debt Lehman showed to investors.
Arguably, if Lehman’s investors had known the truth about the company’s credit condition, most would have liquidated their shares, including the thousands of firm employees who were vested through their 401k. Because none of the parties — Lehman executives, Ernst & Young and creditor banks like Chase and Citigroup — came forward, these stockholders were wiped out.
Fuld and other Lehman executives were allowed to scurry away with millions from their Golden Parachutes. Chase and Citigroup got billions in taxpayer subsidies. Ernst & Young was paid millions for its services, and is still on retainer with thousands of firms from New York to Mumbai.
None of these key players has faced criminal prosecution or civil penalties. Rather, they’ve been richly rewarded for their complicity in triggering the deepest financial crisis in a generation.
These guys have proven the old Mafia adage that “a man with a briefcase can steal more money than a man with a gun.”
With the dust finally settling on this financial crisis, it’s time to criminally prosecute Dick Fuld, and other thieves of his ilk. Their crimes are no less heinous than those committed by the likes of Bernie Madoff, and the penalties should be the same.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com
