Demystify the Lehman Shell Game

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the Lehman Shell Game
On Thursday April 1, 2010, 11:32 pm EDT
Making unattractive assets disappear from corporate balance sheets was one
of the great magical tricks performed by accountants over the last few
Whoosh went assets into off-balance-sheet vehicles that seemed to be owned
by no one. Zip went assets into securitizations that turned mortgage loans
for poor credit risks into complicated pieces of paper that somehow earned
AAA ratings.
As impressive as those accomplishments were, they did not make the assets
vanish altogether. If you dug deep enough, you could find the structured
investment vehicle or the underlying assets of that strange securitization.
Now there is another possibility in the world of accounting magic. Did
accountants find a way to make some assets disappear altogether? Was it
possible for everybody with an interest in them to disclaim ownership?
Until recently, it never would have occurred to me that companies would want
to do that - particularly if the assets in question were perfectly
respectable ones. But now that we have learned Lehman Brothers did it, the
question arises of how far the practice went.
Lehman's reasons for doing it were simple: to mislead investors into
thinking the company was not overleveraged. Were other firms doing that? Are
they still? Lehman thought not, but no one really knows.
Now the Securities and Exchange Commission is demanding that other firms
disclose whether they did the same. If it finds they did, the commission
ought to go further and examine whether there were conspiracies to make the
assets vanish, thus making Wall Street appear to be less leveraged than it
Lehman's practices, outlined in a bankruptcy examiner's report released last
month, showed the creative use of accounting for repos.
Don't let your eyes glaze over. I'll try to keep it simple.
A repo is simply a "sale" of a financial asset to someone else, with an
agreement to repurchase it at a fixed price and date. That amounts to
borrowing secured by the asset, often a Treasury bond, with the added
security that the lender has the bond, and so can sell it quickly if need
Normally, such transactions are accounted for as loans, as they should be.
They are often the cheapest way for a brokerage firm to borrow money.
I had taken for granted that repos were always accounted for as loans, but
it turns out there was a loophole. The Financial Accounting Standards Board
had accepted that under some conditions a repo could be treated as a sale.
One condition: if the securities securing the transaction were worth
significantly more than the loan, that could be a sale.
In the examples the board provided, it concluded that securing the loan with
assets worth 102 percent of the amount borrowed did not produce a sale, but
that 110 percent would push the deal over the line. In between was a gray
Lehman appears to have concluded that 105 percent was enough if the assets
being borrowed against were bonds. If they were equities, it set the bar at
108 percent.
By doing such sales repos at the end of each quarter, and reversing them a
few days later, the firm could seem to have less debt than it really did.
It started the practice in 2001 but really accelerated it in 2007 and early
2008, when investors belatedly discovered there were risks to high leverage
ratios. At the end of 2007, the bankruptcy examiner concluded, Lehman's real
leverage ratio was 17.8 - meaning it had $17.80 in assets for every dollar
of equity. It reported a ratio of 16.1.
By the end of June 2008 - Lehman's last public balance sheet - it was hiding
$50 billion of debt that way, enabling it to appear to be reducing its
leverage far more than it was. When investors asked how it was doing that,
Lehman officials chose not to explain what was actually happening.
Lehman's collapse is history, but after it was allowed to collapse other
firms were rescued. We don't know whether those firms used the same tricks,
although we do know that Lehman thought they were not doing so.
The questions sent to financial companies by the S.E.C. this week should
provide answers to that question. Companies that classified repos as sales
are going to have to provide specifics and explain exactly why the
accounting was justified. The reports will go back three years, so we can
see history as well as current practices.
It would be nice if the commission found that other firms did not choose to
hide borrowing this way.
But if that is not what is found, then the commission should dig deeper into
actual transactions. It should find out how the firm on the other side of
each repo accounted for it.
There are at least two abuses that might have happened.
The first would stem from differing reporting periods. One firm could hide
debt with another when its quarter ended. Then, when the other firm's
quarter ended, that firm could hide debt with the first firm.
The second method would reflect the fact that two companies involved in a
transaction do not have to use the same accounting. Lehman could treat the
repo as a sale, but the other firm could call it a financing. Presto: Nobody
reports owning the assets in question.
That could even be legal. The second firm could conclude that an
asset-to-loan ratio of 105 percent was not high enough to qualify for sales
treatment, while the first firm thought 105 percent was high enough.
But legal or not, it would be misleading.
Wall Street leverage remains an important issue. The S.E.C. should discover
if it was, or is, being concealed, and then get to the bottom of how that
was done.
Floyd Norris comments on finance and economics in his blog at
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