Lehman's Failures: Lots of Blame to Be Shared

The Wall Street Journal has published the 2,200 page Examiner's Report on the Lehman Brothers Holdings bankruptcy. Here's what I gleaned from volume one of nine volumes. First, the Lehman bankruptcy was part and parcel of the global meltdown rather than being the trigger. Lehman's business model was not dissimilar to that of the other major investment banks, except to the extent that it relied on repos to open for business on a daily basis, which was something I didn't realize. Repo markets more than others, rely on confidence of counterparties, and this had to be maintained at all costs, or Lehman couldn't make it through a trading day. Basically, a $700 billion balance sheet was supported by $25 billion in equity. So, we have a highly leveraged business running on a very short term funding mechanism that could freeze up at any moment.

To rush ahead, high level decisions are made, as the subprime crisis was starting to emerge, to "double down" and raise Lehman's exposure in order to gain market share at the expense of competitors who were pulling back. The two mortgage companies that Lehman bought had their "weightlifter" sales people generating all types of "ninja" and "liar" loans in the hottest markets, and Lehman was already having trouble securitizing them, and so they remained on the balance sheet. At the same time, other businesses were increasing their risk profiles, such as leveraged loans to private equity groups and global commercial real estate transactions. These stories have been documented in other books.

In order to appease the credit rating agencies and to lower its reported leverage ratios, Lehman's financial team created an accounting subterfuge called Repo 105 that allowed the troubled assets to be treated as sales rather than as a financing and hence to disappear from the balance sheet for a short time. These transactions are quoted by senior financial staff, from the Controller on up, as being sham transactions with no economic purpose. Remember Enron? Does this sound familiar? They had no purpose other than to temporarily shrink the balance sheet and to allow the CEO, amid rising losses, to report that Lehman had lowered its leverage ratio, when it had done no such thing.

The external auditor, Ernst & Young, received a copy of a warning letter from a senior financial staffer, Mr. Lee, that these transactions had no substance and needed to be looked into. The audit committee apparently specifically requested that the auditor look into Mr. Lee's allegations and report back. Ready? E&Y apparently did not look into the Lee memorandum and did not follow up with the audit committee!

According to the report, "There are colorable claims around Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in their financial statements." A colorable claim is one that would support a recovery.

So, the audit committee was apparently not aware that these transactions were behind the decrease in leverage ratios, and neither were the shareholders because they were not called out in any notes to the financial statements. This kind of complete breakdown of the audit function is eerie, because if reminds me of the very similar breakdown in the bankruptcy of New Century Financial.

Law students and business school students may pore over this examiner's report, but the sad thing is that there won't be any penalties or clawbacks. The examiner notes that the Delaware business judgment rule will cover the decisions to increase the risk profile of the Lehman book of business. That is disappointing, but not unexpected. To paraphrase a Chancery judge, "The business judgment rule does not outlaw or punish stupidity."