Friday, March 12, 2010

The Lehman Report

The court-appointed examiner's report on Lehman Brothers is available to peruse and it is a doozy. Coming in at over 2,200 pages, the report provides a more detailed look into how and why the investment bank failed spectacularly in September 2008. I say "more detailed" because it was obvious to many, even before the firm collapsed, that the bank was mismarking assets and engaging in accounting fraud. You don't wind up with 10 cents on the dollar as a secured creditor unless the assets were wildly overinflated to begin with. Still, it's always nice to know the details.

Most of the report focuses in on the so-called "Repo 105" transactions. Repos are collateralized loans used to finance a bank's assets and are reported as liabilities on the balance sheet. However, if the repo met conditions of an accounting rule called SFAS 140, it could be counted as a true sale and the assets could be moved off the balance sheet. Lehman used these specific Repo 105 transactions to move assets off of its balance sheet to reduce the leverage ratios it reported to investors. Lehman's auditors, Ernst & Young, even signed off on the transactions, so they had to be kosher, right? According to FT Alphaville, Lehman could not find a US lawyer to sign off on their treatment of these particular repos as a true sale. So what did the enterprising folks at Lehman do? They just went abroad and found some London lawyers to sign off on the transactions. Presto! $50 billion in assets disappeared off of the balance sheet. So while maybe technically not illegal, the transactions were most definitely used in a calculated way to mislead investors about the investment bank's true financial condition.

The folks over at Zerohedge have unearthed more juicy tidbits from the report about the ordinary tri-party repo transactions with JP Morgan that indicate the firm was definitely mismarking assets and that JP Morgan knew about it. According to the excerpts from the report, Lehman was attempting to pledge more and more worthless collateral at par against the loans as the bank's financial condition deteriorated. Apparently, as Lehman neared bankruptcy in September 2008, it had attempted to pledge $3 billion of a security called "Fenway," that was actually asset backed commercial paper credit enhanced by Lehman itself. That's right, backed by the full faith and credit of...Lehman Brothers. JP Morgan said, "Um, no thanks. Maybe some Treasuries would be better? Or perhaps a sack of potatoes?"

Back in August 2008, "JP Morgan had learned that Lehman had pledged self-priced CDOs as collateral over the course of the summer." Lehman "pledged $9.7 billion of collateral, $5.8 billion of which were CDOs priced by Lehman, mostly at face value." Of course they were self-priced. There was no liquid market for CDOs so Lehman had to price them using its own models. Pricing them at par was the really stupid and possibly criminal part. Furthermore, why did JP Morgan just "learn" about this in August? Didn't JP Morgan know what collateral was in the repo since JP was the clearing firm that is supposed to verify and price the collateral in its own repos with customers? Why on earth did JP Morgan ever accept CDOs as collateral in its repos? My how far the standards of the repo market have fallen since back in the day when I was a lowly repo trader. If you didn't have treasuries, agencies, or agency backed MBS, no financing for you!

The report goes on to state that when JP Morgan "discovered" the CDOs and decided it wanted other collateral, Lehman said it had no other collateral to pledge. Ok, so Lehman was clearly insolvent, even during the time that the firm continued to claim that it was swimming in a pool of liquidity and was just a victim of short sellers. Furthermore, JP Morgan KNEW that Lehman was insolvent. Meanwhile, the SEC and the Fed sort of knew about some of this, but probably didn't understand and mostly just had their collective heads stuck up their collective asses.

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