'Lehman painted a misleading picture of its condition'

Lehman Report: An Edited Extract
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The Independent Online

There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate.

Lehman's financial plight, and the consequences to Lehman's creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non-culpable errors of business judgement to actionable balance sheet manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by government agencies, who by their own admission might better have anticipated or mitigated the outcome.

In 2006, Lehman made the deliberate decision to embark upon an aggressive growth strategy, to take on significantly greater risk, and to substantially increase leverage on its capital. In 2007, as the sub-prime residential mortgage business progressed from problem to crisis, Lehman was slow to recognise the developing storm and its spillover effect upon commercial real estate and other business lines. Rather than pull back, Lehman made the conscious decision to "double down", hoping to profit from a counter-cyclical strategy. As it did so, Lehman significantly and repeatedly exceeded its own internal risk limits and controls.

With the implosion and near collapse of Bear Stearns in March 2008, it became clear that Lehman's growth strategy had been flawed, so much so that its very survival was in jeopardy. The markets were shaken by Bear's demise, and Lehman was widely considered to be the next bank that might fail. Confidence was eroding. Lehman pursued a number of strategies to avoid demise.

But to buy itself more time, to maintain that critical confidence, Lehman painted a misleading picture of its financial condition. Lehman required favourable ratings from the principal rating agencies to maintain investor and counterparty confidence; and while the rating agencies looked at many things in arriving at their conclusions, it was clear – and clear to Lehman – that its net leverage and liquidity numbers were of critical importance. Indeed, Lehman's chief executive, Dick Fuld, told the Examiner that the rating agencies were particularly focused on net leverage; Lehman knew it had to report favourable net leverage numbers to maintain its ratings and confidence. So at the end of the second quarter of 2008, as Lehman was forced to announce a quarterly loss of $2.8bn – resulting from a combination of write-downs on assets, sales of assets at losses, decreasing revenues, and losses on hedges – it sought to cushion the bad news by trumpeting that it had significantly reduced its net leverage ratio to less than 12.5, that it had reduced the net assets on its balance sheet by $60bn, and that it had a strong and robust liquidity pool.

Lehman did not disclose, however, that it had been using an accounting device (known within Lehman as "Repo 105") to manage its balance sheet – by temporarily removing approximately $50bn of assets from the balance sheet at the end of the first and second quarters of 2008.

Lehman's Global Financial Controller confirmed that "the only purpose or motive for [Repo 105] transactions was reduction in the balance sheet" and that "there was no substance to the transactions". Lehman did not disclose its use – or the significant magnitude of its use – of Repo 105 to the Government, to the rating agencies, to its investors, or to its own board of directors. Lehman's auditors, Ernst & Young, were aware of but did not question Lehman's use and nondisclosure of the Repo 105 accounting transactions.

Lehman publicly asserted throughout 2008 that it had a liquidity pool sufficient to weather any foreseeable economic downturn. But Lehman did not publicly disclose that by June 2008 significant components of its reported liquidity pool had become difficult to monetise.

By 12 September, two days after it publicly reported a $41bn liquidity pool, the pool actually contained less than $2bn of readily monetisable assets.

Months earlier, on 9 June 2008, Lehman pre-announced its second quarter results and reported a loss of $2.8bn, its first-ever loss since going public in 1994. Despite that announcement, Lehman was able to raise $6bn of new capital in a public offering on 12 June 2008. But Lehman knew that new capital was not enough. Treasury Secretary Henry Paulson privately told Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman's existence would be in jeopardy. On 10 September 2008, Lehman announced that it was projecting a $3.9bn loss for the third quarter of 2008. Although Lehman had explored options over the summer, it had no buyer in place; its only announced survival plan was to spin off troubled assets into a separate entity. Secretary Paulson's prediction turned out to be right – it was not enough.

It appeared by early 14 September that a deal had been reached with Barclays which would save Lehman from collapse. But later that day, the deal fell apart when the parties learned that the Financial Services Authority, the United Kingdom's bank regulator, refused to waive UK shareholder approval requirements.

Lehman no longer had sufficient liquidity to fund its daily operations. On the evening of 14 September, SEC Chairman Cox phoned the Lehman board and conveyed the Government's strong suggestion that Lehman act before the markets opened in Asia. On 15 September 2008, at 1.45am, Lehman Brothers filed for Chapter 11 bankruptcy protection.