Britain's financial centre faced fresh embarrassment yesterday after it emerged that London played a crucial role in Lehman Brothers concealing debts of up to $50.4bn (£33.2bn) in the run-up to its collapse.
The failed investment bank approached a London law firm over plans to use a controversial accounting trick – known internally as "Repo 105" – to temporarily conceal the liabilities.
The collapse of Lehman Brothers, the biggest of the financial crisis, sparked near-global panic with even relatively conservative figures talking of "meltdown" and "armageddon". Its demise raised serious questions about lax regulation of banks in the City.
The bank used the Repo 105 tactic in the run-up to the end of its three-month financial reporting periods to help cushion the blow of huge losses in the first half of 2008 and suggest its financial health was far more robust than it was.
Linklaters – which drafted a document which stated that the technique was legal under UK law – was only approached after Lehman was unable to find an American law firm to say that the Repo 105 transactions could be carried out in the US.
A 2,200-page report into the collapse of the 58-year-old institution, by US legal examiner Anton Valukas, stated all subsequent trading was "under the aegis of an opinion letter" written by the Linklaters law firm.
It meant that a string of trades which masked the firm's parlous state from regulators and investors had to go through London. Lehman had used the method since 2001 but in the months leading up to its collapse it had significantly stepped up the amount of debt concealed, repeatedly breaching its own internal limits. Auditor Ernst & Young, the report found, was aware of the company's status but failed to question it.
The bank had become so addicted to using the technique that when executive Bart McDade, who went on to become Lehman's chief operating officer, was asked if he was aware of the device the report cited he wrote in an April 2008 e-mail: "I am very aware ... it is another drug we r [sic] on."
Other executives described the method as "basically window dressing" and "sloppy". The company's own global financial controller told the examiner that "the only purpose or motive for [Repo 105] transactions was reduction in the balance sheet". He said that "there was no substance to the transactions".
Because of Repo 105 the bank was able to report that its leverage – or debt – in the second quarter of 2008 was far lower than it should have been.
Leverage should have been reported as 13.9 per cent but was said to be only 12.1 per cent. That fall was highly significant when credit agencies were asked to assess the bank's financial health after the $2.8bn loss – the second huge loss reported in 2008.
The report says that Lehman "did not disclose ... that it had been using an accounting device to manage its balance sheet – by temporarily removing approximately $50bn of assets ... at the end of the first and second quarters of 2008."
That device involved the temporary sale of assets including loans and mortgages – which would generate cash to make Lehman look far stronger and cash rich than it actually was.
The report lambasts what it calls this "actionable balance sheet manipulation" by executives, including the former Lehman Brothers chief executive, Richard Fuld. It has said there could be legal claims against them and against Ernst & Young.
The report also gives further weight to critics of bankers' pay, saying that while in theory Lehman's pay packages were supposed to discourage excessive risk taking, "in practice Lehman rewarded its employees based upon revenue with minimal attention to risk factors in setting compensation". It added: "None of these risk related adjustments was applied rigorously or consistently."
Linklaters – part of the so-called magic circle of London law firms that also includes Allen & Overy, Slaughter & May, Clifford Chance and Freshfields Bruckhaus Deringer – will not face any legal claims from its advice and is not criticised by the report. But other banks might, with JP Morgan and Citi both in the line of fire for making what the report said were "excessive capital demands" on Lehman Brothers in the run-up to its collapse.
Barclays could face a small claim over the transfer of assets to the company in the run-up to its aborted takeover.
The report also details how HSBC had been quietly disengaging itself from Lehman Brothers since the rescue of another American investment bank, Bear Stearns, by JP Morgan in March 2008 under a scheme known as "Project Opaque". At the end of August it demanded around $1bn in collateral to continue trading with Lehman Brothers.
Had HSBC withdrawn, the report says, Lehman Brothers could have been forced into bankruptcy. The British bank's actions were likened by one Lehman Brothers executive as like "putting a gun to our head".
But the report concludes that HSBC's demands were "grounded in legitimate commercial concerns about Lehman's viability". It will therefore not face any legal action.
The banks that were named declined to comment yesterday.
However, in a statement Linklaters defended its actions, saying: "The US Examiner's report into the failure of Lehman Brothers includes references to English Law opinions which Linklaters gave in relation to a number of Lehman transactions. The examiner – who did not contact the firm during his investigations – does not criticise those opinions or say or suggest that they were wrong or improper."
Ernst & Young also sought to defend its audit work for Lehman Brothers. It said in a statement: "Lehman's bankruptcy ... was the result of a series of unprecedented adverse events. Our opinion indicated that Lehman's financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles, and we remain of that view."
Repo 105: The perfect financial fig leaf
*Repo 105 did not cause the collapse of Lehman Brothers – that was due to an over-reliance on short-term finance to cover long-term liabilities and bad property investments. But it did conceal the bank's parlous state for a long time. Because of Lehman's insatiable need for short-term money, it regularly raised hundreds of billions of dollars on the "repo" market, swapping assets (such as loans and investments) for cash. Money raised like this has to be repaid within days and the "assets" are therefore not considered to have left the bank's balance sheet for accounting purposes.
Repo 105, however, made it look as if they had been removed. Under the device, if Lehman exchanged an "asset" – in this case, debt – on the repo market worth $105 for a short-term loan of $100, the transaction, for accounting purposes, would be considered as a sale. Lehman's balance sheet would therefore look full of readily available cash while the "debts" were considered sold. The fact that they had to be bought back within a few days was not reflected in the balance sheet. If that sounds crazy, that's because it is – but apparently legal in London. The bank typically did this at the end of every quarter, when its numbers would be calculated for financial reporting. After the end of the quarter the short-term cash could be re-paid and the "assets" returned to Lehman with no one (other than Lehman and its auditors) the wiser.