Introduction

Lehman failed for a variety of reasons and the responsibility for the failure is shared by
management, Lehman's high-risk investment bank business model and the failure of government
oversight. However, all of these problems were compounded by the actions of the executives.
Some were simple errors in business judgement, but others were deliberate balance sheet
manipulation.
Lehman's business model rewarded excessive risk-taking and high-leverage. Near the end
Lehman had $700 billion in assets but only $25 billion (about 3.5%) in equity. Furthermore, most
of the assets were long-lived or matured in over a year but liabilities were due in less than a year.
Lehman had to borrow and repay billions of dollars through the "repo" market every day in order
to remain in business. This was considered normal for investment banks, but if counterparties
lost confidence in Lehman's ability to repay, this market would close to the bank and the
business would fail.
Lehman's management did not foresee the depths of the sub-prime residential mortgage crisis,
nor its broad-reaching effects on other markets. Instead they elected to "double-down" their bets,
expecting to make high profits when the market "came back".
Bear Stearns' March 2008 failure revealed the flaws of both the at-that-time-typical investment
bank model as well as the deepening sub-prime crisis. Counterparty confidence in Lehman
began to decline and the executives felt they needed to manipulate their financial statements in
order to halt further erosion. Lehman focused on the leverage ratio (debt-to-equity) and liquidity
as metrics most watched by counterparties and credit rating agencies.
In the second quarter of 2008 Lehman tried to cushion reported losses by claiming improved
leverage and liquidity. What Lehman failed to report was that they had used an accounting trick
(known within Lehman as "Repo 105") to manage their balance sheet. Normal repo transactions
consisted of selling assets with the obligation of repurchase within a few days. Considered a
financing event, these "sold" items stayed on the bank's balance sheet. Repo 105 made use of
an accounting rule where, if the assets sold were valued at more than 105% of cash received,
the transaction could be called a true sale and the assets removed from Lehman's books. $50
billion of assets were removed from the balance sheet in this way, improving their leverage ratio
from 13.9 to 12.1 at the time.
Multiple sources from the time note there was no substance to transaction except to remove
unwanted assets, a significant violation of generally accepted accounting principles in the United

States. Ernst & Young, Lehman's auditors, were aware of Repo 105 and the non-disclosure of its
scope.
Regarding liquidity, throughout 2008 Lehman made false claims of having billions of dollars in
available cash to repay counterparties when in reality, significant portions of the reported
amounts were in fact encumbered or otherwise unavailable for use. September 12, 2008, 2 days
after reporting $41 billion in liquidity, true available funds totaled only $2 billion. Lehman filed for
bankruptcy on September 15.
Summarized Conclusions
While the business decisions that brought about the crisis were largely within the realm of
acceptable business judgement, the actions to manipulate financial statements do give rise to
"colorable claims", especially against the Richard S. Fuld (CEO) and Erin Callan (CFOs) but
also against the auditors.
In the opinion of the Examiner, "colorable" is generally meant to mean that sufficient evidence
exists to support legal action and possible recovery of losses.
Repo 105 was not inherently improper, but its use here violated accounting principles that require
all legitimate transactions to have a business purpose. Repo 105 solely existed to manipulate
financial information.
In a written letter in June 2008, Lehman Senior VP Matthew Lee advised the auditors and Audit
Committee that he thought Repo 105 was being used improperly. The auditors failed to advise
the Audit Committee about issues raised by this whistle-blower despite specific requests by the
Committee. Auditors "Ernst & Young" failed to investigate the allegations and likely failed to meet
professional standards

So what went wrong? The collapse of Lehman Brothers was not the result of a single
lapse in ethical judgment committed by one misguided employee. It would have
been nearly impossible for an isolated incident to bring the Wall Street giant to its
knees, especially after it successfully withstood so many historical trials.
Instead its demise was the cumulative effect of a number of missteps perpetrated by
several individuals and parties. These offenses can be categorized into three acts:
Lies told by Chief Executive Officer Richard Fuld; concealment endorsed by Chief
Financial Officer Erin Callan; and negligence on behalf of Ernst & Young.
Three Wrongs

1. When the housing marketing began faltering in 2007, Fuld was entrenched in a
highly aggressive and leveraged business model, not unlike many other Wall Street
players at the time. Unlike the competitors, a few of whom had the foresight to
identify the pending collapse and evaluate possible consequences of mortgage
defaults, Fuld did not rethink his strategy. Instead he proceeded into mortgagebacked security investments, continuously increasing Lehman Brothers asset
portfolio to one of unreasonably high risk given market conditions.
2. The second ethical lapse, which was perhaps the most premeditated and
fundamentally wrong, was Callans approval of siphoning assets away from Lehman
Brothers accounts and into Hudson Castle, the phantom subsidiary created for the
benefit of its parent companys balance sheet. This blatant misrepresentation of
financial health, perpetrated through the employment of Repo 105, was an attempt
to grossly manipulate the banks many stakeholders and also clearly indicative of a
much bigger problem. Even more telling is the fact that this technique was used in
two consecutive quarters.
3.

Finally, Ernst & Young, the only third party privy to the happenings at

Lehman Brothers, failed to reveal the extensive steps taken by executive leadership
to conceal financial problems. As a firm of certified public accountants expected to
honor and uphold an industry-wide code of ethics, Ernst & Young may be accused of
being responsible for gross negligence and lack of corporate responsibility. Why
would such a highly respected organization risk its own reputation and turn a blind
eye on behavior that is clearly unethical? Obviously Lehman Brothers was a sizeable
(and presumably lucrative) client of the firm. But past scandals involving
questionable accounting observances, such as Enron, have demonstrated firsthand
that inaction is as equally reprehensible as direct involvement in the scheme itself.
More than just a paycheck was at risk, and failure to act successfully discredited
Ernst & Young on the basis of ethical and industry standards.
The story of Lehman Brothers demise is unfortunate, and not just because its
collapse meant the end of a Wall Street institution. The real tragedy lies in the lack
of ethical behavior of its executives and professional advisors. They made conscious
decisions to deceive and manipulate, and the consequences proved too dire to
preserve the historic investment banks existence. The perennial lesson of the
Lehman Brothers case is that no matter how dire the circumstances may appear,
transparency and accountability are paramount. Right action up front may sting
initially, but as history has repeatedly shown, gross unethical business practices
rarely endure in the long term. A global financial crisis such as that of 2008 may not
be prevented from happening again. What can be improved, in large measure
through ethics education, is how corporations behave. Wall Street should take note
of the case of Lehman Brothers to ensure history does not find a way to repeat itself