Report Title

Causes of the collapse of Lehman Brothers and accounting fraud- Repo 105

Introduction
Subprime mortgage crisis in the United States had a detrimental impact on Lehman Brothers
and it led to bankruptcy in 2008. Collapse of Lehman Brothers was the largest bankruptcy in
the history and triggered global economic and financial crisis. In 2006, balance sheet of
Lehman Brother increased rapidly and contained many long-term investments that financed
by short-term borrowing. Residential and commercial mortgage-back securities were
substantial parts of companys assets. Starting from 2007, mortgage-backed securities began
to lose their values and housing bubble burst showed signs of trouble. However, Lehman
ignored signs of crisis and own risk models and took more risk to increase the benefit from
the countercyclical crisis. The balance sheet was manipulated by top managers, using
repo105, showing signs of bad ethics within the organization and its decision making process.
These actions combined with inefficient auditing system lead to Lehman Brothers collapse.

Repo105 transactions
Like other Wall Street investment banks, Repo agreements were widely used by Lehman
Brothers as a vehicle to meet short-term liquidity needs. Repo is known as a repurchase
agreement that involves temporary transfer of securities with an agreement to counterparty to
buy back the same securities at a specific price in the future. To minimize repayment risk to
the lender and secure loan, borrower pledges financial assets to the lender known as collateral
in the event of default on the loan. The repurchase of these securities should be over original
sale price that represents the interest also known as repo rate. At the agreed time, Firm repays

borrowed amount with agreed interest rate to take back collateralized assets. From a legal
standpoint, in the initial sale, legal title to the securities shifts from the seller to the buyer
until repurchase of securities occurred. Under typical repurchase agreement, when firm
receives cash by selling its securities to the other party, it is recognized as a secured loan
liability in the balance sheet. The liability would disappear from the balance sheet after
repayment of this loan. This accounting transaction does not have any influence leverage
ratio of the company.
SFAS 140 that issued by Financial Accounting Standards Board also allow treating some repo
transaction as sales based on certain qualifying criteria. According to SFAS 140,
collateralized asset value was set between 98% and 102% of borrowed amount, it means bank
retain effective control over transferred asset and transaction would not be characterized as a
sale. In contrast to typical repo that haircut transaction was 2%, Lehman Brothers established
new types of transaction called repo 105 and repo 108 by setting higher haircut of 5% and 8%
respectively. Reason for high haircut was to demonstrate that Lehman did not maintain
effective control over the asset and allow the company to report it as a sale. Under this
accounting practice, collateral asset was considered as a sale by Lehman and excluded
securities and related liabilities from its balance sheet and equity remained unaffected. The
reduction in assets and liabilities allowed to decrease leverage ratios and to portray healthy
looking financial statement. In comparison to typical security transaction, repo 105 was a
more expensive way for Lehman Brothers to finance immediate liquidity needs. At the
quarter end of 2008, income securities valued at more than $ 50.4 billion were moved off
Lehmans balance sheet through Repo 105 transactions and put them back on the balance
sheet a week later. Leverage ratios went down significantly over the two years. The nature of
Repo 105 was never disclosed in Lehmans statement of Income, Statement of Cash Flow and
Statement of Financial Condition.
Net Leverage Ratio

Leverage ratio

Q2 2008

Q1 2008

Q4 2007

Q3 2007

24.3

31.7

30.7

30.3

28.7

28.1

26.2

16.1

16.1

15.4

15.4

14.5

Net Leverage ratio 12.1

Repo 105 usage (bil) $50.4

15.4
$49.1

$38.6

$36.4

Q2 2007

$31.9

Q1 2007

$27.3

Q4 2006

$24.5

Source: Report of Anton R.Valukas, Examiner on Lehman Brothers Holding Inc, Volume three,
Section three, pp 889

Lehman transferred its securities to U.K affiliate thats known as Lehman Brother
International. Reason for international transaction was to meet condition that outlines the
transferred asset must be isolated from the transferor1 in order to recognize for sale
accounting (Lloyd & Shah 2013). Lehman Brothers was unable to obtain a true sale opinion
from a US firm because of the legal system of US, but English law system allowed getting a
true sale opinion, from U.K law firm Linklaters.
Risk and equity ratio
In early 2007, Lehmans stock reached a record $86.18, however defaults on mortgages
within the housing market rose to a seven-year high. A month later, Lehman had its biggest
stock drop in five years, due to concerns that the rising default rate would affect Lehmans
performance, and in contrast to this they posted their highest revenue and profit. Lehmans
CFO stated that the rising rate of default on mortgages were contained and would have very
little impact on the organisations performance.
In August 2007, the collapse of two Bear Stearns hedge funds led to Lehman stocks
plummeting. The firm commenced underwriting the most mortgage-backed securities in the
country, and obtained a portfolio of $85 billion. At this stage, investor confidence is key to
the companys success as it is financed on short-term loans. This led to a high level of
leverage, the ratio of Lehmans assets to shareholders equity, known as equity ratio or equity
multiplier. Having high leverage indicates that the firm has a lot of assets compared to equity
and can indicate that the company has large debt in order to stay in business. Lehmans shares
then begun to fall, and as Hamel, Mikes and Yu (2013, pp. 3) highlighted, confidence in the
company deteriorated, and saw them post their first loss of $2.8billion.
After this loss, Lehman begun to reduce their leverage by decreasing gross assets, however it
was too late by this point, and Lehman Brothers filed for bankruptcy on September 15, 2008.
Lehman Brothers are a great example of how defective accounting practices such as incorrect
risk measurement and high equity ratio can impact confidence in the market. This is what
Rosato and John (2010 pp.4) describe as a lethal combination, and leads to the collapse of

large corporations.

Performance evaluation
Apart from miscalculation of risk and a high equity ratio, the performance evaluation
methods or criteria must be questioned as it plays a key role in the goals/targets of Lehman
Brothers. It is clear that the main goal of Lehman brothers was to obtain a large portfolio and
generate record profits, however the consequences of their actions show that they lacked a
few financial and non-financial measurements of performance. In particular, they neglected
the equity ratio, debt/equity ratio, improvement in ratios, productivity measures and confined
themselves to a narrow or short term focus.

Ethics
Lehman Brothers collapse is also directly related to ethics and its decision making process.
According to the International Federation of Accountants (2014), there are five fundamental
principles of professional ethics: Integrity, objectivity, professional competence and due care,
confidentiality and professional behavior. Lehman Brothers have broken two of these:
integrity and professional behavior, as they have manipulated their balance sheet and
undertaken activities which are illegal in the US.
By not adhering to the previously mentioned principles, Lehman Brothers have undertaken
teleological or consequential ethics. This means that they base their decisions primarily on
the result of the action. For example by using repo105 and tampering with financial
statements, they were able to reduce the leverage ratio. This benefit is seen as outweighing
the cost, therefore leading to a morally correct decision. In this instance, consequential ethics
can be linked to creative accounting. Creative accounting allows a company to distort its
financial statements for benefit.
By highlighting ethics and its role in the decision making process, we can see how it can lead
to defective accounting practices. In this instance, what we can describe as bad ethics,
combined with defective risk measurement, led Lehman Brothers to a dramatic collapse. If
Lehman Brothers had adhered to the five principles of professional ethics, they would have a

taken upon deontology or non-consequential ethics, which may have saved them or at the
very least postponed their bankruptcy.

Auditing at Lehman
E&Y, a well-known external audit firm, started to cooperate with Lehman from 1994 until
2008 of the latters downfall. The audit firm was in charge not only of Lehmans accounting
but also supported it with advisory and tax services. Although being an accounting firm
controlling the entities operational transparency, Ernst and Young was accused by the US
government officials for committing a huge accounting fraud in terms of extracting
multibillions of dollars from the L&B balance sheet to mislead the society about the
companys liquidity position.
Soon after Lehmans collapse filed in US Court of Bankruptcy, the examiner was employed
by the court in finding the precise information on the cause of the bankruptcy of the firm. The
main issue was finding out whether the outcome had linkage with the Lehmans corporate
auditors involving E&Y. The report that provided by the examiner contained descriptive
information on the Lehmans doubtful accounting policy surrounding the acceptable leverage
ratios. By using its accounting methods Lehman could show good ratios to misguide the
investors. Upon reveal of findings by examiner the Securities and Exchange Commission
(SEC) immediately started investigation and issued letters for financial firms asking whether
they utilize Repo transactions in their accounting reports. Although it was found that
Lehmans treatment of accounting standards were congruent to Generally Accepted
Accounting Principles (GAAP), it was said the regulators have modified the rules to prevent
others from similar actions. The SEC therefore had also investigated Repo 105 transactions
along with the rest of the means of Lehman Brothers downfall.
On the other hand, defenders of Ernst & Young argued that the auditing company should not
be accounted for the misbehaviors of Lehman Brothers. The engagements of the audit firm
with the issue were found in the letter describing the E&Ys commitment to the Audit
Committee in accordance with the Sarbanes-Oxley Act (2002). Moreover, they claimed the
audit firm recorded all transactions consistently to the GAAP and therefore justified
themselves for transparency. Thus they ignored all the accusations against them stating that
they were not the reason for the companys bankruptcy and linking the collapse to the fact of

Lehmans financial statements which was highly leveraged and risky. In addition Ernst and
Youngs partner claimed that they were unaware of such transactions.
In contrary, Lehmans officials argued that in their statement to E&Y before Lehmans
downfall it was indicated American securities also involved in the Repo 105 transactions. The
audit firm was informed about the issue, because they received a number of statements
consistently including the amount of Repo 105 transactions by Lehman. Lehmans former
financial controller stated that E&Y has relied on treatment under GAAP that was a reason
for Lehman to remain comfortable.
Furthermore, there were several suspicious matters regarding to senior management of both
companies. Christopher OMeara, One of the financial executives in Lehman during 20042007 was a former E&Y senior manager in its Financial Services division. Lehmans former
CFO between 2000-2004, David Goldfarb was also E&Y employee as a senior partner in the
Financial Services. He was accused of being the one who created the transactions as known
as Repo 105. Neither any regulatory action has been taken against Lehman and its officers by
SEC nor activities held against the audit firm E&Y. Since then, the SEC has proposed new
regulations in regards to manage companies to give detailed and in depth information
comprising both qualitative and quantitative measures about short-term loans and borrowings
and repurchase duties.

Conclusion
Sudden collapse of US financial giant Lehman Brothers Corporation in 2008 put US
accounting standards on a serious scrutiny. Lehman, the fourth largest investment bank in the
US was found of manipulating the General Accounting Practices (GAAP) by revealing
deceptive financial data misusing Repo 105 transactions deliberately. As a result, global
confidence in the financial markets, especially US market has significantly declined and
investors now are more suspicious of the financial data they encounter. Although US
government blamed on the Lehmans former audit firm for companys downfall and
demanding on the payback of the earnings that it gained from Lehman, Ernst and Young
officials came up with several claims and argues that they should not be held responsible for
the Lehmans bankruptcy.

In short, the event of demise of a giant investment bank Lehman Brothers remains the biggest
collapse in American history and will stress the necessity of better accounting regulations and
management for the firms regardless of its size.

Further emphasis on correct risk

calculations, performance evaluation, positive ethics and well regulated auditing practices
will regain global investor confidence in financial markets for the coming future.

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