Monday, December 20, 2010

What Really Happened at Lehman: Maybe Its Auditor Knows For Sure

For the first time since the beginning of the financial crisis, a major financial institution duty-bound to certify the soundness of a huge investment bank might have civil charges filed against it. The targeted firm is Ernst and Young, one of the big Four audit and accounting firms. There used to be Five, but Arthur Andersen, which audited Enron, dissolved soon after Enron did in 2001.

Governor-elect and still attorney general Andrew Cuomo is close to filing charges that Ernst and Young stood by while Lehman lied about the risks it was taking with investors' money and employees' lives which led to its bankruptcy. Many economists believe that Lehman's bankruptcy helped trigger the devastation that followed.

In Liz Rappaport and Michael Rapoport's article in the Journal, Cuomo is investigating whether Lehman engaged in "window dressing", also known as repo debt (Lehman called the activity "repo 105), where banks borrow money on a short-term basis so they can take bigger risks. The more money you can play with (especially borrowed money) the more risk you tend to take. When it came time for quarterly reports, Lehman would lower its repo debt to make it look more sound to investors.

Instead of accounting for Repo 105 as loans, Lehman called them "securities" and Ernst and Young nodded in approval. After Lehman went bankrupt in September 2008, the bankruptcy examiner found that Lehman had moved some $50 billion off its balance sheets:

The attorney general's investigation, which began after the bankruptcy examiner's report, found that Ernst and Young specifically approved of Lehman's use of Repo 105 transactions and provided the investment bank with a complete audit opinion from 2001 through 2007.

Other big banks, such as Bank of America, also engaged in "window dressing". Earlier this year B of A disclosed 6 dubious transactions.

There was a whistleblower at Lehman, Matthew Lee, senior vice president, who complained that Repo 105 violated Lehman's ethics code. He put his concerns in a letter to senior Lehman executives 4 months before Lehman's collapse. As gratitude, he was fired. Ernst and Young did see the letter and said that Lehman management determined that Lee's "allegations were unfounded."

Shades of Enron. Enron was an energy trading company based in Houston which also worked cozily with its accounting firm to hide massive amounts of debt using special investment vehicles. Again, employees and shareholders were left holding the bag. The situation was certainly rigged for the employees: they were only allowed to invest in Enron stock for their 401-Ks. Enron collapsed at the end of 2001. Its share price went from +$90 in mid-2000 to less than $1 in November 2001.

At least a high-level executive, Jeffrey Skilling, went to jail in that case on multiple federal felony charges.

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