Drugged Elephant(s) in the Room:
How to Address Off Balance Sheets Hiding Leverage?

London, UK - 15th March 2010, 16:55 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

The 158-year old Lehman Brothers' collapse on September 15, 2008, was the largest bankruptcy in US history. That event is etched on the financial world's collective memory because it unleashed the most devastating financial crisis in generations, causing panic in capital markets, accelerating The Great Unwind, and bringing about a virtual freeze in global trade, The Great Reset. This led to trillion dollar rescue packages from Washington and other capitals.

It has taken a year of painstaking research and a 2,200-page report in nine volumes by a Chicago-based lawyer, Anton Valukas, to lift the lid on the management failures, destructive internal culture and reckless risk-taking that confined Lehman to history. The bankruptcy examiner's massive report on the collapse of Lehman Brothers has found "credible evidence" that top executives, including the Chief Executive, approved misleading statements and used accounting gimmicks as drugs to hide the truth from investors and the public. Worse, the report raises serious questions about the behaviour of auditors and regulators, who are supposed to protect the public. Specifically, the report's revelations include:

Drugged Elephant(s)

The Whistle-Blower

Inside Lehman Brothers Holdings Inc, some executives were very concerned about the firm's Enron-like accounting practices as the company headed to the brink in September 2008. In May 2008, Matthew Lee, a former Lehman senior vice president wrote a letter to senior management warning that the company may have been masking the true risks on its balance sheet. His warnings, revealed in the bankruptcy report, show that Lehman's auditors knew of potential accounting irregularities and allegedly failed to raise the issue with Lehman's board. At the time Mr Lee voiced his concerns in May 2008, Lehman was under siege from investors who questioned whether the securities firm was accurately valuing its risky assets. "We are also dealing with a whistle-blower letter, that is on its face pretty ugly and will take us a significant amount of time to get through," William Schlich, a former lead partner on Ernst & Young's Lehman team, wrote in a June 5, 2008, email to a colleague, which is included in the examiner's report.

Repo 105 and The Drug of Balance Sheet Manipulations

In a June 12, 2008, interview with Ernst & Young, the whistle-blower Matthew Lee raised the issue that Lehman was moving as much as USD 50 billion off its balance sheet, using a practice the firm called "Repo 105," the report says. The accounting device was used by Lehman to temporarily park assets off its books at the end of a quarter to make it look as if the firm had less debt, the report concludes, something investors and credit raters would tend to look favourably on. Lehman "had way more leverage than people thought; it was just out of sight," Mr Lee told the examiner in July 2009, according to the report. Herbert "Bart" McDade, the man known inside the bank as its "balance sheet tsar", described the "Repo 105" instruments in an email as "another drug we're on". Another executive ordered traders to "wean themselves off" Repo 105 as if it was a drug.

"The examiner has investigated Lehman's use of Repo 105 transactions and has concluded that the balance sheet manipulation was intentional, for deceptive appearances, had a material impact on Lehman's net leverage ratio and, because Lehman did not disclose the accounting treatment of these transactions, rendered Lehman's [financial statements] deceptive and misleading," the report says. The device was so rare that Lehman could not find a US law firm to give a legal opinion on it, using instead UK-based Linklaters, says the report.


In a meeting the day after they interviewed Mr Lee, Ernst & Young auditors failed to mention his allegations about Repo 105 to Lehman's board "even though the Chairman of the Audit Committee had clearly stated that he wanted every allegation made by Lee -- whether in Lee's May 16 letter or during the course of the investigation -- to be investigated," the report states. The examiner's report doesn't just raise questions as to the liability of Ernst & Young, Lehman's auditor; it raises questions about the entire foundation of public reporting. What precise purpose does it serve to have a supposedly independent auditor -- paid for by the company -- sign off on accounts? After Enron's collapse led to the annihilation of its auditor Arthur Andersen, the industry was meant to have been transformed. Aren't accountants subject to the same searching scrutiny as ratings agencies, regulators and the banks themselves? From Enron to Lehman and from Satyam to Parmalat, it is clear that the major accountants lack either the skill or the determination to ferret out fraud.

Crux of Deteriorating Risk Management

The crux of the report, based on the review of 34 million pages of documents out of the 350 billion pages obtained by Mr Valukas, is its portrayal of Lehman's insatiable risk appetite and its alleged efforts to cover up the extent of its financial crisis. At the end of 2006, senior officials at Lehman decided to increase the ceiling on the firm's risk limits, or how much Lehman stood to lose from its trading and investment activities, Mr Valukas recounts. Madelyn Antoncic, then Lehman's chief risk officer, resisted an increase in the limit from USD 2.3bn to USD 3.3bn but was overruled, according to the probe. By the end of 2007, it was USD 4bn. The report provides a scathing picture of just how weak Lehman's risk-management practices ultimately became -- and how they contributed to Lehman's implosion.

Stress Tests

Lehman Brothers, like its peers, was required to stress-test its trading positions and investments. Despite the risks posed by Lehman's dramatic ramping up of its illiquid investment portfolio, the firm's own stress tests excluded illiquid assets. Specifically, the firm excluded its principal investments in real estate, its private equity investments and its leveraged loans backing buyout deals. For example, a USD 2.3bn bridge loan for the buyout of Archstone-Smith Real Estate Investment Trust in May 2007 was never included in its risk usage calculation, although that single transaction would have put Lehman over its already enlarged risk limit, the examiner notes.


Lehman's practices meant that the firm did not have a true picture of just how vulnerable it was to volatility in capital markets and, more importantly, in the markets for the illiquid assets in which it had invested. The issue was all the more crucial to Lehman because the firm, with only USD 25bn in capital, had far less of a balance sheet buffer than its much stronger competitors.


The bankruptcy examiner's nine volumes report could have far-reaching implications for former Lehman Brothers' executives, including its former chief, Dick Fuld, and its auditors Ernst & Young. The bank that comes out of the report is an organisation prepared to take short cuts and huge risks to boost earnings, where control and accounting procedures were found to be sorely lacking. It also sheds a damning light on the inner workings of some parts of Wall Street that may be hell-bent on maximising profits and hiding losses plus true leverage using off balance sheet techniques. Contagion risks and counterparty failure have been the main hallmarks of The Great Unwind and The Great Reset thus far. In the light of the Lehman report, the question is whether there is a better way to ensure volatile investment banking and proprietary trading functions do not dominate the future stability of the commercial banking and financial intermediation environment that is so critical to real economic activity across the world. Could transparent leverage rules outlawing the use of obscure off-balance-sheet structures achieve this?

The world outside of policy making is still waiting for a fundamental reassessment of banks’ business models with sophisticated off balance sheet activities that hide true leverage. What banks are actually doing inside and how they may play acrobatics with rules to compete with each other has become utterly opaque and non-transparent to the investors, amongst other stakeholders. Wouldn't a single new rule barring off-balance-sheet techniques prevent a future "Lehman Brothers" to use accounting manoeuvres to make itself look financially stronger than it actually is? This is the “drugged elephant in the room” syndrome on which some policy makers have not yet had the time or inclination to focus.

The post mortem report emphasises not only the need for transparent and comparable accounting rules, for improvements in corporate governance, but it also supports the imposition of a transparent group leverage ratio to provide a binding capital constraint -- that Basel risk-weighted rules have been unable to achieve -- and suggests the need for the elimination of non-transparent off balance sheet activities to hide true leverage. These reforms are essential to deal with contagion and counterparty risk that are so integral to the ‘too big to fail’ drugged elephant(s) in the room.


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Best wishes

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