Lehman failed, but so did their auditors, Ernst and Young to report deliberate balance sheet manipulations that the company used to show better metrics to the outside world.
Leverage and liquidity ratios are the two key metrics that counterparties and credit rating agencies look at while evaluating investment banks. When Bears Sterns’ failed in March 2008, confidence in the industry as well as Lehman began to decline. At that time the executives felt the need to manipulate the financial statements in order to stop the declining confidence.
In the 2nd quarter of 2008, they started to manipulate their balance sheet by using accounting tricks, referred in Lehman world as Repo-105. The Normal repo transactions consisted of selling assets with the obligation of repurchase within a few days. These are considered a financing activity; and these sold assets stay 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.
Throughout 2008 Lehman made false claims of having billions of dollars in available cash to repay counterparties, showing a far better liquidity picture than what was true, significant portions of the reported amounts were encumbered or otherwise unavailable for use. September 12, 2008, 2 days after reporting $41 billion in liquidity, true available funds totaled only $2 billion. And 3 days later, on September 15, 2008 Lehman filed for bankruptcy. An end to another behemoth.
