Lehman Brothers: Faulty Accounting Principles and a Financial Crisis

Lehman Brothers 7

Lehman Brothers: Faulty Accounting Principles and a Financial Crisis

ID#

Dr. Bruton

PHI 300 Sec. 1

April 25, 2010

Lehman Brothers: Faulty Accounting Principles and a Financial Crisis

The role of corporation’s have always seemed to captivate the minds of people around the world, and Lehman Brothers was no exception to this view. Lehman Brothers had been around for well over a hundred years and at the turn of the twenty-first century it, “was the fourth-largest investment bank in the United States” (Q&A, par. 16). Many people viewed this corporation in a similar fashion that was held to the Titanic, “God Himself could not sink this ship.” However, with their erratic investments and dubious accounting principles, it would prove to be the end of the large corporation. The accounting principles used by Lehman Brothers were wrong because they gave investors a false sense of security as they viewed their financial statements. In order to fully understand what happened to Lehman Brothers, a brief history is required.

During the mid-1990’s, the residential and commercial real estate market began to boom. Lehman Brothers, along with several other corporations, saw the potential to make easy money and they wasted no time buying mortgage-backed securities. However, there was a problem with the recently purchased assets. With the market steadily climbing and no end in sight, “bankers searched for new ways to enhance earnings, they continued to crawl further down the credit quality scale” (Williams, p. 102). By doing this, the banks approved loans to clients who did not meet the previously so high credit requirements. In turn, people who were not financially stable began to buy houses that were well beyond their means. High credit scores began to become a common sight on paper work that was presented by the banks and credit agencies; and with the market steadily climbing and money continuously rolling in, no one was concerned about what the future market would produce.

The lucrative and liquid market continued on into the twenty-first century; and Lehman Brothers was there every step of the way, confirming its stronghold on the market. In fact, they were so large in this particular market that “by 2004, capital markets activity, including trading and sales, represented 66 percent of the firm’s revenue; investment banking represented only 20 percent of revenue” (Williams, p. 107). By the firm representing these kinds of numbers, it clearly indicated that they were betting their entire financial security on the residential and commercial real estate market.

The sky rocket performance displayed by the market never brought any concerns to the table. However, with loans awarded to anybody and everybody that walked through the door, it was not long before the inevitable took place. Loans began being defaulted on left and right as people lived beyond their means. This spelled disaster for Lehman Brothers and they “slid into bankruptcy in 2008 and became the nation’s largest Chapter 11 bankruptcy filing” (Bruno & Papini, Par. 8). The bankruptcy threw up red flags everywhere and questions arose from every direction.

Everyone, including the Securities and Exchange Commission (SEC) and the Treasury Department, wanted to know why this happened. Perhaps most importantly is, how did this happen? Surely, somebody somewhere, saw this coming on a financial perspective. Why did Lehman Brothers not do anything about it? It sparked a massive investigation with Anton Valukas as the bankruptcy auditor. During Mr. Valukas’ investigation, he “alleged that this Repo 105 maneuver allowed Lehman to shift $50 billion in assets off its book and so make the firm appear financially stronger than was really the case” (Reilly, par. 3). Some people may ask, well why did they want to move $50 billion dollars of assets off the books? The answer is quite simple; the majority of Lehman Brothers’ assets were purchases of mortgage-backed securities from the loans that were given out to everyone. Once people began defaulting on their loans, the assets became illiquid assets.

Now that most of Lehman Brothers’ holdings are illiquid assets, they do not want this information on the shareholders’ financial reports. Lehman Brothers began using an accounting principle called repurchase agreements or repos, which they called “Repo 105.”

Repos, or repurchase agreements, are transactions which banks use to borrow cash short term. The deals involve raising cash to fund operations by lending out high quality assets for a short period of time. As part of the deals, the banks agree to repurchase their collateral within days or weeks. (Lehman’s Repo 105, par. 4)

Though repo deals are legal and part of the Generally Accepted Accounting Principles (GAAP), the manner in which Lehman Brothers used repos was not legal. Repo deals are temporary loans which are recorded in the accounting journal and on financial statements as a loan. Lehman Brothers recorded these deals as sales revenue. The other major factor is based on the fact that Lehman Brothers failed to disclose any information of these deals on any financial reports.

As their defense, Lehman Brothers basically felt as though shareholders did not need to know every time a meeting was held in another office; and I cannot argue this view. If financial reports contained minute full disclosure on daily decisions and daily operations, they would be non-existent for the sheer fact corporations would not have the man power to complete such a task. After all, at the time the financial reports went out to shareholders they did hold the cash, which they used to lower leverage, and they did not hold the illiquid assets. However, a red flag was raised during the “first quarter 2008, when other firms showed crippling mortgage-related losses, Lehman showed profit” (Williams, p. 151). This false profit was allowed by recording the repo 105 deals as sales without disclosure. Repo deals are allowed to be recorded as sales only when control of the asset is lost and will not be recovered.

The defense given by Lehman Brothers is unjustifiable. The so-called whistle-blower, “Martin Kelly, told the bankruptcy examiner that “the only purpose or motive for the transactions was reduction of the balance sheet.” He further added that “there was no substance to the transactions” (Reilly, par. 5). The investigation also discovered that “fees paid by Lehman to Ernest & Young for audit services exceeded $30 million in 2007” (Williams, p. 198). The pay rate was also another huge red flag that something was wrong. Why would such a fee be required for regular job performance? There is not a doubt in my mind that Lehman Brothers knew they were deceiving their shareholders on the pretense they were hoping to continue to gain money from investors.

A few investors were able to save a small percentage of their investment. Unfortunately, the majority of investors lost everything in the company they had once placed so much faith upon. The bankruptcy of Lehman Brothers was felt around the world, especially in the United States. The only other time Lehman Brothers had significant problems was during the Civil War. The irony in the demise of Lehman Brothers comes from that time when “responding to economic hardship caused by the blockades of the Civil War, Emanuel Lehman had simply stated: “Everything is over.” Nearly 146 years later, his premonition was coming true” (Williams, p. 163). Except this time, they had no one else to blame but themselves. I believe full disclosure is absolutely essential and crucial in financial reporting, especially in regards to the G.A.A.P. Perhaps if Lehman Brothers had chosen not to deceive people through their accounting methods, they might have still been in operation today. Furthermore, Lehman Brothers is a classic example of what happens when greed and deception shake hands during the light of business.

References

Bruno, J. B., & Papini, J. (2010, March 13). Lehman Report Confirms Former Employee’s

Suspicions. Wall Street Journal.com.

Lehman’s Repo 105: More Than You Ever Wanted to Know. (2010, March 15). Wall Street

Journal.com.

Reilly, D. (2010, March 13). Lehman Maneuver Raises Accounting Question. Wall Street

Journal.com.

Reilly, D. (2010, March 15). Questions on Ernest Auditing. Wall Street Journal.com.

Williams, M. T. (2010). Uncontrolled Risk. The McGraw-Hill Companies.

Q&A: Lehman Brothers bank collapse. (2008, September 16). BBC News.com.