Damning insight into corporate culture sheds light

飞雪寒冰

September 15 2008 is etched on the financial world's collective memory. The day Lehman Brothers collapsed into bankruptcy was a pivotal moment in the most devastating financial crisis in generations, causing panic in capital markets and a virtual freeze in global trade.

Scores of books and magazine articles have chronicled Lehman's rapid and ruinous fall from global investment banking powerhouse to the largest corporate failure in US industry.

But it took a year of painstaking research and a door-stopper report by a Chicago-based lawyer to lift the lid on the management failures, destructive internal culture and reckless risk-taking that sent Lehman to its grim fate.

The 2,200-page tome Anton Valukas - the examiner hired by a US court to probe who was responsible for the bank's failure - released on Thursday could have far-reaching implications for former Lehman executives, including its former chief, Dick Fuld, and its auditors Ernst & Young.

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Mr Valukas begins his story at a high point in Lehman's 158-year history. On January 29 2008 the firm reported record yearly earnings of $4bn for the previous year.

Within eight months, those profits - and the rest of the firm - had turned to dust.

"There are many reasons why Lehman failed and the responsibility is shared," writes Mr Valukas, before adding that its plight "was exacerbated by Lehman executives whose conduct ranged from serious but non-culpable errors of judgment to actionable balance-sheet manipulation".

The examiner concludes that, based on different metrics, Lehman and some affiliates were already insolvent at various times in the months of 2008 leading up to its bankruptcy filing.

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The crux of the report, which is based on the review of 34m pages of documents out of the 350bn 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 woes.

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.

The decision came just as the firm moved to expand its commitment to real estate investing, even though the US mortgage market was already starting to implode. Indeed, Lehman would increase its firm-wide risk appetite limit three times over the following year.

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Madelyn Antoncic, then Lehman's chief risk officer, resisted an increase in the limit from $2.3bn to $3.3bn but was overruled, according to the probe. By the end of 2007, it was $4bn.

The report also provides a scathing picture of just how weak Lehman's risk-management practices ultimately became - and how they contributed to Lehman's implosion.

For example, the firm, like its peers, was required to stress-test its trading positions and investments. But Lehman excluded its principal investments in real estate, its private equity investments and its leveraged loans backing buyout deals, thereby leaving out its most risky assets from -calculations.

A $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.

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Lehman's practices meant that the firm did not have a true picture of just how vulnerable it was to swings 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 $25bn in capital, had far less of a balance sheet buffer than rivals such as Goldman Sachs.

In the aftermath of the near-collapse of Bear Stearns in March 2008, Lehman found itself unable to sell some of its most illiquid assets. With ratings agencies and investors demanding a reduction in Lehman's balance sheet, the company ramped the use of an "accounting gimmick" it had been resorting to since 2001, according to the report.

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Known internally as "Repo 105" - but never disclosed externally - the mechanism enabled Lehman to move up to $50bn in assets off its balance sheet for just enough days to get through the end of the quarter.

That, in turn, helped the firm to reduce its leverage ratio (the level of indebtedness on its balance sheet), avoid a rating downgrade and appear healthier than it actually was.

"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.

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Linklaters said yesterday it was "not aware of any facts or circumstances which would justify any criticism" of its opinions.

Lehman's many counterparties in the trades also never appeared to have questioned them or the fact that they were receiving better terms than in traditional repo transactions.

As with other corporate scandals, internal e-mails offer a revealing glimpse of how the rank-and-file saw the practice. In one e-mail in February 2008, a senior trader tells a colleague: "We have a desperate situation and I need another $2bn [balance sheet reduction] from you either through Repo 105 or outright sales."

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A few months later, the same trader urges a colleague: "Let's max out on the Repo 105 for your stuff."

A few managers were not so sure. Bart McDade, a Lehman executive who was worried about Repo 105, described it as "a drug".

Another executive ordered traders to "wean themselves off" Repo 105. One even pointed to the risks of covering up the practice, warning: "The more people that know the truth, the more dodgy it can be."

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Mammoth task

Investigate why Lehman Brothers failed, whose fault it was and what legal claims could be pursued as a result. That was the daunting task handed to Anton Valukas, a Chicago lawyer, by a US bankruptcy court in January 2009.

His highly anticipated findings - filed with the court earlier this year but sealed until this week - were considered the ultimate tell-all on the largest bankruptcy in US history.

Only a brief portion of the 2,200 pages has been redacted.

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Mr Valukas, 66, has already earned praise for a report described as "riveting" for its narrative-style account of the negotiations surrounding the bank's demise, and overwhelming in its detailed and thorough exploration of the complex behind-the-scenes transactions.

Before being appointed examiner he was far less well known in New York circles than in the political and financial world of Chicago, where he has been a fixture for three decades.

Mr Valukas has been a partner with law firm Jenner & Block since 1976, with the exception of a stint as the US attorney for the northern district of Illinois from 1985 to 1989.