JOURNALISTIC WORK SAMPLE Case Study on Lehman Brothers By: Nadine Sebai Date Published: 05/02/2010 Title: Investment

Bankers Play Dirty: The Art of Bending the Rules Lehman Style Originally Published On: SimoleonSense.com Target Audience: Business Readers, Investors, and Financial Analysts Purpose: In March 2010, the Bankruptcy Examiner of Lehman Brothers, Anton Valukas, released a 350page report outlining the use of Repo 105 transactions to enhance the perception of the bank!s solvency and profitability. This case study employs a model called the Fraud Triangle to analyze Lehman Brother!s motivations for using Repo 105 transactions and explains how auditors and government regulators failed to detect wrongdoing. Process: 1. Read and analyzed the report released by Bankruptcy Examiner Anton Valukas. 2. Learned about Repo 105 transactions and how investment banks utilize them. 3. Researched the Financial Accounting Standards Board (FASB) regulations regarding Repo 105 transactions to understand the Bankruptcy Examiner!s logic. 4. Selected the Fraud Triangle as an analytical framework to analyze the bank!s accounting practices. 5. Crafted the story. 6. Created and added visuals to simplify the reader!s understanding of how Lehman Brothers used Repo 105 transactions to mislead investors. 7. Edited and revised the story. 8. Published. Note: All guest posts written by me on SimoleonSense were under the pseudo-name Fraud Girl. The work sample provided has been edited and revised since its initial release in May 2010.

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Investment Bankers Play Dirty: The Art of Bending the Rules Lehman Style Recently Anton Valukas, the Bankruptcy Examiner for Lehman Brothers, released a report detailing the reasons behind the investment bank!s demise. One area of the report sparking numerous discussions involves claims that (since 2000 but heavily in 2007 and 2008) the bank knowingly misstated its balance sheet by using a financial instrument called Repurchase (Repo) 105 transactions. By using these instruments, Valukas stated that Lehman Brothers was able to hide over $50 billion in debt, lower its leverage ratio, and mislead investors. This week we!re using the Fraud Triangle to (1) demonstrate that Lehman Brothers had all the incentives to commit fraud and (2) explain how they did so with Repo 105 transactions. Warning Signs According to Valukas! report, there were a handful of warning signs showing that Lehman Brothers was involved in deceit. A valuable model used to uncover fraud is known as the Fraud Triangle:

The Fraud Triangle claims that fraud is likely to occur if a company (or individual) feels financial pressure to perform, has the opportunity to commit fraud, and can rationalize why it!s acceptable to do it. Let!s analyze each factor to understand what led Lehman to use accounting tactics to boost its financial image. Financial Pressure At the height of the financial crisis, Lehman was under intense pressure to shrink their balance sheet and lower their leverage ratio. Their involvement in the sub-prime mortgage industry had caused them to accumulate large sums of debt and they had no means to repay them. In an email from former CFO Erin Callan to former CEO Richard Fuld, Callan said: [W]e may get a very short leash if we show up with a rough quarter if we do not get the balance sheet exercise completed. No matter what, the skeptics are focused on our balance sheet and that is the key to the future. . . . I know we are saying it over and over but we HAVE to deliver on the balance sheet reduction this quarter and cannot give any room to FID [Fixed Income Division] for slippage.

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Prior to the financial crisis, the bank utilized ordinary repos frequently exercised by other investment banks. All repo transactions, ordinary or not, allow investment banks to borrow cash from companies (or governments) for a short period of time in exchange for assets valued at more than the borrowed amount they are receiving. At the expiration of the repurchase agreement, the investment bank pays back the principal borrowed plus interest and takes back their assets. The repo agreement is categorized based on the value of the assets an investment bank gives up for taking on a short-term loan. An ordinary repo, for example, is generally categorized as a Repo 102 transaction which means the assets are worth 102% above what the investment bank is getting for them. When Lehman purchased ordinary repos, they agreed to exchange assets valued at 102% for short term cash. Lehman expected to get the assets back upon payment of the loan, so there was never a reduction of assets on the balance sheet. This is how the Repo 102 transaction would affect the bank!s balance sheet: ! CASH -ASSETS ! LIABILITIES ! LEVERAGE RATIO

Lehman would then use the borrowed cash to pay down other debts causing their leverage ratio to become neutral. " CASH -ASSETS " LIABILITIES (Neutral) LEVERAGE RATIO

During the height of the financial crisis in 2007 and 2008, Lehman began investing heavily in nonordinary Repo 105 transactions. The accounting for Repo 105 transactions was identical to that of ordinary repos except for one very important difference. At the moment the assets were given to the counterparty, Lehman Brothers acted as if it sold the assets to them even though the bank knew they would get the assets back in a short period of time. Doing this caused the balance sheet to have the following effects: ! CASH " ASSETS -LIABILITIES (Neutral) LEVERAGE RATIO

Lehman Brothers would use the borrowed cash to pay down other debts causing a decrease in both cash and liabilities, which ultimately lowered their leverage ratio. " CASH -ASSETS " LIABILITIES " LEVERAGE RATIO

An ability to decrease the company!s leverage ratio meant good feedback from investors and a better outlook for the company, no matter how artificial the outlook may have been. Feedback was given most during each quarter end, and it is apparent by the chart below that Lehman Brothers understood this. The bank purchased more Repo 105s at each quarter end than at any other time of the year in 2007 and 2008.

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Chart by Anton Valukas, Bankruptcy Examiner Meeting analyst!s quarterly expectations was important for Lehman!s success. With a looming financial crisis and the investment community looking for results, Lehman Brothers felt the pressure to please their investors. Opportunity As Lehman Brothers continued to record Repo 105 transactions, auditors and regulators didn!t voice concerns. Although the bank was using accounting tricks to pump up its balance sheet, it was doing everything according to accounting standards put forth by the Financial Accounting Standards Board (FASB). To book the Repo 105 transactions as sales, for example, FASB required that Lehman prove they relinquished control over the assets when they were given to the counterparty. When a collateralization is between 98% and 102% (like the ordinary repos), a borrower preserves control over the transferred assets and can not move them off the balance sheet. This is because at a low haircut of around 2%, a bank can easily replace the assets with one almost identical to the one it is trying to relinquish. As a result, FASB (through SFAS 140) does not allow for the assets to be removed from the bank!s balance sheet. For a Repo 105 transaction, however, Lehman believed (and SFAS 140 agreed) that they would not be able to easily replace an asset valued at 5% more than what they got for it. This interpretation results in a relinquishment of control, which is then classified as a true asset sale. With SFAS 140 on their side, Lehman Brothers was allowed to account for their assets as sales and lower their debt. Their reasons for choosing this haircut do not appear to be coincidental, simply because the transaction would otherwise not be financially prudent for the company. Lehman could borrow $100 by giving up only $102 instead of $105. Why would a company give up more of its assets if it didn!t need to? To finalize a repo transaction as a sale under SFAS 140, FASB requires that the transferor (Lehman Brothers) obtain an opinion letter from a law firm confirming the true sale and

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relinquishment of control over assets. Lehman could not find a United States law firm that would draft an opinion letter for their Repo 105 transactions. A London based law firm, however, agreed to draft the letter under UK Law. To facilitate the process, Lehman created Lehman Brothers International Europe (LBIE) to execute the Repo transactions in the UK. LBIE would either use assets owned by LBIE or assets owned by, and originated from, a United States-based Lehman entity for the Repo 105 transactions. With the 5% haircut and an opinion letter from a UK law firm, Lehman now had the opportunity to freely book their relinquished assets as sales and hide their debt. Rationalization Through loopholes and the pressure to meet market expectations, Lehman Brothers made $50 billion in debt disappear from their balance sheet. Their leverage ratio, as a result, was lowered by an average factor of 1.8 percent per quarter in 2007 and 2008. Many people at the bank were concerned about the company!s growing dependence on Repo 105 transactions. Despite the concerns, Lehman!s auditor approved of their Repo 105 program and noted the bank!s consistency in abiding by FASB!s accounting standards. Lehman could justify their actions by claiming they had received a stamp of approval from their auditors and government regulators. Regardless of the fact that Lehman knew they were materially misstating their balance sheet (they never disclosed that they had recorded some repos as sales in a quarterly or annual report), the law was on their side. The Hamster Wheel of Business We!ve seen stories like the Lehman Brothers bankruptcy before; a big company gets away with doing something that, in hindsight, should have been caught much earlier. Meanwhile, the company!s auditors and government regulators who are required to protect investors and the financial markets sign off on the company!s actions. This combined with a financial environment that fixates on quarterly results leads companies like Lehman to take extreme measures to hide risks and highlight returns.