I. Lehman Brothers: Subprime Accounting?

Lehman Brothers Holdings Inc. was originally founded in Montgomery, Alabama, in 1850 by three brothers. The company began as a small retailer that took cotton as payment for goods. The company gradually expanded, first into trading cotton, before growing into a giant investment bank. By 2007, the company was the fourth largest investment bank in the United States, recognizing record profits of $4.2 billion. While other companies in the industry were beginning to struggle and show losses, Lehmans CFO assured investors that the risks posed to Lehman were minimal and would have little impact on the firms earnings. However, behind the record profits and executive confidence were a slew of undisclosed liabilities and shaky security valuations. When the company filed for bankruptcy on September 15, 2008, it was the largest bankruptcy in history. To put the size of this collapse into perspective, when WorldCom filed for bankruptcy in 2002, it was the largest in U.S. history, with $41 billion in debt and $107 billion in assets. Lehman Brothers entered bankruptcy with a mind-boggling $618 billion of bank debt alone and hundreds of billions of additional debt, many times the amount of debt of Enron and WorldCom combined. How did such a historic company reach this situation with so little warning?

SUBPRIME LENDING

Lehmans storied history came from humble beginnings in the cotton trade. In 1899, the company shifted its focus to bringing other companies into the stock markets. In the early 1900s, Lehman Brothers brought such giants as Sears, Roebuck and Company, as well as R.H. Macy & Company and B.F. Goodrich Co. into the public markets. The company thrived through the great depression by focusing on venture capital markets since the public equity markets were in turmoil. The firm remained primarily run by Lehman descendants until 1969. The company continued to grow and in 1984 was acquired by American Express, eventually merging with E.F. Hutton to become the financial giant Shearson Lehman Hutton. It was during the late 1980s when the company began building an aggressive leveraged finance businessa model characterized by primarily debt-based financing. The model can be highly profitable, but increases risk. In 1994, American Express divested its interest and spun off the company in an IPO as Lehman Brothers Holdings Inc. Lehman Brothers Holdings Inc. was a highly profitable company reporting quarterly profits for 55 consecutive quarters after the spinoff, up through March 2008.

However, during this profitable period, Lehman, along with other large investment banks, became involved in subprime lending. Subprime lending is characterized by banks making loans to borrowers who would not traditionally qualify for a loan. In many cases, the loans did not have any protection from declines in collateral value because they were issued without a traditional downpayment. Further, many of the borrowers had either poor credit history, or the loans were issued without any requirement for a credit history. Why would a bank do such a thing? Investor demand drove the subprime lending craze. Investors were hungry for securities that could earn higher rates of returns, so banks would bulk large numbers of loans into portfolios, break the portfolio into different levels of risk, and sell these mortgage-backed securities (Mortgage Backed Securities MBSs) to investors craving high rates of return. However, many subprime lenders provided default guarantees to investors, and some of the most risky MBS were practically unsaleable. As a result, Lehman Brothers, along with many other large investment banks, was faced with a huge amount of riskhigh amounts of debt, mostly with short-term maturities, and illiquid assets with long-term maturities. When the housing market began to collapse in 2007, borrowers walked away from the loans, leaving the banks with massive foreclosure costs and holding the titles to properties with values far less than the amount of the loan.

As a result of the subprime mortgage crisis, nearly all of Lehman Brotherss competitors showed giant losses in the first quarter of 2008, including a huge $5.1 billion loss for Citigroup. However, CFO Erin Callan reported that Lehman was well protected from the collapse and reported a profit of $489 million. The markets were thrilled, and the price of Lehman Brotherss stock shot up nearly 50 percent. Behind the scenes, however, Lehman Brothers was also collapsing. How was it able to continue to show profits and report lower levels of leverage than its competitors? The answer was a combination of optimistic valuations and an accounting gimmick that Lehman Brothers coined Repo 105.

A SOLUTION: INFLATED ASSET VALUATIONS

The majority of Lehman Brotherss assets were considered financial inventory held for sale, which GAAP requires to be reported at fair market value. In 2007, Lehman Brothers adopted the new FASB standard for determining fair market value. Under ASC 820, assets without observable values are considered to be Level 3 fair values. Level 3 fair values require entities to use their judgment to determine a valuation based on assumptions presumed to be used by the markets. Often, companies use a discounted cash flows approach. As the subprime mortgage crisis ballooned during 2007 and 2008, observable market activity for many of Lehman Brotherss assets declined, leading to more judgment. Lehman Brothers made many attempts to disclose their methods, however financial markets were reluctant to accept them. David Einhorn, an investor who held short positions betting on the decline in value of Lehman Brothers stated, Lehman does not provide enough transparency for us to even hazard a guess as to how they have accounted for these items. Markets were clearly skeptical: By June 2008, Lehman Brothers had a total stock market value of $19.2 billionmore than 25 percent below the reported book value. However, the assets held by Lehman Brothers were so difficultperhaps impossibleto value that, despite market skepticism and impairment losses far lower than competitors, no one, not even the bankruptcy examiner, had been willing or able to conclude that Lehman Brothers reported unreasonable valuations.

A LESS TRANSPARENT SOLUTION: REPO 105

Lehman Brothers was facing massive amounts of debt and likely realized that unless it reduced its leverage, it would fail. However, the assets were not particularly marketable, so Lehman took full advantage of short-term loans from other big companies. This is known as the repo market, short for repurchase. Lehman Brothers would acquire cash on a short-term basis from other companies by selling certain assets, with the understanding and agreement that it would repurchase the assets very quickly. This enabled Lehman Brothers to pay off other short-term debt that was coming due. However, because the sales of the assets are accompanied by an agreement to repurchase the assets, GAAP requires that these repurchase agreements be fully disclosed and accounted for as a liability.

Lehman Brothers bypassed these accounting rules by creating the Repo 105 transaction. Unlike typical repo transactions, Lehman Brothers would sell assets worth more than the amount of the loanat least 105 percent of the amount of the loan, hence the name. By doing this, it was able to bypass the repurchase agreement accounting requirements and avoid recognizing the liabilities. In addition, Lehman Brothers made the nontransparent choice of failing to even disclose these agreements anywhere in the financial statements. Through these transactions, Lehman Brothers kept massive amounts of debt out of the financial statements, including more than $50 billion of debt during 2008. No wonder it looked better than its competition!

WHERE WERE THE AUDITORS?

Ernst & Young (EY) spent considerable time auditing the valuation of Lehman Brotherss assets. EY performed walkthroughs to understand the valuation process, identify the significant classes of transactions, and document the appropriate what could go wrongs that could have a material effect on relevant assertions. Further, EY substantively tested the valuations for significant classes of assets. In the end, small changes in underlying assumptions could lead to valuation fluctuations many times materiality, making it nearly impossible to determine that a valuation is unreasonable. EY issued an unqualified opinion for its 2007 audit and did not find anything to indicate the valuations were unreasonable in its 2008 quarterly reviews.

EY audited Lehman Brothers for many years. It was well informed about the companys accounting policies. In fact, lead engagement partner William Schlich informed Anton R. Valukas, the Examiner in the eventual bankruptcy proceedings, that EY had long been aware of Lehmans Repo 105 transactions. It did not approve the policy but became comfortable with the Policy for purposes of auditing financial statements. EY indicated to the Examiner that it concurred with Lehmans approach, although it did not have an opinion on the use of the transaction to manage the companys reported debt. Following ASC 860 directly, it would appear that the Repo 105 transactions were accounted for as stated in the standards. However, the lack of disclosure of the transactions appeared far more questionable. In fact, the bankruptcy Examiner concluded that there was sufficient evidence to support the finding of colorable claims against EY for failure to meet professional standards related to the lack of disclosure.

THE AFTERMATH

Lehmans bankruptcy filing in September 2008 triggered a period of intense volatility in the financial markets. Coupled with other economic difficulties, the Dow Jones Industrial Average experienced intra-day ranges of more than 1,000 points and extreme price declines. The components of Lehman Brothers were sold off in bankruptcy to many different companies, and many of the derivative securities owned by Lehman Brothers and other banks were deemed worthless. Lehman emerged from bankruptcy in 2012 but did not return to operations; it merely continued winding down the business. The Lehman Brothers situation is a clear demonstration that the old mantra of too big to fail is not universally correct.

As usually happens when companies fail, many lawsuits followed, many taking years to reach settlements. JPMorgan agreed in January 2016 to pay $1.42 billion cash to settle claims that it profited by taking advantage of its close financial relationship with Lehman Brothersessentially receiving payment for debts just prior to Lehmans bankruptcy filing. Several other smaller investor lawsuits were settled out of court also.

EY did not admit to any deficiencies in its audits but, nonetheless, settled two separate lawsuits in 2013 and 2015 for $99 million with investors and $10 million with the state of New York.

1. In your opinion, is there value to an auditors opinion if it is impossible to narrow down a valuation range to within the limits of materiality?