You, Lehman’s Re-Po Magic, and Ernst & Young

Ernst & Young, one of four remaining large auditing firms, allegedly botched its financial audits of Lehman Brothers, the bankrupt investment banking firm. E&Y responds that its audits met legal and professional requirements.

My view, reported in today’s New York Times, wonders, suggesting E&Y offers a “technical compliance defense,” when what’s needed is an objective judgment, based on professional skepticism, of whether financials provide a fair presentation.

Though the allegations sound esoteric, it is easy to translate them into simple terms.  When considering the following analogue between Lehman’s deals and your personal finance, think about how an independent accountant would assess what I suppose you are doing.

Suppose you apply for mortgage credit to buy a home. Your assets are cash and a car with a total value of $20,000; your debt totals $19,000. The difference between those two figures is your net worth, $1,000. Banks decline your application, saying your “leverage ratio,” debt compared to net worth, is too high. The ratio is 19:1 (debt of $19,000 versus net worth of $1,000). Banks say they can only lend to borrowers with leverage ratios below 15:1.

You imagine ways to reduce  your leverage ratio. One is to sell assets for cash and pay off an equivalent amount of debt. Thus suppose your car is worth $5,000, you sell it for that, and use the proceeds to pay down $5,000 of debt. Now total assets are $15,000 and total debt $14,000. Your net worth is still $1,000, so your leverage ratio is down to 14:1. You have made yourself legitimately eligible for your mortgage loan.

But suppose your car is a clunker and no one will buy it. Another way to reduce your leverage ratio is to get someone to take your car off your hands temporarily, giving you $5,000 today, while you promise to reverse the exchange after getting your mortgage and home. Some may be troubled by the two-step, thinking it looks more like a loan—someone lending you $5,000 and holding your car until repaid.

Yet you could convince yourself it really was a sale by observing that the other guy is paying you full value for the car, since most lenders only lend a portion of that. For example, the home you want to buy costs much more than what banks will lend you. You could make it more convincing by upping the amount to $5,250 or so.   

If you could not convince yourself of that, you’d say you borrowed money, secured by your car, and your leverage ratio would increase, not decrease. So you convince yourself it really is a sale and leave it that.

That analogizes allegations made against Lehman, hinging on what it called Re-Po 105 deals. Its leverage ratio, above 17, made borrowing difficult or impossible. It owned assets no one would buy.

So it transferred the assets in exchange for cash equal to or greater than their purported value, often 105% of that.  It simultaneously promised to repurchase them, at roughly the same price.

With the cash infusion, it retired debt.  It accounted for the initial transfer as a sale. The combination decreased its leverage ratio, close to 14, enabling it to borrow. It used borrowings to close out Re-Po 105s.  That returned its leverage ratio to above 17.

Was that legitimate? Is E&Y, Lehman’s outside auditor, liable for any illegitimacy? One technical defense is that of my rationalizing car seller above. Maybe the transfer really was a sale, not a loan, and accounting for it that way in technical compliance with applicable accounting standards.

Another technical defense is it was not the auditor’s business anyway, when it signed its opinions. If, as of that moment, the financials had netted out both sides of the Re-Po, they would still fairly present Lehman’s position then.

But are these technical arguments persuasive? If you got your accountant to sign off on your mortgage application using the Re-Po 105 approach, how would your lender respond?

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1 Response

  1. Though it isn’t fair to demand E&Y’s head on a stick because of this, it is the auditors job to find bizarre accounting tactics if not outright fraud. If this isn’t a perfect example of a dash of both, I’m not sure what is.

    And hey, what if E&Y auditors failed to catch the fraud AND PwC failed to notice it when they decoded Lehman’s accounting in the bankruptcy?

    Ooooh, burn.