Analyst K E Y P O I N TS
AGENDA • A court-appointed examiner’s report
Lessons from Lehman
How can investors learn to detect warning signs?
BY LORI PIZZANI
T
wo years ago the collapse
of Lehman Brothers
shocked financial markets
across the world and
became the flash point of a painful
global recession. With the benefit of
hindsight — and a remarkably reveal-
ing court-ordered report that exposed
a multitude of questionable behind-
P RO F E S S I O N A L P R AC T I C E
the-scenes activities at Lehman —
what lessons should investors learn
about detecting serious problems
before a publicly traded company
heads into a death spiral?
Subsequent revelations about
Lehman highlight the need to size up
companies. The list of possible abuses
includes assets that can magically dis-
appear from balance sheets only to
mysteriously reappear later (then dis-
appear again) and assets that are sup-
posed to be marked to models but are
instead marked to make believe.
“This is an unusual case. Rarely
do we have an examiner’s analysis to
do a retrospective on to see what hap-
pened,” says Fred Fraenkel, vice
chairman of Madison, New Jersey-
based Beacon Trust Company. “Very
rarely do we have a smoking gun.”
Lesson 1:
Beware of “Window Dressing”
Misuse of a perfectly legitimate
accounting rule governing sales of
repurchase agreements was one of the
most shocking revelations to come out
of the mid-March 2010 report issued
by bankruptcy court–appointed
examiner Anton Valukas, chairman
of the law firm Jenner & Block.
According to the report,
“Lehman employed off-balance sheet
devices (such as Repo 105 transac-
tions) to temporarily remove securi-
ties inventory from its balance sheet,
24
usually for a period of seven to ten
days, and to create a materially mis-
leading picture of the firm’s financial
condition in late 2007 and 2008.”
In effect, this internal accounting
transaction allowed Lehman to hide
US$50 billion, thereby reducing total
liabilities and total assets on its
balance sheet. More importantly, it
allowed Lehman executives to
obscure the firm’s true leverage ratio.
Standard repurchase and resale
transactions allow for one party to
temporarily transfer assets/securities
to another party as collateral for a
short-term borrowing of cash, with
an agreement that the cash will be
repaid and the collateral returned at a
specific time in the near future. But
Lehman accounted for its repo trans-
actions as sales (instead of financing
transactions), which allowed Lehman
to remove the item entirely from its
balance sheet. Lehman then used the
cash it borrowed from the transaction
(105 percent) to pay down its liabili-
ties, thereby reducing leverage. After
the start of the next quarter, Lehman
would borrow the funds necessary to
repay the cash borrowing (with inter-
est), repurchase the fixed-income
securities, and restore the assets to
the balance sheet. “Lehman reverse-
engineered the firm’s net leverage
ratio for public consumption,” the
report noted.
This creative accounting was
used because Lehman executives
found it impossible to sell any of the
illiquid securities in Lehman’s inven-
tory, which included leveraged loans
as well as residential and commercial
real estate positions. Moreover, not
only did Lehman find it necessary to
reach across the ocean to obtain a
favorable opinion on such sales from
a U.K.-based law firm, but the use
of Repo 105 transactions was not
CFA MAGAZINE SEPT–OCT 2010
exposed a multitude of questionable
behind-the-scenes activities at
Lehman Brothers.
• To protect themselves in the future,
investors should pay special attention
to “window dressing,” misuse of lever-
age, pricing of Level 3 assets, and
“criminogenic” circumstances that
lend themselves to control fraud.
• Analysts should look for clues and
hidden information in financial
reports, question inconsistencies,
and demand satisfactory answers.
disclosed. Lehman’s former global
financial controller admitted to the
examiner that even a careful review
of Lehman’s quarterly or annual
financial reports would not have
revealed the company’s use of Repo
105 transactions.
If the Lehman case produces an
eerie déjà vu sensation, it shouldn’t
be surprising. From Enron executing
energy trades to someone at Kidder
Peabody hiding trades in a desk
drawer to Lehman Brothers taking
asset-backed securities off the balance
sheet, schemes tend to have common
elements. “Repo 105 was an old-fash-
ioned parking of securities, just with
a shiny new bow wrapped around it,”
says John Donaldson, CFA, vice pres-
ident of fixed income at Haverford
Trust Company in Radnor, Pennsyl-
vania. “Taking things off the balance
sheet, parking them or putting
them somewhere just to hide them,
has been illegal and will continue
to be illegal.”
After the fact, the surprise was
the amount of off-balance-sheet activ-
ity that occurred. “I don’t think
anyone knew there was that much,”
Donaldson says. “You could see the
origination and sales data. But nobody
asked, ‘Where is this stuff going?’”
“This accounting just stinks to
high heaven,” says Terry Connelly,
dean of the Ageno School of Business
at Golden Gate University in San
Francisco. “If this was a true sale,
Lehman could have gotten away with
it just once,” he adds. “The problem
for investors is: what do you look at
if you can’t really see the balance
sheet? We need accounting changes.”
“As a matter of principle, all
transactions should be reflected in
the financial statements,” says Sandy
Peters, CFA, CPA, and head of the
financial reporting policy group for
the Standards and Financial Market
Integrity division of CFA Institute.
“The issue here comes down to
understanding why management is
engaging in a transaction, what is the
intent of the transaction, and do the
financial statements reflect that eco-
nomic reality?”
An investigation instigated by
reporters at the Wall Street Journal
led to regulators probing whether
other large banks caught up in the
mortgage mayhem of 2007– 08 may
have used similar accounting tactics
to obscure liabilities in an attempt at
“window dressing.” In July, Bank of
America and Citigroup both admitted
to similar transactions, albeit to a
lesser extent, but called the transac-
tions unintentional errors.
Lesson 2: Avoid Giant Leverage
Machines Balanced on the Head
of a Pin
Leverage can — and often does —
boost returns when markets are
rising, but leverage can prove devas-
tatingly difficult to overcome when
markets are descending.
Understanding the dangers of
leverage helped some investors avoid
the Lehman debacle. Jeanie Wyatt,
CFA, CEO and chief investment offi-
cer of South Texas Money Manage-
ment, owned Lehman in client
accounts from late 2003 until early
2006. “It was a growth stock for us,
meaning that revenues and earnings
were accelerating,” Wyatt explains.
“Moreover, the one-year sales growth
for Lehman was accelerating between
the third quarter of 2003 and the
second quarter of 2006.”
But by the first quarter of 2007,
a reversal was becoming evident as
growth began slipping. “When growth
companies are no longer growing on
the top line, that can become a
dangerous time for company manage-
ment in terms of the risk of the
company becoming too creative with
financial engineering because their
basic business model is no longer pro-
viding growth,” Wyatt says. She sold
Lehman because her firm followed
its discipline of selling a stock once
it reaches a target price or no longer
meets the firm’s growth criteria.
“The most blatant measure of
risk that would have prevented us
from rebuying Lehman was the debt-
to-equity ratio,” Wyatt explains.
“Lehman’s ratio was around 30 times
as I recall. While that was, interest-
ingly enough, almost exactly the
same as the debt-to-equity ratios of
other investment banks, including
Bear Stearns, Goldman Sachs, Merrill
Lynch, and Morgan Stanley, that
didn’t matter to us.”
“With that much leverage,”
Wyatt points out, “it is very unlikely
that any company can survive an
economic downturn without help
from their investment banking friends.
It turns out Lehman had few friends.”
“It’s also a good idea to monitor
the trend in the yields on a company’s
bonds, commercial paper, and credit
default swaps,” she adds. “Deteriora-
tion on credit quality by a market as
efficient as the bond market is a good
indicator of financial risk. Lehman’s
credit default swap spreads started
widening in the summer of 2007.”
“Lehman was a giant leverage
machine balanced on the head of a
pin,” says Connelly.
Lesson 3: Verify Everything, and
Don’t Try to Analyze in a Vacuum
Although auditors can often spot trou-
ble in the making, not all problems
are evident to even the most skeptical
independent auditors, especially if
management is intent on hiding some-
thing. Auditors may need to look
closer and ask more relevant ques-
tions of their audit clients. But ana-
lysts, portfolio managers, and other
investment professionals should be
ready to question inconsistencies even
if an auditor hasn’t raised concerns.
“CFA charterholders are not
auditors,” says Michael Bechara, CPA,
CFA MAGAZINE SEPT–OCT 2010
managing director of Granite Consult-
ing Group in Brewster, New York.
“They are trained to take audited
materials and analyze that. CFA char-
terholders have to work with the data
provided and perform their analysis
based on this.” But he notes that at
least one hedge fund manager chal-
lenged Lehman a few times when its
public numbers didn’t reconcile with
data provided at road shows and what
was relayed during conference calls.
Investors should ask for clarification
when necessary.
“You have to trust the auditor
report, but you need to look at it all
and be ready to challenge,” says
Jeffrey Hakala, CFA, CPA, co-founder
and chief investment officer at
Clarkston Capital Partners in Birm-
ingham, Michigan.
And once questions are asked,
investors shouldn’t settle for a dismis-
sive response from the man behind
the curtain. “Just about any time
someone belittles analysts who ask
questions with responses like ‘It may
be too sophisticated for you to under-
stand,’ they are trying to hide some-
thing,” Donaldson says. When man-
agement tries to sound like they are
trying to do something super special
or are generating profits through
methods that can’t yet be revealed,
it’s a red flag. “Good people with long
and distinguished track records feel
they don’t have to hide anything,”
adds Donaldson.
Still, when bubbles are forming,
it can be very hard not to drink from
the punchbowl. Analysts need to look
not only at the company’s balance
sheet but also at its income statement
to see what’s fueling growth. In the
case of Lehman, it was being fueled
by debt. In addition, industry peers
should be evaluated to see what they
are experiencing. “You have to recon-
cile what a company’s management is
saying with what’s happening in the
real world. You can’t analyze in a
vacuum,” Hakala adds.
Also, keep in mind that footnotes
to companies’ financial statements
can provide valuable details that may
Continued on page 26
25
 Analyst
AGENDA
Continued from page 25
not otherwise be obvious and can be
a perfect starting point to ask more
probing questions.
“In the footnotes, Lehman repre-
sented that it treated its Repo 105
transactions as financings, but as the
bankruptcy examiner notes, Lehman
treated its Repo 105 transactions as
sales instead,” says Ann Gittleman,
CPA, CFF (Certified in Financial
Forensics credential), a consultant
at Kinetic Partners in New York City.
“It’s the auditor’s job to assess the
footnotes and ensure that the state-
ments being made are accurate.” The
auditors also should have discussed
P RO F E S S I O N A L P R AC T I C E
any unusual transactions with the
audit committee. “At a minimum,
the auditors should’ve exercised pro-
fessional skepticism and tested
Lehman’s practices to be sure that it
was recording its Repo 105 transac-
tions as financings and not sales,”
she adds. “Repo 105 isn’t illegal; the
important thing here is for the audi-
tor to understand the true business
purpose for the accounting treatment
applied.” Moreover, notes Gittleman,
“It’s critical for the auditors to really
understand what’s going on from
both an accounting and business
standpoint when auditing transac-
tions for the financial statements.”
“You cannot ignore the foot-
notes,” counsels Hakala. “Lehman’s
footnotes at one point showed Level
3 assets at US$42 billion. That
US$42 billion was a red flag.”
Lesson 4: Pay Special Attention to
Hard-to-Price Level 3 Assets
At the heart of Lehman Brothers’
problems were asset-backed securities
that Lehman was said to be pricing
accurately despite the bottom falling
out of the mortgage market in 2007
and 2008. When a true, liquid, and
verifiable market price does not exist
for an asset, management will start
marking so-called Level 3 assets to
prices derived from proprietarily
developed models.
26
But the court-appointed exam-
iner’s report concluded that the valu-
ations of items on Lehman’s balance
sheet were totally opaque. “No one in
the company could figure out how to
value these,” says Fraenkel, who in
addition to his position as CEO of
Beacon Trust Company also chairs
the company’s investment policy
committee and was a managing direc-
tor of global research at Lehman
Brothers in the early 1990s. “The
company itself had two checks on
itself and had differing pricing meth-
ods that didn’t agree,” he adds.
Fraenkel faults the company’s
lackadaisical management. “The
people running Lehman Brothers at
the highest levels were not particu-
larly intellectually curious about what
those assets were all about,” he says.
“Post-2003, when Sarbanes – Oxley
says that if you sign this and this is
wrong [you’ll be held accountable],
you’d best be intellectually curious.”
Lesson 5: Watch for “Control Fraud”
and “Criminogenic” Circumstances
Investors must watch for and take
“control fraud” very seriously, says
William Black, associate professor of
economics and law at the University
of Missouri–Kansas City and former
executive director of the Institute for
Fraud Prevention from 2005 to 2007.
In April, Black testified before a
House committee investigating
Lehman Brothers’ activities.
“Control fraud refers to individu-
als that control seemingly legitimate
entities and use them as a weapon
to defraud,” he says. “In the financial
sphere, accounting is their weapon
of choice. Accounting fraud produces
exceptionally large losses as CEOs
and CFOs cheat big rather than
small, and individual control frauds
are capable of causing greater losses
than any other forms of property
crime combined.” When control
frauds “cluster” in particular indus-
tries, they can become epidemics and
“hyper-inflate bubbles,” which can
cause systemic crises if not curbed by
prosecution or regulation.
CFA MAGAZINE SEPT–OCT 2010
Black believes clues and red flags
went beyond Lehman’s financial
statements.
Lehman was the leading seller of
non-prime assets. It primarily sold a
no-income-verification loan, known
in the trade as “liars’ loans,” Black
says. Not being the underwriter for
those loans means that, inherently, a
risk was adverse selection, meaning
at least some of those loans had what
is called a “negative expected value,”
according to Black. The phenomenon
of adverse selection is “criminogenic”
in that it produces widespread con-
trol fraud. “Honest firms do not
engage in businesses they know will
create a negative expected value,”
Black says.
“Lehman was one of the largest
vectors spreading fraudulent mort-
gage product throughout the system.
It was a prime villain, not an inno-
cent victim,” he comments.
What has the now well-known
lack of action by banking and securi-
ties regulators taught us?
“If one appoints ‘anti-regulators’
to positions of power, one creates a
self-fulfilling prophecy of regulator
failure,” Black says. “These leading
anti-regulators believed that markets
invariably and promptly eliminated
fraud and were efficient.” As he sees
it, the U.S. Federal Reserve declined
to use its unique authority to regu-
late mortgage lenders that were not
federally insured and the insufficient
number of U.S. SEC staff assigned
to regulate all U.S. investment banks
was a farce.
In other words, investors can’t rely
on regulators to protect them. Detect-
ing and avoiding dangerous invest-
ments requires constant vigilance.
Lori Pizzani is an independent financial
services journalist based in Brewster,
New York.
RECOMMENDED RESOURCES
“Of Candor and Conflicts: What Were We Thinking?”
By Marianne M. Jennings
Conference Proceedings Quarterly (March 2009)
Research Foundation Publications (December 2009)
(www.cfapubs.org)