Homer & Friends on Lehman Brothers and Accounting Rules vs Principles – Part 1

Today's panel discussion features our usual suspects, Homer Simpson, Henry David Thoreau and Gordon Gekko, who, just like Claude Rains in Casablanca,  are shocked by reports that Lehman Brothers might have used accounting gimmicks in the period leading up to its collapse.  Release of Gordon's new movie (Wall Street – Money Never Sleeps) has been postponed until September, but it is still on the way.

Homer -  So, what happened - Lehman cooked the books, went broke and got caught in the postmortem with its hand in the donut jar?

Gekko– Possibly Homer, but it's probably not quite that simple.  Mr. Valukas, a high-powered corporate lawyer appointed as examiner by the Lehman bankruptcy court,  reports that Lehman used repos to take debt off its books, and he considers it a gimmick.  In each repo, Lehman would sell an asset and agree to buy the asset back at a future date.  Lehman gets the use of cash, just like a loan.  The spread between the original sale price and the repurchase price functions as interest, but these repos were accounted for as sales so Lehman uses cash from the repos to reduce debt that would otherwise have appeared on its books.  Of course, the assets “sold” also came off the books.

Thoreau – Sounds like a gimmick.

Gekko – Easy Henry, Generally Accepted Accounting Principles (GAAP- and don't be fooled by the name, GAAP is mostly about rules, not principles) has very specific tests to determine when a repo should be accounted for as a sale instead of a loan.  Most repos involve an overnight sale/repurchase of treasury securities and are accounted for as loans.  Lehman sold $105 of securities for each $100 it received in somewhat longer term transactions , and, based on what we know so far, it appears that each of Lehman's repos, examined individually, may have passed the test for accounting treatment as a sale. 

Thoreau– If the only purpose was to hide the extent of Lehman's debt, it's still a gimmick,, in fact it's worse because it makes no sense to sell a $105 security for $100 – even if Lehman did get it back at the same discount less interest.

Gekko – Your a born regulator Henry.  The SEC just sent a letter to the CFO's of twenty-four large financial firms asking for details on repos accounted for as sales, and one of the first questions in the letter is “what is the business purpose”.  A good answer might be, “overcollateralizing lowered my cost of funds and I just followed GAAP on the accounting.”  One not so good answer might be, “we needed to reduce debt to avoid triggering expensive  defaults under covenants in our loan agreements”.  Another not so good answer might be, “we knew the analysts wanted to see less debt, and we followed the rules on the accounting.”  Note that even the not so good answers are, from a narrow perspective, preserving value for the existing shareholders, but doing so at the expense of the creditors and the securities markets.

To be continued.

Photo Credit: fotographix.ca