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The purpose of this dissertation is to address questions that have arisen from the observation that the use of off-balance transactions in the last decades has risen rapidly and some financial institutions in their use on off-balance sheet financing seem to have deviated from its legitimate purposes. Lehman Brothers' Repo 105 transactions are the blazing example of the author's observations. This paper will examine aggressive and misleading financial reporting practices. The case of Lehman gave the author an opportunity to discuss both financial and legal concepts in equal amounts.
The topic is relevant because the lack of transparency in the financial reporting creates obstacles for professional and unsophisticated investors. Importance of disclosures is important now more than ever. Materiality of the Repo 105 transaction had the ability to impact the decisions of prudent investors. But what is the most troubling that even after Sarbanes-Oxley act passage and corporate governance scandals such as Enron, the history repeats itself. The Lehman bankruptcy produced a worst financial crisis and economic downturn in 70 years. It's been 4 years since the collapse of Lehman brothers, and no one has been charge for misleading investors.
The author thinks that there are lessons to be learned from
Dissertation consists of 4 sections. We start with a short background for Lehman Brothers and the role the property market boom has played in its rise and fall. In the first section we introduce the reader to the world of off-balance finance and look at the role it is playing in the modern financial reporting. Off-balance finance is looked upon differently from the regulators and users point of view. In the second section we briefly discuss ordinary repurchase agreements and analyse the anatomy of the Repo 105 transactions in detail. It is argued that Repo 105 has been designed to reverse engineer the leverage ratio. In the second section we discuss the importance of financial leverage in financial markets and in Lehman balance sheets. Next, we discuss the role mark-to-market accounting and the issues an investment bank faces when deleveraging. For comprehension purposes the Repo 105 effect on the balance sheet will be illustrated step by step.
After getting all the pieces of the puzzle together we move to discussing legal technicalities that enabled the Repo 105 transaction to happen. In the fifth section we will stress the importance of disclosures and highlight the problems when defining materiality. We discuss the anti-fraud provisions of SEC act, which in the author's opinion, were violated. We examine Generally Accepted Accounting Principles, Sarbanes Oxley Act, Securities Exchange Act of 1933 & 34 as well as SEC rule 10b-5 will be examined. In the sixth section we will touch upon corporate governance issues. Then to test the author's ideas we will look at legal opinion on litigation between former Lehman Brothers executives and misled investors. Finally
Background for Lehman Brothers
2007 was a record breaking year for Lehman. A reason for this success - bricks and mortar. Both President Bill Clinton and George W. Bush championed home ownership. American house prices were rising steadily since 1950s, but rocketed after 2001 when interest rates were slashed. The boom was fuelled by loans with tempting introductory rates being offered to risky clients. The real money came to Wall Street came not from selling individual mortgages to homeowners but from selling bundles of these loans among themselves and other institutional investors. These bundles were labelled as low risk assets by the banks. By 2007 Lehman was the largest underwriter of real estate loan in U.S. A general view in the marketplace was that sophistication of 21 century financial markets has enabled to eradicate risk.
That false sense of confidence led Lehman to borrow heavily to invest in real estate. It borrowed $44 for every $1 it had in the bank to finance their investment deals. By 2007 it was investing $60 billion dollars in commercial property, hotels, shopping centers and residential developments around the world. While leverage multiplies profits when the prices go up, it also multiply losses when prices fall. And that is what happened in 2007. A growing number of people who have been "seduced" with cheap introductory mortgage rates could not keep up with the payments when the rates increased. Repositions rocketed and house prices slumped. The subprime crisis exploded on the world.
It was the decision to invest in commercial developments that was a tipping point. The bank invested aggressively at the property market at its peak. But could not get out before the crash. In essence Lehman â€¦ sell the syndicated loans globally. And when you can't sell it and share the risk it become a led weight on the balance sheet over time. Lehman executives manipulated balance sheets and financial reports when investors began losing confidence in the firm and competitors closed in.
On September 15, 2008, Lehman Brothers, a global financial services firm and the fourth largest investment bank in the world declared bankruptcy sparkling chaos in financial markets and playing a major role in the global financial crisis. Twenty six thousand employees lost their jobs, millions of investors lost all or a part of their money. It has been called the largest bankruptcy in history. Larger than General Motors, Washington Mutual, Enron and Worldcom combined.
The federal bankruptcy court appointed Anton Valukas, a former United States attorney to conduct an investigation to determine what happened. Included in the 9 volume, 2200 page report was the finding that there enough evidence for a prosecutor to bring a case against top Lehman officials and the company's accounting firm Ernst & Young for misleading government regulators and investors.
But what was most apparent and damaging was Lehman's misuse of an accounting trick called Repo 105. Lehman would move approximately $50 billion of assets from the U.S. to the U.K. just before they printed their quarterly financial statements. And about a week after the financial statements had been distributed to the public, the $50 billion dollars would reappear back on the books in the U.S. By temporarily removing this money from its ledgers it looked like it though Lehman was reducing its dependency on borrowed money and was paying down its debt. Lehman never told investors or regulators about this tactic. It truly was the highest form of deception.
Off-balance sheet finance
'Off-balance sheet' transactions can be difficult to define, and this poses the first problem in discussing the object. The term implies that certain things belong on the balance sheet and that those which escape the net are deviations from this form. The practical effect of off-balance sheet transactions is that the financial statements do not fully represent the underlying activities of the reporting entity. The items in question may be excluded from the balance sheet altogether on the basis that they do not represent assets and liabilities. Examples include operating lease commitments and certain contingent liabilities.
Off-balance sheet financing is a form of borrowing in which the obligation is not recorded on the borrower's financial statements. Off-balance sheet financing can employ several different techniques, which include development arrangements, leasing, product financing arrangements or recourse sales of receivables. Off-balance sheet financing will raise concerns regarding the lenders' overall risk, but it improves their debt to equity ratio, which enhances their borrowing capacity. As a result, loans are often easy to arrange and are given lower interest rates because of the improved debt structure on the balance sheet. For example, loans issued by a bank are typically kept on the bank's books. If those loans are securitized and sold off as investments, the securitized debt is not kept on the bank's books.
Depending on their roles, different people react differently to the term 'off-balance sheet finance'. To an accounting standard setter, or other financial regulator, the expression carries the connotation of devious accounting, intended to mislead the reader of financial statements. Off-balance sheet transactions are those which are designed to allow an entity to avoid reflecting certain types of its activities in its financial statements. The term is therefore pejorative and carries the slightly self-righteous inference that those who indulge in such transactions are up to no good and need to be stopped.
It is argued by Mizen (2008) that off-balance-sheet vehicles had emerged as a known and tolerated way for banks to get round the capital adequacy required by the Basle I regime for bank regulation: by transferring debt and risk to a wholly-owned subsidiary, the beneficial owners of banks were able to continue to take on risk.  . 'Hiding' the debt in special purposes vehicles is a fascinating topic, which deserves a separate paper, will not be considered in this dissertation.
Off-balance financing allows not showing assets and liabilities on the balance sheet. However, it is still a requirement to disclose the transactions in financial statements' footnotes. But key financial ratios and, most importantly, regulatory capital is calculated using balance sheet positions alone. Because off-balance sheet liabilities are not included in the financial statements, banks can take positions almost impossible for the regulator to assess. It can be argued that nowadays, the footnotes are a more important source of information than the balance sheet itself. In case of AIG off-balance sheet items have grown more than the actual balance sheet.
Leverage exacerbates the problem further - instead of taking a position in the underlying, banks can use derivatives, thus multiplying both profits and losses. When a big financial institution fails, not only its shareholders, but a general public and the whole economy share the loss. It is also difficult for the market to discipline banks for excessive risk taking. In the author's opinion such extensive risk taking practices can develop a feeling of impunity.
However, there is also room for a more honourable use of the term 'off-balance sheet finance'. Entities may wish, for sound commercial reasons, to engage in transactions which share with the other parties the risks and benefits associated with certain assets and liabilities. Increasingly sophisticated financial markets allow businesses to protect themselves from selected risks, or to take limited ownership interests which carry the entitlement to restricted rewards of particular assets.
Benefits of off-balance sheet finance:
Part of financial innovation
Enables to share risk
Makes it easier to raise capital
Improves B/S from the firm perspective
Dangers of off-balance sheet finance:
Lack of transparency
Promotes increased leverage
Promotes risk taking
Concentration in illiquid assets
Difficult to regulate
In theory, it should be possible to determine what items belong in the balance sheet by reference to general principles such as those in the IASB's Framework and similar concepts statements. In practice, however, such principles on their own have proved a less than adequate response to the increasingly indigenous and aggressive structures being developed for what would generally be regarded as the less-honourable forms of off-balance sheet finance. 
The Conceptual Framework for Financial Reporting, developed by the International Standards Committee (IASC), sets out the principles that should underlie the preparation and presentation of financial statements. The Framework was adopted in 1999 by the International Accounting Standards Board (IASB) as the foundation for its work in developing new International Reporting Standards (IFRS's). Under the framework company's balance sheets are required to show a 'true and fair view' of the company's financial position. What is 'true and fair view' has not yet been defined, but could be explained as follows; True, i.e. free from all relative material error and Fair, i.e. fair from bias.
Another import qualitative characteristic of financial statements for our discussion is materiality. Materiality is a threshold quality and only material information needs to be considered further. Information is material if it could influence user's decisions or where its misstatement or omission could result in the information being misinterpreted. There is no general definition of materiality, as a high degree of experience human judgement is needed to make a decision on the subject.
Let's consider a simplified example to make the problem clear. It is common for the companies to look for additional funding towards the end of financial year or the reporting quarter. The company A obtains a secured loan, using its assets as collateral. The company shows the loan under its liabilities, and users of financial statements take it into account when making investment decisions.
The company B, instead of borrowing the funds, arranges a sale of its assets, agreeing to repurchase the asset at a later date. Users of financial statements believe that this company is in a better financial position and is less leveraged, because it does not report the loan under its liabilities. The result will be that the balance sheet suggests less exposure to assets and liabilities than really exists, with a consequential flattering effect on certain ratios, such as gearing and return on assets employed This may lead to different investment decisions.
As company balance sheets are required to show a true and fair view of the company's financial position, many accountants are naturally reluctant to approve balance sheets which they consider misleading. This reluctance is increased when, as is usual, the balance sheet omission was deliberately contrived, rather than accidental.
To conclude: Off-balance item is an asset or liability that does not appear on the company's balance sheet, which is used by investors and supervisors to evaluate a company's financial health. Companies will often use off-balance-sheet financing to keep their debt to equity and leverage ratios low. These types of transactions and agreements were often used to try and show improved performance with a higher ROCE, together with keeping debt off the balance sheet to show lower 'gearing', and therefore lower risk, resulting in lower cost of borrowings.
The case of Lehman Brothers has showed how dangerous off-balance sheet transactions, combined with leverage and illiquid markets can be. The Lehman Brother used Repo off-balance sheet device, known as Repo 105.
What are Repo 105s?
Sale and repurchase agreements ("repos") are agreements in which one party temporary transfers assets (often fixed income or equity securities) to another party as collateral for a shortâ€term borrowing of cash, while simultaneously agreeing to repay the cash and take back the collateral at a later date (often as short as a week or ten days). When the repo transaction matures, the borrower repays the funds plus an agreed upon interest rate or other charge and takes back its collateral.  A haircut in a repo transaction is the difference between the value of the collateral used to secure a borrowing and the amount of cash that is borrowed. Repurchase agreements involve minimal risk for the lender if structured carefully, having no market risk but only a credit risk. To reduce the repayment risk, the borrower transfers liquid assets to the lender as collateral. The collateral protects the lending party if the borrowing party defaults on the loan.
Repos are wholesale funding instrument within the banking industry. Repo transactions are widely used by financial institutions and are a legitimate tool for raising shortâ€term funding to pay for operating expenses, to meet reserve requirements and manage liquidity. Banks often need short term cash and have assets they cannot liquidate immediately. In repo market liquidity is high and rates are competitive. Published reports indicate that overall size of the repo market is large, estimated at close to $12 trillion.(source?)
The ordinary repurchase agreements are usually not and off-balance sheet item. The substance of the transaction is to provide a short term loan. It is difficult to argue that the financial institution is actually selling the assets to the counterparty. However, for our discussion we are interested in the specific accounting treatment of repurchase agreements.
According to the SFAS 140 paragraph 100 repo transactions are considered financing or borrowing transactions. In a typical repo transaction temporary transferred assets remain on the firm's balance sheet, along with a liability for the provided cash from the financial transaction. Repo 105 transactions are nearly identical to a typical repo transactions, which are used by the most Investment banks to obtain short-term cash, with a key difference: Lehman accounted for these transactions as a sale, when in fact it was simply a secured borrowing arrangement.
The number 105 (or in many instances 108) was appended to the term Repo to describe the amount of loan collateral and reflects the use of the transaction as a vehicle to achieve an accounting result.  105 per cent collateralization was used for the fixed income assets and 108 per cent was the amount used for equity. For example, to secure a 100$ cash loan, a borrower would provide a collateral of liquid securities equivalent to $105 million. On the surface such overcollateralization was puzzling, as lender did not request it to be so high. The usual collateralization amount at that time was 102 per cent (2 per cent haircut). It made no economic sense to put up to $105 million of collateral to obtain a $100 million short-term cash loan, when the same could be done using a lesser amount. By using overcollateralization or a higher than normal haircut Lehman was able to recharacterise the Repo 105 transactions as a sale and to remove them from the balance sheet. In the later chapters we discuss legal technicalities that allowed for the recharacterization.
Lehman's Repo 105 transactions occurred around the end of the reporting quarter and lasted for a period of seven to ten days, creating a materially misleading picture of its financial position in late 2007 and 2008. Murtaza Bhallo, the former Business/Risk Manager for PTG Liquid Markets, described that Repo 105 was "an accounting gimmick".  Marie Stewart, the former Global Head of Lehman's Accounting, described Repo 105 transactions as "a lazy way of managing the balance sheetâ€¦" 
As described by Hallman (2010), a typical Repo 105 would begin with Lehman's European unit transferring $105 million or $108 million worth of securities to a counterparty in exchange for $100 million in cash. Lehman would then use the money to pay down other short-term liabilities, so that it could report quarterly leverage numbers low enough to satisfy the ratings agencies, and thus investors. A few days after the quarter ended, Lehman would repay the cash, plus interest, and get its collateral back.
The transaction worked as follows:
Step 1: Original purchase. Lehman Brothers, using its subsidiary Lehman Brothers Special Financing Inc. (U.S.) purchased from the street a government bond worth $105.
Step 2: Intercompany repo (no haircut). Before the end of the quarter, the U.S. based entity transferred these securities valued at $105 via an intercompany repo transaction to the Lehman Brothers International Europe (U.K).
Step 3: Repo 105. Upon receiving the securities worth $105, London affiliate LBIE would execute Repo 105 transaction with a European counterparty. The minimum haircut of 5 per cent is applied to the transaction, thus LBIE receives $100 cash and agrees to buy back the securities at a higher price.
Step 4: Add $5 derivative asset. Lehman Brothers Holdings Inc (LBHI) provides $5 to its London counterpart LBIE to then transfer the total of $105 to the United States based entity.
Step 5: Reduction of liabilities. The United Statesâ€based Lehman entity used the $105 in cash either to pay for the repoed securities inventory or, more likely, to pay down its shortâ€term liabilities, thereby reducing leverage.
Step 6: Borrow cash. A few day after the reporting date, armed with seemingly healthy financial statements, Lehman would borrow the $105 needed to buy back the securities
Step 7: Repurchase the security. When the term of the repo expired, LBIE repurchased the securities from the Repo 105 counterparty at 105 percent of the values and then returned the securities to the United Statesâ€based Lehman entity through an intercompany repo. 
Lehman dramatically increased its usage of Repo 105 transactions in late 2007 and early 2008. There was concern expressed by Lehman personnel and officers. Bart McDade, Lehman's former Head of Equities (2005-2008) and President and Chief Operating Officer, in an April 2008 eâ€mail asking if he was familiar with the use of Repo 105 transactions to reduce net balance sheet, replied: "I am very aware . . . it is another drug we r on."
Lehman had to set limits on itself as the temptation to employ more of Repo 105 was too great. If spikes in the trading volume are extreme just before the reporting date, there is a risk of attracting the attention of regulators. Lehman senior management set limit on how the firm can reduce its leverage using Repo 105. In 2006 the limit was $17 billion. Along with the $5 billion limit for the Repo 108 the total was $22 billion. As January 2008 the total cap for Repo 105/108 transactions was increased to $25 billion. There were other internal rules to make sure the transactions have a legitimate business purpose or that the amount of the transactions do not spike more than 120% near the reporting period. 
But Lehman did not follow these self-imposed rules. Beginning in midâ€2007 - the very time that the market began to particularly focus on investment banks' leverage - Lehman breached its internal limit on Repo 105 activity at every quarterâ€end, temporarily removing as much as $50.38 billion in securities inventory from its balance sheet in second quarter 2008. Thus, Repo 105 volume in fact was increased twice above the cap in the second quarter of 2008
Firstly, If there was an economical benefit of using Repo 105/108 transaction it makes no sense to limit the use of this device. Secondly, a secured short-term financing could not been a business purpose of the transaction because the financing received in exchange for collateral was not reflected in Lehman's periodic reports as a liability. A Repo 105 was a more expensive way to obtain financing compared to the ordinary repo, which Lehman could conduct using the same counterparties at a lower cost. Hence, another proof that Lehman officers were fully aware of the pure "window dressing" effect of the device.
Did the Examiner find any legitimate possible use of Repo 105 other than affect balance sheet? The examiner asked that question repeatedly to the persons who were involved but did not find an answer. Why to use Repo 105 when the firm can do a regular repo and pay less money to get the same financing. Why to move everything to London, pay a premium to get exactly the same borrowings as gotten here without paying the premium. Thus the true purpose of the Repo 105 was the balance sheet manipulation, specifically the reduction of the net asset component (the numerator) of the financial leverage calculation. There is no evidence of any other business purpose.
The result: Lehman wildly inflated the value of their company in the days before and after they issued their quarterly reports. In the Q4 of 2007 they had $39 billion of troubled assets using this technique, in the Q1 of 2008 they had $49 billion and finally in Q2 of 2008 $50 bililon dollars. It was the end of the next quarter when Citibank and JPMorgan called Lehman to pay up on all that money that the entire house of cards ultimately collapsed.
In the next chapter we discuss why the leverage plays such a crucial part in modern finance.
Never disclosing that they have to pay back 50 billion dollars they have borrowed for those assets.
The proceeds obtained from these "alleged" sales were used to pay down liabilities. Hence, on the quarterly financial reporting date, Lehman would show a balance sheet composed of less risky assets, less debt and possibly more cash. To outsiders, it appeared as if Lehman was less leveraged and in really great condition. This resulted in the appearance of healthy financial statements and the related healthy leverage ratios. Armed with healthy financial statements, Lehman would go out and obtain loans from financial institutions. However, the obligation to buy back the collateral remained with Lehman. Thus, immediately after the financial statements were issued, the company would use the cash obtained from the loans and buy back its original troubled assets at 105 percent of their value. This means that Lehman would pay a 5 percent interest rate rather than the industry norm of 2 percent (hence the classification by Lehman as Repo 105). After the repurchase of the troubled assets, Lehman's leverage would spike back up again and its balance sheet would be brought back to its true inferior position (less the 5 percent paid to repurchase their troubled assets).
Importance of Financial Leverage
To fully understand the cause of off-balance sheet device usage it is vital to explain the importance of financial leverage in the business cycle and the market dynamics beneath it.
From the accounting perspective, leverage is the measure of the proportion of loan capital, and other borrowings in total capital employed. An entity is considered to be highly leveraged where there is a greater proportion of debt within the capital employed, as compared with other companies, or industry average. The effect of leverage is that there is a potentially greater rewards, but also greater risk for the equity shareholders. This is because the loan capital will generally carry a fixed rate of return. Thus, if the return on capital employed is greater that the interest rate on loan capital the shareholders will obtain financial leverage with a greater rate of return. The proportion of debt to equity is of paramount interest to shareholders. Therefore, a major goal in Lehman's Repo 105 transactions was to show favourable financial leverage. A favourable financial leverage means that the company is earning a return on borrowed funds that exceed the cost of borrowing the funds.
The economic perspective gives an additional dimension to leverage. During the bull market, banks believe that the markets will continue to increase and that all of their competitors will be maximally leveraged to take advantage of the expected rise. If a bank decreases its leverage, it means it will lose money in the future (or lose opportunities with respect to competitors, since performance is relative to benchmarks and to the industry), so, guided by the practice of maximizing short-term profits by any means necessary, banks increase their leverage in order to get more return in the future.  How large they will increase their leverage depends on their expectation of the future market.
Leverage - measure of risk. In the bull market leverage multiplies profits, but in the bear market it multiplies the loss.
Investment banks have traditionally been highly leveraged and lowly capitalized institutions relative to other industries. However, the collapse of securitization market brought the danger of over-leveraging to light. Before the mid-2007 public, analysts and media were concerned with the profit and loss of the firm. Starting in midâ€2007, credit agencies began to more carefully scrutinize the leverage of investment banks.
One of the purposes of balance sheet management is credit rating upgrade. In a September 2007 eâ€mail comparing Lehman's net leverage ratio to Bear Stearns', Paolo Tonucci, Lehman's Global Treasurer, wrote that Lehman's net leverage calculation "was intended to reflect the methodology employed by S&P who were most interested and focused on leverage.
The reduction of financial leverage was crucial to maintaining the favourable credit ratings. The inability to forestall rating downgrade could have a direct monetary impact on Lehman. For example, A rating downgrade could also lead to higher cost of financing for Lehman through counterparties demanding to post more collateral.
Lehman real estate and mortgages portfolio was a primary obstacle to for the upgrade. It was argued by the media that Repo 105 is was used to temporarily remove these troubled assets from the Lehman balance sheet. However, it is important to note, that Lehman was not able to remove commercial and residential mortgage backed securities from its balance sheet using its Repo 105/108 programme. The effect of having sticky assets  (like commercial real estate and leveraged loans) was mitigated by the use of Repo 105 program. Removing more than $50.38 of liquid assets was enough to offset the $52.12 billion of illiquid real estate securities, which was a lead weight to a balance sheet.
The author strongly agrees with that sharp observation: At the top of a credit cycle, the income statement for a financial institution shows "the best of times", but buried in the balance sheet is "the worst of times" to come.  In the bull markets analysts are concerned with the income statements of the firm as its revenues, profit and loss entries show can the peak performance. In the bear markets it is the balance sheets that ultimately matter. Careful scrutiny of the quality of the company's assets and amount of capital will show if it is able to take the hit from the decrease of the market value of its assets.
In light of these dynamics, Lehman increasingly relied on its Repo 105 transactions at each publicly reported quarter in late 2007 and 2008 to affect the balance sheet.
However shadowy and evil these transactions do appear to the detached onlooker it is important to understand that it was a product of public consumption. Government regulators, rating agencies and Lehman managements reverse engineered leverage ratios for public consumption.
In the author's opinion it is interesting to draw a parallel between Lehman bankruptcy and sovereign debt crisis as both had the same cause - too much leverage. The crisis of 2006 was a problem of too much debt and leverage of the private sector, banks, financial institutions and corporates. Now is the result of the response to the crisis - fiscal stimulus, bailing out banks and other who had a massive surge in public debt and deficits. Now there is a risk of countries as opposed to individuals and investment banks like Lehman going belly up. Countries having sovereign risk and defaulting as already happened in Greece. And unfortunately when you have too much private and public debt it takes long time, up to a decade, to do deleveraging, which means to spend less to save more to reduce debts over time. That implies low economic growth, high unemployment rate and some degree of social and political instability and unhappiness. This slow economic growth or recession or a risk of default by government may stay with us for a number of years.
Mark to market accounting and the cost of deleveraging
Probably, the most important reason why off-balance sheet transactions are so widely used is mark to market accounting or fair value accounting. For Lehman selling the assets was not a viable option and off-balance sheet devices were employed. To understand why we need to look at the accounting side of the equation and specifically the role that mark-to-market accounting is playing
Fundamentally, under any balance sheet measurement system, changes in asset and liability values drive performance measurement. The current IASB definition of fair value as incorporated in its standards is "the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction". Market prices are most comprehensive method of identifying fair value.
Many of the losses the investment bank was taking came not from the actual realised losses from selling securities at a loss in financial markets but from the write downs in the value of assets they still actually hold. Accounting rules require that banks mark financial instruments to market or in other words carry them on their books and reflect any gain or loss in the value of these instruments in the tradable market as if it was the actual realised gain or loss even if the banks continues to hold the instrument.
This is the important point to understand for several reasons. In order for investment firms mark-to-market, there need to be an actual market where these instruments are trading. The problem now is that there been so many issues with mortgage-backed securities and other asset-backed securities and so many buyers have gone into trouble that no one wants to touch it. This creates a situation when the market is very illiquid or in other words there are very few buyers, so if a firm wants to sell these instruments it going to take a substantial hit in value. Lehman would have significant difficulty exiting its real estate/mortgage positions.
For this reason Lehman was trying to hold on to these instruments, hoping that order and liquidity would return to the market. And hoping when it does, these instruments would begin to trade at a price, which the investment bank feels more directly reflects their true value. The problem with this is many firms are got into trouble and had to sell these instruments even at distress prices, which all they would fetch because they needed to raise capital at almost any cost and when this happened it created a chain reaction throughout financial system as everyone else who held similar types of debt had to mark the value of that debt down to new level, taking a hit to their balance sheet as a result.
This is a big problem for two reasons. First, as the author has mentioned above, investment banks are required to hold a certain amount of capital on their books at all times to meet their reserve requirements. When they take write downs on the value of their positions this is the direct hit to their capital base, putting many of these banks in a positions, where they have to go out and raise additional capital to meet their reserve requirement. Secondly, these banks rely on the soundness of their balance sheet to borrow money at low interest rates and on a short term and fund their operations and fund their longer term investments, such as real estate developments. So when they write down the value of these instruments it is a direct hit to their balance sheet, putting them in a position when they have to go out and raise capital like Merrill Lynch and Citigroup did in 2008, when they had to sell off some of these instruments at distress prices further exacerbating the problem. Moreover, a fire sale could lead to a loss of confidence of valuation of the remaining assets of the firm.
In 2007 Richard Fuld, Lehman former CEO, stated that "Exiting large commercial mortgage-backed securities (CMBS) positions in Real Estate and sub-prime loans in Mortgages before quarter end would incur large losses due to the steep discounts that they would have to be offered at and carry substantial reputation risk in the marketâ€¦ A Repo 105 increase would help avoid this without negatively impacting our leverage ratios."
An early 2007 document from Lehman's archives concluding that "Repo 105 offers a low cost way to offset the balance sheet and leverage impact of current market conditions,"
A Repo 105 increase would help avoid this without negatively impacting our leverage ratios." While Lehman did not utilize Repo 105 transactions for selling sticky inventory, the firm's expanded use of Repo 105 transactions at quarterâ€end impacted Lehman's publicly reported net leverage ratio.
In order to reduce its leverage Lehman could decrease (net assets (the numerator) or increase the equity (denominator) in the net leverage calculation. Raising equity appeared not to be a viable option to the Lehman executives, possibly because of the signalling effect and it would not fix the problem of having illiquid assets. The sale of inventory comprised mostly of mortgages and loans would result to substantial losses to Lehman. Potential losses of moving $22 billion of illiquid assets would cost Lehman $750 million as for the time mid-2008.
In the reply to the analysts inquires about the means on how Lehman is reducing its leverage, CFO Callan told analysts that the company is reducing its leverage through the sale of less liquid assets. However, nothing was said about the use of Repo 105. The has to add, that the CFO was not honest when giving this answer, as we already know, selling the assets was not a viable option.
In the author opinion any time earlier in 2006 or 2007 deleveraging would not cost nearly as much as $750. It is the belief that the markets will change its course and inability to cut the losses that ultimately led to the worst outcome.
There are many arguments relating to how aggressive at marking illiquid assets to market we should be On the one side of the isle, supporting the efficient markets, is that we need to be even more aggressive that we have been. The argument on the other side of that is that if we are too aggressive than we are in danger in collapsing the whole financial system.
On October 1 2008, two weeks after Lehman filed for bankruptcy the U.S. Senate, as plan of its rescue plan, approved legislation that gave SEC the right to suspend mark-to-market accounting. The SEC ruled that if an active market does not exist for a security, it is permissible to rely on models. Of course it is questionable broker quote represent the fair economic value, but still reports based on observations are more truthful then the ones that are based on assumptions and predictions. The author can only guess which big financial institutions this political interference prevented from failing.
Misleading financial statements
As we saw from the discussions in the previous chapters leverage is important because measure of risk and is highly monitored investors, credit rating agencies and analysts. Inability to decrease the leverage can lead to a credit rating downgrade.
According to the Report, "Lehman's failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those "low" leverage numbers to investors as positive news, created a misleading portrayal of Lehman's true financial health." 
Under Lehman's definition of net leverage ratio, Lehman divided net assets by tangible equity. In the author opinion the Net Leverage is rather crude way of measuring leverage as it does not take into account quality of the assets, which in case of Lehman were illiquid mortgage backed securities.
The impact of the Repo 105 transactions allowed the firm to temporarily remove approximately $50 billion of bad assets from its balance sheet at the end of its first and second quarters of 2008. These amounts are extremely material and allowed Lehman to present a superior balance sheet to the public and appear to be extremely healthy at a time when the financial markets were extremely nervous. Anton R. Valukas, the bankruptcy examiner stated that Lehman's failure to disclose the use of (their) accounting device to significantly and temporarily lower their leverage, at the same time that it affirmatively represented those "low leverage" numbers to investors as positive news, created a misleading portrayal of Lehman's true financial health (Valukas, 2010).These deceitful window dressing practices deceived investors, creditors, and other interested parties and led to huge losses to these people who put their faith as well as their wealth in Lehman. These practices also ultimately led to the downfall of Lehman Brothers and huge losses to investors, creditors and others.
Adopted from the examiner report are four illustrations below . Assume a simplified balance sheet of Lehman at the end of reporting period:
Assets (in millions $)
Short Term Borrowings
Long Term Borrowings
(total assets divided by stockholders' equity)
(total assets - collaterized agreements) divided by stockholder equity
Return on assets
(operating income divided by total assets)
Ordinary repurchase agreements are accounted as
If Lehman executes a typical repurchase agreement, for example, at amount of $50,000 we will see an increase of both cash position and collaterized financing liabilities:
Assets (in millions $)
Short Term Borrowings
Long Term Borrowings
(total assets divided by stockholders' equity)
(total assets - colaterized agreements) divided by stockholder equity
Return on assets
(operating income divided by total assets)
Because the instruments remain on the balance sheet we see the increase in the leverage ratios and decrease in the returns on assets (not a good news for the investors. Assuming, the Lehman uses cash to pay down its liabilities the net effect would be neutral. We are back to where we started: cash will fall by $50,000 and liabilities will decrease by the same amount. Our key financial ratios will be the same as on Illustration 1.
Now comes the most interesting part. The recharacterization of a repo transaction from financing to a sale, pursuant to the SFAS 140 in effect at 2007-2008, leads the following consequences:
Even though transferor is required to repurchase the securities, the inventory is derecognized, i.e. removed from the balance sheet.
The obligation to repay the funds is not recorded in the liabilities part of the balance sheet. The "borrowing" is not recorded on the balance sheet, thus the liabilities part does not increase.
Total assets remain unchanged at the moment of transaction, because transferor receives cash funds in exchange of financial instruments
Illustration 3 shows the effect on the balance sheet:
Assets (in millions $)
Short Term Borrowings
Long Term Borrowings
Return on assets
At the time of transaction financial leverage is unaffected. As a last step, Lehman used borrowed funds to pay down its short-term liabilities. By doing so, Lehman was able to reduce leverage ratios and increase its return on assets, as in illustration 4 below:
Assets (in millions $)
Short Term Borrowings
Long Term Borrowings
Return on assets
Lehman leverage and financial health depended heavily on its Repo 105 practice.
When the Repo 105 matured, Lehman borrowed funds in to repay the borrowing and transferred the assets back to the securities inventory.  Total assets and liabilities increased accordingly.
It is obvious that these transactions had no economic substance as the same funding could have been obtained at the lower cost with the same counterparties. The examiner concludes that the motive for undertaking Repo 105 was to manage the balance sheet and to affect the publicly disclosed leverage. 
These leverage numbers
The Materiality of Lehman's Repo 105 Practice
Defining the materiality will allow the author to make confident conclusions. Accountants are to judge all aspects of transactions to decide whether to disclose information or not in the financial statements.
Preparation of financial statements requires a high degree of judgement. Materiality cannot be defined using strict numerical guidelines. No general definition of materiality can take into account a high degree of experienced human judgement. According to SFAS 2 "A decision not to disclose certain information may be made, say, because investors have no need for that kind of information (it is not relevant) or because the amounts involved are too small to make a difference (they are not material). â€¦.  Thus, materiality is a disclosure matter.
According to the SFAS paragraph 132 "The essence of the materiality concept is clear. The omission or misstatement of an item in a ï¬nancial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or inï¬‚uenced by the inclusion or correction of the item"
IASB puts emphasis on the term "relevance" instead. According to the IASB framework "Relevant financial information is capable of making a difference in the decisions made by users. Materiality is an entity-specific aspect of relevanceâ€¦"
U.S Supreme Court in TSC Industries defines materiality: "â€¦ material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote"  Lehman case reasserts the need to base materiality upon user's perspectives.
All definitions put emphasis on investment decision of a reasonable investor. As was discussed in previous chapters, inability to reduce leverage could result in a credit rating downgrade for the Lehman. In the author's opinion such information clearly makes a difference in decision making of investors.
According to the examiner report, Lehman's Repo 105 practice at quarterâ€end in late 2007 and for the first two quarters 2008 had a material impact on Lehman's publiclyâ€reported net leverage ratio - and Lehman management knew it.
A proof to it is a walkâ€through document related to Ernst & Young's 2007 fiscal yearâ€end audit of Lehman, which defines "materiality", as "any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion)."  It represents Lehman's determination of a "materiality threshold" in connection with Lehman's own criteria for when to consider reopening and adjusting the closed balance sheet.
Looking at the table below we can observe the ratios using Repo 105 and using correct accounting. As a result of its quarterâ€end Repo 105 practice from late 2007 through the second quarter 2008, Lehman publicly reported a net leverage ratio that was 1.7 to 1.9 points lower than what its net leverage ratio would have been if Lehman had used ordinary repo transactions instead of Repo 105 transactions. It is difficult to argue that the $50 billion transactions , even if broken down to many small amounts, are not material, as there was one purpose.
It is true that the case of Lehman emphasises that information is material if it could influence user's decisions. But it is not necessary to assert that the investors would acted differently if knew about the actual leverage ratio. However, we should not forget the possible credit rating downgrade had very tangible consequences. Author is strongly convinced that this is material information and had to properly disclosed in the notes to financial statements and to the filings to SEC. The reported ratios are false and give a misleading picture about Lehman financial position.
($ in Millions)
May 31, 2008
Feb 29, 2008
Nov 30, 2007
Aug 31, 2007
May 31, 2007
Feb 28, 2007
Nov 30, 2006
Repo 105/108 Usage
Net Leverage Ratio
If repos were used in place of repo 105s:
Net Leverage Ratio
Principles vs. Rules
Lehman use of Repo 105 opens a principles vs. rules discussion that compares U.S. Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS). Lehman entities around the world maintained their books using U.S. GAAP. The Repo 105 transactions were designed to meet the GAAP provisions for financial reporting as a sale. However, as David Tweedie, former chair of the International Accounting Standards Board observed, "International Financial Reporting Standards does not provide for so-called Repo 105 transactionsâ€¦We don't allow it. That's why we have principles, not rules, so you can't do it. They find ways to get around rules." 6 In fact,
Did Lehman violate Generally Accepted Accounting Principles?
This chapter will help to discuss the legal technicalities that enabled to recharactarize Repo 105 transaction as a true sale.
Despite the identical structure of ordinary repo, Repo 105 received a different accounting treatment: Lehman treated these transactions as "sales", which enabled to remove the securities inventory off balance sheet. Statements of Financial Accounting Standards (SFAS) No. 140 provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities.
Under the SFAs No. 140, paragraph 9 "A transfer of financial assets in which the transferor surrenders control over those assets is accounted for as a saleâ€¦" A transferor surrenders control over a transferred asset - and therefore may treat the transaction as a sale - only if:
The transferred assets have been isolated from the transferor-put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership.
Each transferee â€¦ has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its rig ht to pledge or exchange and provides more than a trivial benefit to the transferor.
The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call. 
Therefore, if repo transaction satisfies all three conditions the transferor is said to have surrendered control over the asset and SFAS 140 paragraph 98 permit the transaction to be accounted as a sale of the asset and forward purchase commitment.
SFAS 140.98 states: "If the criteria in paragraph 9 are metâ€¦ the transferor shall account for the repurchase agreement as a sale of financial assets and a forward repurchase commitment, and the transferee shall account for the agreement as a purchase of financial assets and a forward resale commitment."
Lehman decided that transactions met SFAS 140 criteria and accounted for them accordingly. The previous chapter had showed the immediate effect on the balance sheet as a result. Excerpt from the Lehman internal Accounting Policy for Repo 105 acknowledge typical repo transaction as "secured financing transactions" but Repo 105 "as sales of inventory and forward agreements to repurchase".
However, question on how Lehman was able to demonstrate that they have relinquished control of the transferred assets remains. A five per cent minimum haircut for repo 105 transaction was greater than the haircut in typical repo transactions. However this premium was essential to profit from the SFAS 140 accounting treatment.
Relevant discussion of control is contained in the paragraph 217 and 218 of SFAS 140: "to maintain effective control, the transferor must â€¦ reacquire securities that are identical to or substantially the same as those concurrently transferred." and "the transferor's right to repurchase is not assured unless it is protected by obtaining collateral sufficient to fund substantially all of the cost of purchasing identical replacement securities during the term of the contract"
Paragraph 218 of SFAS 140 further provided: Judgment is needed to interpret the term "substantially all" â€¦ that the terms of a repurchase agreement do not maintain effective "control" over the transferred asset.
However, arrangements to repurchase or lend readily obtainable securities, typically with as much as 98 per cent collateralization â€¦ or as little as 102 per cent overcollateralization â€¦, valued daily and adjusted up or down frequently for changes in the market price of the security transferred and with clear powers to use that collateral quickly in the event of default, typically fall clearly within that guideline. The Board believes that other collateral arrangements typically fall well outside that guideline."
In other words the criteria above would only be met only if the cost of the pledged security would be between 98 and 102 per cent. Repo 105 and Repo 108 refer to securities sold at minimum of 105 for equity and 108 per cent for fixed income respectively. These percentages fall outside the SFAS guidelines.
As Anton Valukas, the Examiner puts it: Specifically, if Lehman had the ability to "fund substantially all of the cost of purchasing the same or substantially the same replacement assets," Lehman would be "viewed as having the means to replace the assets" and was therefore "considered not to have relinquished control of the assets.
Thus, Lehman determined that because of the higher haircut they may not have enough cash to buy back the exact assets or similar assets. As we know they received only $100 for something worth $105. Lehman posted more collateral in order achieve off-balance sheet treatment. It is important to note that there is no rule that allows 105 per cent overcollateralization to be qualified as a "sale". The 98 and 102 per cent guideline was a loophole on which Lehman not failed to capitalize upon.
As noted in a letter from Robert H. Herz (then FASB Chairman) to the House Financial Services Committee, (Re: Discussion of Selected Accounting Guidance Relevant to Lehman Accounting Policies, April 19, 2010):
It appears that Lehman structured the transactions in an attempt to support a conclusion that there was inadequate cash collateral to ensure the repurchase of the securities in the event of a default by the counterparty, and, on that basis, Lehman determined that sale accounting was appropriate.
Now FASB Update 2011-03 specifically marks out the controversial 98 and 102 per cent guidelines for treatment for repo agreements. It may be argued by principal-based standard supported that rule-based standards open too many loophole to be exploited. The author does not agree with that opinion as the rationale behind this rather arbitrary guideline remains unknown. Is it just a typical arrangement example? Why exactly 102 per cent?
In the author opinion it is the contractual obligations and not the value of collateral that must dictate the waiver of control. Transaction also lacked any business purpose as was argued in the previous chapters. However, author doubts that these allegations are sufficient to violate SFAS. If litigation is under rule-based system such as GAAP, it may be difficult for a plaintiff to prove that the violation of the abovementioned principles. It is well-documented legal technicality which is likely to prevail.
More to add, as the later chapter will show it is increasingly hard to support a claim which is based only on principles-based standards.
A major standard was introduced in UK accounting FRS 5 - 'Reporting the substance of transactions', which dealt with Sale and repurchase agreements, Sale and leasebacks, Factoring of receivables, Consignment inventory, etc. These types of transactions and agreements were often used to try and show improved performance with a higher Rate on capital employed ROCE, together with keeping debt off the balance sheet to show lower 'gearing', and therefore lower risk, resulting in lower cost of borrowings. There is no specific standard yet in international financial reporting standards, but there is a general requirement to reflect the commercial substance of transactions even where this conflicts with the legal form.
Linklaters True Sale Opinion Letter
In addition to the required overcollateralization, Lehman had to make an additional steps to qualify for a "sale". To achieve a "true sale" treatment under SFAS 140 assets needs to be isolated - put beyond the reach of transferor and its creditors in the event of default of the transferor. To meet this requirement a transferor must obtain a true sale opinion letter.
Under the United States case law the treatment of repurchase agreement varies and there is a risk that the transferor's creditors may have a claim on the collateral. Lawyers in the U.S. could not provide Lehman with the required opinion letter. Under English law there is apparently much less uncertainty about the how transfer would be viewed by the court in the event of insolvency of the transferor. Lehman was able to get the "true sale" legal opinion from the Linklaters firm based in London.. Nothing calls into question, that the transactions, were, in fact, a true sale under UK law. The law firm provided a letter for exclusive benefit of the LBIE without any reference to GAAP or SFAS 140
Conducting transaction through its London affiliate LBIE was the result of its inability to obtain a true sale opinion letter from the U.S. law firm. In the author's opinion Linklaters failed to identify who was the true beneficiary of the transaction, as the significant amount of the transactions was conducted for the benefit of the U.S. ba