For readers who did not follow the run-up to the crisis closely, one of the heated debates was over “how sick is Lehman?” We were of the “very sick” persuasion because Lehman was making large mis-marks on assets that outside parties could see, such as greatly exaggerating the worth of garbage barge commercial real estate investments in exurban California (SunCal and Archstone). A general rule is if you need to cook your books, do it in such as way as to be difficult to detect. Lehman had so many position that would not be readily observed by third parties that it could fudge that it clearly had to be desperate if it also needed to tart up valuations that could be checked.
After the crisis, a very large “pretty it up” technique of Lehman’s was exposed, the so-called Repo 105. As we wrote in 2010:
Quite a few observers, including this blogger, have been stunned and frustrated at the refusal to investigate what was almost certain accounting fraud at Lehman….. Indeed, it was such common knowledge in the Lehman flailing about period that Lehman’s accounts were sus that Hank Paulson’s recent book mentions repeatedly that Lehman’s valuations were phony as if it were no big deal.
Well, it is folks, as a newly-released examiner’s report by Anton Valukas in connection with the Lehman bankruptcy makes clear. The unraveling isn’t merely implicating Fuld and his recent succession of CFOs, or its accounting firm, Ernst & Young, as might be expected. It also emerges that the NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations….
The key revelation is that Lehman as of late 2007 was routinely using repo transactions at the end of the quarter to mask how levered it truly was:
Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.2850 Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851 Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.
Yves here. The stunning bit is these “repos” were actually a conventional type of repo, despite the name, but Lehman was engaging in blatant misreporting, treating these “repos” (in which a bank still shows them on its balance sheet as sold with the obligation to repurchase) as sales. Note that at the time (as the report notes) analysts and others kept probing at the seeming miracle of Lehman’s deleveraging in a difficult market.
Fast forward to the new revelations via the Financial Times:
Foreign banks operating in the US short-term debt markets are “window-dressing” their accounts, routinely cutting about $170bn of balances at the end of each quarter to appear safer and more profitable, says a new study.
The study from the Washington, DC-based Office of Financial Research describes a pattern of behaviour that has prevailed since July 2008, and suggests that the banks are carrying more risk than their investors or customers can easily see.
The study examines the vast market for repurchase agreements, or “repos,” where banks lend out assets in return for short-term financing. It finds that dealers sell heavily to customers in the last days of the quarter, and immediately buy assets back once the new quarter starts…
Analysts said the behaviour outlined in the study has shades of the notorious “Repo 105” trades that Lehman Brothers used to bring down its reported leverage in the quarters leading up to its collapse. In that programme, the broker accepted a relatively high 5 per cent fee in order to count its repo transactions as true sales, even though it remained under a contractual obligation to buy the assets back.
Joshua Ronen, a professor of accounting at New York University’s Stern School of Business said the OFR’s study — which did not cite individual banks by name — showed that lenders with the lowest capital ratios were making the biggest quarter-end reductions.
Sports fans, that list is sure to include Deutsche Bank, which is the worst capitalized of the major banks, and separately, as the Financial Times pointed out, is also a major dealer in repo. The article points out that banks are required to provide more transparent repo reporting by 2018 but some counterparties may still be surprised. Gee, does that mean that the officialdom anticipates that the abusers of repo won’t be able to get their balance sheet houses in order by then?
Even worse is that balance sheet reporting problems are almost always symptoms of bigger issues. For instance, as law professor and derivatives expert Frank Partnoy warned in 2010:
The Repo 105 section of the Lehman report shows that Lehman’s balance sheet was fiction. That was bad. The Valuation section shows that Lehman’s approach to valuing assets and liabilities was seriously flawed. That is worse. For a levered trading firm, to not understand your economic position is to sign your own death warrant.
We’ve seen with Deutsche Bank that not only are they the most seriously leveraged major dealer bank, but their risk control metrics have been sorely wanting. For instance, Deutsche’s failure to model the cost of a gap option on the biggest trade in its derivatives book led it to overstate its Tier One more than €8 billion during the crisis. Marking it properly would have also put the bank’s capital below the 8% minimum required by German regulators. And as a result of the understating of the risks of this trade, the Canadian commercial paper market needed to be bailed out (no, I am not making this up, I’m merely giving you the short version. Of this so-called “leveraged super senior” or “LSS” trade:
The LSS trade, if properly modeled and accounted for, would never have been done in the volume that it was and Canadian investors would have been spared at least some of the disruption and losses that they suffered. But the traders and their managers were able to pull out more in bonuses by booking the trade in a way that exaggerated its profits. This is looting, pure and simple. Tough accounting and controls won’t catch all bad or sloppy behavior, but it would have stopped this trade, and you can be sure it would have prevented others.
There is good reason to be concerned about Deutsche’s accounting. Consider the warnings issued by the New York Fed. From the Financial Times in March:
The German bank’s attempts to improve its regulatory reporting structure suffered a blow after a private letter from the New York Federal Reserve leaked last year accusing the bank of having “low quality, inaccurate and unreliable” reporting.
The Fed said it “identified numerous and significant deficiencies across Deutsche Bank Trust Corporation’s risk-identification, measurement, and aggregation processes; approaches to loss and revenue projection; and internal controls”.
The US central bank examined only a small part of Deutsche’s US operations — Deutsche Bank Trust Corp — which has a $62bn balance sheet and houses its wealth management and transaction banking operations.
The German bank’s much bigger broker-dealer operations are housed in Deutsche Bank Securities Inc, which is due to be included in the Fed stress tests from 2018.
What is disconcerting is that the problems at Deutsche may well extend to the critically important trading operations. A colleague who worked from them more than a decade ago in a financial control function has said privately how poor their systems were. He was recently approached about working for them again and was told, “You know how it works here. Nothing has changed.” Given Deutsche’s political and financial standing in Germany, the odds do not favor tough enough questions being asked about the state of the giant bank’s books and risk management.