Lehman Brothers’ Accounting Magic – Deleveraging and Moral Hazard

Author: 
Professor AJ Kreimer
Published Date: 
12 Jul 2012

As Wall Street’s problems were reaching a crescendo during 2007 and 2008, Lehman Brothers, a prominent New York based investment bank, faced a continuing drain on its cash and reserves. Its debt laden balance sheet, coupled with illiquid assets with uncertain valuations, constrained its ability to borrow or raise new capital. Lehman needed to convince its lenders, investors, and government regulators that its position was not as dire as the rumors on the Street suggested.

How then, could they make their quarterly 10Q reports appear to show deleveraging of their balance sheet, thereby enhancing critical ratios, and allay the solvency fears circulating on Wall Street? If they could manage to put lipstick on the pig, government regulators, analysts and investors would relax – and perhaps the shorts (speculators driving down the stock price by “shorting” Lehman’s stock) would retreat.

To solve the initial problem of raising cash, Lehman, as well as other investment banks, frequently employed the use of repurchase agreements, or repos. A common tool in the industry, repos, allows banks and other entities to raise cash quickly for short periods of time. The transaction is relatively straight forward. The borrower pledges collateral (securities, bonds, etc.) equal to the amount of cash that will be borrowed from the counter party, typically a bank or other entity with excess cash on hand. The lender receives a fee plus interest on the funds while they’re outstanding. When the transaction is unwound, the lender receives its funds and releases the hold on the collateral…

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