Lehman Brothers 2008: Trust, Accounting Tricks, and the Collapse

Why the Lehman case matters for small businesses too

An investment bank with a balance sheet of hundreds of billions of dollars seems far from the everyday life of a trade business. The mechanics behind it are not. Lehman depended on lenders being willing to extend credit anew every day. Every business with an overdraft, supplier credit, or factoring knows this dependence on a small scale.

This article therefore asks: How were trust, an accounting trick, and the collapse connected at Lehman, and what follows for a business that depends on short-term financing? To answer it, we first describe the documented facts, then explain leverage as a thinking model, look more closely at Repo 105, weigh two readings, and derive a test for your own business.

What happened at Lehman: the documented facts

Lehman Brothers was one of the major investment banks on Wall Street. According to the report of bankruptcy examiner Anton Valukas, analyzed by Caplan, Dutta, and Marcinko (2012), the bank changed its strategy from 2006. Instead of holding securities only briefly and passing them on, it committed long-term to commercial real estate, leveraged loans, and illiquid private equity. These holdings grew from 87 billion dollars in 2006 to 175 billion dollars at the end of the first quarter of 2008. A senior executive named revenue growth of 13 percent as the target.

1. 2007: record year

   Lehman reports a profit of over 4 billion dollars. At the start of 2008, the bank is worth over 30 billion dollars on the stock market.

2. Late 2007 to mid-2008: Repo 105

   At quarter-ends, Lehman books short-term loans as sales of securities, lowering its reported debt. In the second quarter of 2008, this affects around 50 billion dollars.

3. May and June 2008: a warning

   Manager Matthew Lee writes to senior management and contacts the auditors. He considers the accounting for Repo 105 improper. According to the Valukas report, the audit committee does not learn of it from the auditors.

4. September 15, 2008: insolvency

   After takeover talks fail and lenders withdraw, Lehman files for bankruptcy protection. It is the largest corporate insolvency in US history.

5. March 2010: the report

   Valukas presents a report of around 2,200 pages. He calls Repo 105 balance sheet manipulation and sees possible claims against former executives and against the auditor Ernst & Young.

According to press reports, no one was criminally charged. Following an internal memo that became known in 2012, the staff of the Securities and Exchange Commission (SEC) did not recommend charges, partly because intent to deceive would have been hard to prove. Former CEO Richard Fuld has always denied knowing about Repo 105. The assessments in the Valukas report are findings of an examiner in bankruptcy proceedings, not court judgments.

The thinking model: leverage and the thin cushion

Leverage describes how many assets a company holds per euro of equity. Leverage of 10 means 10 euros of assets, of which 1 euro is own money and 9 euros borrowed. Leverage magnifies profits, because equity receives the entire increase in value. It magnifies losses just as much. If the value of the assets falls by the share of equity, the equity is used up.

With the figures from Caplan, Dutta, and Marcinko (2012), Lehman's leverage at the end of 2007 was around 28: 700 billion dollars in assets on 25 billion in equity. A loss in value of about 3.6 percent would have consumed all of the equity.

An everyday analogy: imagine someone buys a house for 700,000 euros with 25,000 euros of equity and has to renew the loan every night with a new bank. As long as house prices rise and the banks play along, it works. If the price falls slightly or one bank has doubts, they are insolvent the next morning. According to the Valukas report, Lehman borrowed tens of billions of dollars every day.

High leverage does not make losses larger; it shortens the time in which you can explain them.

Repo 105: how a loan became a sale

A repo, short for repurchase agreement, is a short-term loan against collateral. The bank hands over securities, receives money, and commits to buying the securities back a few days later at a fixed price. On the balance sheet, it remains a loan: the securities stay as assets, and the money appears as a liability.

With Repo 105, Lehman gave securities worth 105 dollars for 100 dollars of cash. Because of this overcollateralization, the bank treated the transaction as a sale under its interpretation of the US standard SFAS 140. This was supported by a legal opinion from a British law firm under English law, because, according to reports, no US law firm could be found to confirm it. With the money, Lehman paid down other debt at quarter-end. A few days after the balance sheet date, it repurchased the securities and took on the debt again.

According to the Valukas report, Lehman used Repo 105 for around 50 billion dollars in the second quarter of 2008. As a result, the reported net leverage ratio was 12.1 instead of 13.9. In their analyses, Jeffers (2011) and Hines, Kreuze, and Langsam (2011) arrive at the same core: the transactions were material but were disclosed neither in the notes nor in filings with the SEC. No economic purpose other than the nicer ratio could be identified.

The auditor and the whistleblower

Lehman's auditor was Ernst & Young. According to the Valukas report, the auditors knew about Repo 105 and questioned neither its use nor the lack of disclosure. When Matthew Lee raised his concerns, according to the report they did not inform the audit committee, although it had explicitly asked about such warnings. Ernst & Young has rejected the allegations and stated that it had only reviewed, not audited, the interim statements for the first and second quarters of 2008.

The New York Attorney General sued Ernst & Young in December 2010. The firm paid 99 million dollars in a 2013 settlement with investors and 10 million dollars in a 2015 settlement with the State of New York, in each case without admitting wrongdoing. How vulnerable the relationship between auditor and audited is described in How independent are auditors?.

The case shows how valuable an internal warning can be and how easily it fizzles out when nobody is obliged to pass it on. The duties that apply to businesses today are discussed in Whistleblower protection.

How trust disappeared: the run on the repo market

The collapse is explained not by the accounting trick but by the financing. Gorton and Metrick (2012) describe the crisis of 2007 and 2008 as a run on the repo market. Lenders who provided short-term credit against collateral increasingly doubted the solvency of banks and the value of the collateral. They demanded larger haircuts, that is, more collateral for the same loan. With falling values and rising haircuts, the US banking system was, according to their analysis, effectively insolvent for the first time since the Great Depression.

For Lehman, this meant that the same lenders who rolled over billions every day could stop on any given day. It is the same logic as the bank run according to Diamond and Dybvig, which Silicon Valley Bank 2023 describes using deposits as the example. At Lehman, it was not savers who withdrew, but professional lenders, and they withdrew faster because they watched the situation more closely.

Two readings: cause or symptom?

What role did Repo 105 play in the collapse? The answer differs depending on whether one looks at the balance sheet or at the market.

Hines, Kreuze, and Langsam (2011) take the first reading: the accounting may have disguised the real problems long enough for bankruptcy to become the only option. The work of Gorton and Metrick (2012) supports the second: the pressure came from a market that distrusted the entire system. I consider the second reading the better explanation of the collapse and the first the more important lesson. Repo 105 did not bring Lehman down. But it bought time in which capital could have been raised or risk reduced, and it destroyed the trust that was missing in the end. Where the line between structuring and deception runs is discussed in Earnings management and accounting fraud.

Caplan, Dutta, and Marcinko (2012) highlight a further question: whether detailed rules that can be followed to the letter protect less well than principles that ask about economic substance. The case argues for principles. A sale that is reversed after a few days is economically a loan.

The balance sheet date test for your business

Small businesses know their own form of balance sheet date grooming: issuing invoices in December, paying suppliers only in January, briefly paying down the overdraft at year-end. Much of this is permissible. From the Lehman case, I nevertheless derive a test that I call the balance sheet date test.

1. Average instead of the reporting date

   Compare cash, liabilities, and inventory at the balance sheet date with the annual average. Large deviations show how far the financial statements reflect everyday reality.

2. Terms against commitments

   Check whether long-term assets are also financed long-term. Financing machines and inventory through the overdraft is a small Lehman risk.

3. Count your lenders

   List who gives you money at short notice: bank, suppliers, factoring, customers with deposits. Ask what happens if one of them stops in a single day.

4. Take warnings seriously

   Decide where employees can report concerns about figures and who reviews them. A warning that only reaches the person concerned is no warning.

How growth ties up liquidity is described in Growth costs liquidity. How banks read balance sheet date figures is shown in How banks decide on loans.

Conclusion: accounting tricks buy time, not trust

To the guiding question: Lehman collapsed because a highly leveraged bank financed long-term, illiquid holdings with loans that had to be rolled over every day. When lenders lost trust, a thin cushion was no longer enough. Repo 105 made this situation look smaller at quarter-ends. It was not the cause, but it extended the time in which nobody saw the true leverage, and it destroyed trust as soon as it became known. No one was criminally charged.

For a business, the conclusion is simple: trust rests on figures that are also right on an ordinary day. Whoever grooms them only for the reporting date shifts the problem to the day someone looks more closely.

• Compare cash and liabilities at the last balance sheet date with the annual average.
• For every major investment, check whether the financing runs as long as the commitment.
• List all short-term lenders and record a plan for the loss of the largest one.
• Set up a fixed channel for warnings about figures and processes.