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REV: DECEMBER 10, 2013
Lehman Brothers and Repo 105
A Whistleblower’s Story
In May 2008, Matthew Lee, employed by Lehman Brothers Holdings, Inc. (Lehman) for the past
fourteen years, read once again from his employer’s Code of Ethics:
If an individual engages in or becomes aware of any conduct or activity that may violate
the Code of Ethics or an applicable law or regulation, it is that individual’s
responsibility to promptly report the matter by notifying his or her immediate supervisor or
divisional Human Resources Director, or an appropriate representative of Legal, Compliance
or Internal Audit. . . . No individual will be subject to retaliation of any kind (or threat of
retaliation) for reporting in good faith any ethical concerns, suspected securities law
violations or other suspected misconduct. Any individual who believes that he or she
has been retaliated against (or threatened or harassed) in violation of this policy should
immediately report the matter to his or her immediate supervisor, divisional Human
Resources Director, or an appropriate representative of Legal, Compliance or Internal Audit.1
Lee was now a senior vice president in the finance division, overseeing balance sheet accounting
across the more than one thousand legal entities worldwide that constituted Lehman. He had meant
to write this letter for a while, but had not been fully convinced until then that it was the right thing
to do. However, a recent meeting with his lawyer persuaded him that it was his duty to report on
what he knew. He thus started to type:
I have become aware of certain conduct and practices . . . that I feel compelled to bring to
your attention, as required by the Firm’s Code of Ethics, as Amended February 17, 2004 (the
“Code”). . . . In the course of performing my duties for the Firm, I have reason to believe that
certain conduct on the part of senior management of the Firm may be in violation of the Code.
The following is a summary of the conduct I believe may violate the Code and which I feel
compelled, by the terms of the Code, to bring to your attention.
Professors Anette Mikes and Gwen Yu and Research Associate Dominique Hamel prepared this case with the assistance of Teaching Fellow
Matthew Packard. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of
primary data, or illustrations of effective or ineffective management.
Copyright © 2011, 2013 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-5457685, write Harvard Business School Publishing, Boston, MA 02163, or go to This publication may not be
digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
This document is authorized for use only by Mohammed Almanqari ([email protected]). Copying or posting is an infringement of copyright. Please contact
[email protected] or 800-988-0886 for additional copies.
Lehman Brothers and Repo 105
1. Senior Firm management manages its balance sheet assets on a daily basis. On the last
day of each month, the books and records of the Firm contain approximately five (5) billion
dollars of net assets in excess of what is managed on the last day of the month. I believe this
pattern indicates that the Firm’s senior management is not in sufficient control of its assets to
be able to establish that its financial statements are presented to the public and governmental
agencies in a “full, fair accurate and timely manner.” (see Exhibit 1 for the full letter).
Approximately two weeks later, Lee was called into his supervisor’s office and summarily told he
was dismissed as part of a broader downsizing program.2 There was no other reason given. Lee
contested his firing, but later accepted a severance package that included a confidentiality clause
prohibiting him to talk further about his allegations. Lehman went bankrupt in September 2008 and
he never received the full amount of the package.
Commenting on Lee’s letter in 2010, Lehman Brothers’ former auditor Ernst & Young (E&Y)
Lehman conducted an investigation of the allegations in the employee’s May 2008 letter. In
July 2008, Lehman’s management reported to the Audit Committee and concluded the
allegations were unfounded and there were no material issues identified. We never concluded
our review of the matter, because Lehman went into bankruptcy before we completed our
The Rise and Fall of Lehman Brothers
Founded in 1850, Lehman was one of the oldest and most profitable investment banks on Wall
Street. Sold to Shearson/American Express in 1984, it was spun off in 1994 through an initial public
offering. To lead this new stand-alone public firm, Richard S. Fuld Jr., a Lehman trader since 1969,
was named chairman and CEO.
While Lehman’s historical strength was in underwriting and trading fixed income securities, the
firm decided to diversify its revenue sources. Lehman was reacting to investors’ worries that the firm
was over-exposed to fixed income markets. Consequently, the proportion of Lehman’s revenues
derived from its fixed income activities slid from 55% in 1995 to 39% in 2007, with an increasing
proportion of revenues coming from its equity and advisory businesses.a In mid 2000s, Lehman also
made a deliberate decision to pursue a higher growth strategy and switched from the low-risk
brokerage model to a higher-risk banking model.4 Lehman’s balance sheet transformed from merely
“transferring” assets to third-parties to “holding” them on their own balance sheet. As a consequence,
Lehman started internalizing the various risks it took on the company’s balance sheet.
Lehman took on increasing leverage during the 2000s. While Lehman’s assets increased by about
$300 billion between 2004 and 2007, equity rose by a mere $6 billion during the same period.5 Shawn
Tully, senior editor-at-large of Fortune, explained the rationale behind this strategy: “The game Wall
Street played relied on leveraging up the cash provided by shareholders to enormous levels and
a For more information, see “Before the Fall: Lehman Brothers 2008,” HBS Case No. 309-093 (Boston: Harvard Business School
Publishing, 2009).
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Lehman Brothers and Repo 105
using all the debt to accumulate a giant portfolio of securities. As long as interest rates trend
downward, the value of that portfolio swells, yielding gigantic returns on a slim equity base.”6
Lehman, following other Wall Street peers, had expanded increasingly in riskier activities, such as
the packaging and trading of exotic types of mortgage-backed securities. These high-margin products
helped Lehman to post record profits ($4.2 billion) and revenues ($19.3 billion) in 2007.7 Fuld
emphasized that Lehman had a core competence in dealing with these risky products: “Smart risk
management is never putting yourself in a position where you can’t live to fight another day.”8
As Lehman had no access to a stable base of retail deposits, it relied instead on constantly
refinanced short-term loans. It was therefore vital for the company to maintain investor confidence:
bad news alarming Lehman creditors could jeopardize the short-term financing of the firm. Lehman
knew how dangerous such a financing model could be: in 1998, the company suffered greatly
following rumors about Lehman’s insolvency in the wake of the near-collapse of the hedge fund
Long Term Capital Management. Fuld’s successful management of the investors’ confidence crisis at
that time was seen by many as the defining moment in his career at Lehman.9
However, investor confidence was shaken immensely in March 2008 when another highlyleveraged firm, Bear Stearns, collapsed. While analysts and rating agencies had been increasingly
worried about investment banks’ leverage positions since mid-2007, it then became urgent for most
Wall Street firms, Lehman included, to calm the markets by conveying reassuring news about their
leverage ratios.
Erin Callan, then Lehman CFO, said at that time that Lehman was fighting “hand-to-hand
combat” to fend off rumors and concerns about its liquidity.10 She had reassured investors about
Lehman’s leverage on March 18, 2008, during the first quarter earnings call:
We did, very deliberately, take leverage down for the quarter. We ended with a net
leverage ratio of 15.4 times down from 16.1 at year end [see Exhibit 2]. And we will continue to
allocate capital on the balance sheet in the market in a way that we consider prudent, and that
reflects the liquidity profile of the balance sheet.11
Citing market conditions and possible forthcoming losses, on June 2, 2008, Standard & Poor’s
downgraded Lehman’s credit ratings from A+ to A, however, on a positive note, it praised Lehman’s
“strong funding/liquidity profile.”
Less than a week later, Lehman pre-announced its first ever quarterly loss as a public company,
$2.8 billion. The firm appointed a new CFO and announced that it would issue $6 billion in stock, its
third capital raise since the beginning of the year. New CFO Ian Lowitt reiterated the focus on
reducing leverage in the subsequent earnings call, on June 16, 2008: “As a result, we reduced our
gross leverage from 31.7 times to 24.3 times at May 31, and we reduced net leverage from 15.4 times
to 12 times. … I think we feel the appropriate leverage for us to operate is in the low double digits at
the moment. … We’re going to operate conservatively.”12
However, this strategy did not reassure everyone. David Einhorn, a hedge fund manager, had
started to short Lehman’s shares in July 2007, and encouraged investors to do the same. He was
particularly critical of Lehman’s leverage, and mistrusted its publicly stated ratios: “The problem is
the overall leverage and loan portfolio . . . they are 40 times levered on tangible equity, and they own
This document is authorized for use only by Mohammed Almanqari ([email protected]). Copying or posting is an infringement of copyright. Please contact
[email protected] or 800-988-0886 for additional copies.
Lehman Brothers and Repo 105
things that don’t strike me as being the kinds of things that should be levered at all.”13 While some
analysts downplayed Einhorn’s claims, the fact remained: by June 2008, Lehman was the Wall Street
investment bank with the highest level of shares sold short.
Over the summer, Moody’s lowered its outlook for the firm to negative, citing additional mark-tomarket losses, mortgage exposures and potential franchise erosion. On the plus side, it noted that
“Lehman ha[d] been proactive in its efforts at bolstering capital and de-leveraging its balance sheet”
and that “Lehman’s liquidity management and stand-alone liquidity position remain[ed] sound.”14
In August, Lehman laid off 1,500 employees, 6% of its workforce, as analysts anticipated another
quarterly loss. Wall Street was anxious: in the first eight months of 2008, Lehman’s shares had lost
73% of their value.15
On September 10, 2008, Lehman announced a second quarterly loss of $3.9 billion, along with its
intent to sell off most of its investment-management business. Fitch Ratings placed Lehman’s ratings
on Rating Watch Negative, citing heightened pressures that had adversely impacted Lehman’s
financial flexibility and its ability to raise capital.
Three days later, then President of the Federal Reserve Bank of New York Timothy F. Geithner,
convened Wall Street bankers for a meeting on the future of Lehman, in which he made it clear that
the government would not bail out the firm. Many plans were drawn up during that weekend as to
which (or whether any) financial firm would accept to buy Lehman without government backing.16
There was no taker. Lehman filed for bankruptcy under Chapter 11 of the Bankruptcy Code on
September 15, 2008, citing “significant liquidity problems.”17 With over $600 billion in assets,
Lehman’s was the largest bankruptcy filing in American history.18
Repo 105 Transactions and Balance Sheet Management
Accounting for Repo Transactions
Lehman, like its Wall Street peers, frequently used repurchase agreements (“Repos”) as a vehicle
to provide liquidity, and to finance its short-term borrowings. Repos were a fast growing source of
financing and commonly used by many banks and financial institutions. In 2007, the repo market had
doubled its size since 2002, with gross amounts outstanding of roughly $11 trillion in the US and
Standard repo transactions were completed in two steps. Lehman would first borrow cash using
assets on its own balance sheet as collateral. The value of the collateralized asset equals the original
borrowed amount plus the haircut (i.e., 2% for repo 102 transactions). Subsequently, as Lehman
repaid the cash it would then repossess the collateralized asset and pay the lender the originally
borrowed amount plus interest.
Accounting for a typical repurchase agreement was straightforward. At the inception of the loan,
the borrowing bank recorded a short-term liability for the cash received. When the loan was repaid,
the liability would disappear and an interest expense recorded for the amount paid in excess of the
initial borrowed amount. The collateralized assets remained on the bank’s balance sheet often with
footnote disclosures noting the collateralized amount. Such an accounting treatment effectively
This document is authorized for use only by Mohammed Almanqari ([email protected]). Copying or posting is an infringement of copyright. Please contact
[email protected] or 800-988-0886 for additional copies.
Lehman Brothers and Repo 105
considered the repo transaction as a financing activity, thereby recognizing both the increase in cash
as well as the liabilities from entering a repurchase agreement.
SFAS 140 governed the accounting for “transfers and servicing of financial assets,” such as the
repurchase transactions and similar financing transactions and asset transfers. In certain
circumstances, the transfer would qualify as a sale, as opposed to a financing activity. The “control”
criterion determined a transfer of an asset as a sale, or not. SFAS 140 indicated that when the
collateralization was between 98% and 102%, a repo borrower maintained effective control over the
collateralized assets and consequently the transaction could not be considered as a sale. SFAS 140,
however, stated three conditions (which amounted to surrender of control) under which a sale could
be recorded, but also noted that it was very rare that repurchase commitments were considered as
such (see Exhibit 3).
Lehman’s Interpretation of SFAS 140 and Repo 105 Transactions
Lehman had created a new type of repo transaction which allowed the firm to consider the
transaction as a sale. Lehman, by taking higher haircuts of 5 or 8% (the haircut of a typical repo
transaction was 2%), justified the transaction as a sale in accordance with its interpretation of SFAS
140. Lehman’s rationale was that a higher haircut established a surrender of control over the asset.
Considering the transfers as sales implied that at the inception of borrowing, Lehman, would
record (apart from an increase in cash) a reduction in the collateralized assets, equivalent to the
borrowed amount plus the haircut. The difference between the cash received and the transferred
asset value (the haircut) was recorded as an option to repurchase (an asset account). Since the total
assets remained unchanged, the transfer of assets by itself did not have a large effect on Lehman’s
leverage ratio.
Lehman would then use the cash proceeds from the Repo transaction to pay down other liabilities,
thereby reducing the total liabilities on its balance sheet. Equity remained unchanged which implied
lower leverage ratios (see Exhibit 4). Lehman was able to reduce its net balance sheet through its
Repo 105 practice by more than $138 billion between the fourth quarter of 2007 and the end of the
second quarter of 2008. Lehman regularly increased its use of Repo 105 transactions in the days prior
to reporting periods which reduced its net leverage (see Exhibit 5).20,b
Lehman never publicly disclosed its use of Repo 105 transactions, and its accounting treatment for
these transactions. In its financial statements, Lehman accounted for the Repo 105 transactions as
derivatives but added them to the larger group of more “traditional” derivatives, presented in a
footnote. Faced only with the total value of Lehman’s derivatives, readers were thus unable to know
that Lehman had engaged in Repo 105 transactions. Moreover, there was no indication in the
Lehman’s definition of net leverage was net assets over tangible equity. Net assets were defined as
total assets excluding (1) cash and securities segregated and on deposit for regulatory and other
purposes; (2) securities received as collateral; (3) securities purchased under agreement to resell; (4)
securities borrowed; and (5) identifiable intangible assets and goodwill. Lehman calculated tangible
equity capital as stockholder’s equity and junior subordinated notes less identifiable intangible asset
and goodwill. (Report of Anton R. Valukas, Examiner on Lehman Brothers Holdings Inc. Chapter 11
Proceedings, p. 805).
This document is authorized for use only by Mohammed Almanqari ([email protected]). Copying or posting is an infringement of copyright. Please contact
[email protected] or 800-988-0886 for additional copies.
Lehman Brothers and Repo 105
financial statements that Lehman had the obligation to repurchase securities worth tens of billions of
dollars on a short-term basis.
“An Important Ratio”
Starting mid-2007, market participants began to scrutinize more carefully the leverage of
investment banks, and their focus moved from revenue to balance sheets. In fact, according to a
Lehman insider, Lehman’s chief risk officer Madelyn Antoncic, who was responsible for setting
trading limits did, in late 2006, advise “caution, pullback, and extra study” at meetings of the
executive committee during the discussion of deal proposals.21 However, in 2007, she was sidelined:
“whenever there were tense issues involving risk being aired in front of the executive committee”,
CEO Fuld asked her to leave the room together with the deal team.22 All the while, top Lehman
executives pressured the firm’s businesses to reduce the net leverage ratio of the firm by selling assets
in order to meet market expectations and avoid a ratings downgrade. It is against this backdrop that
Lehman’s traders significantly increased the quarter-end use of Repo 105 transactions.
In March 2008, Fuld appointed Bart McDade, a Lehman veteran, as “balance sheet czar” to further
emphasize the importance of de-leveraging. McDade wanted Lehman’s traders to exercise more
discipline with respect to Repo 105 transactions, and in an email declared Repo 105 as “another drug
we [are] on.”23 From his perspective, Lehman’s traders should have sold inventory to reduce the
balance sheet.
However, when traders found it hard to sell sticky assets or wanted to avoid selling them at a
discount, they knew they could “rent the balance sheet,” by removing certain inventory temporarily
through Repo 105 and still reach Lehman’s net leverage ratio …
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