Part 2: What went wrong?

Financial innovation can be defined as;

“the act of creating and then popularising new financial instruments as well as new financial technologies, institutions and markets. It includes institutional, product and process innovation” (FT, 2013)

Financial innovation represents both as an economy wide and firm specific factor in Lehman’s demise as the use of complex financial instruments destabilised Lehman’s business model. From the late 1990s/early 2000s onwards the use of financial innovative products such as CDOs and CDSs  (see end for definitions)  ballooned across the economy and Reuters estimates that the CDO market peaked at $534.2bn in 2006 which was almost an 800% increase on the 2000 figure (NY Times, 2011).

(Henry Paulson U.S. secretary of the treasury)

Lehman used these products excessively as financial innovation played a large part in Lehman’s aggressive growth strategy. An example of this excessive use occurred in 2006 when financial instruments made up 45% of total assets (Lehman Brother Inc, 2006). In particular Lehman was heavily invested in CDOs and CDSs and in 2008 held $614.6m equity securities in CDOs (Lehman Brother Inc., 2008). These CDOs lost a huge proportion of their value when confidence faltered in the market.

In addition to CDOs and CDSs Lehman used a financially innovative product to indulge in some very creative accounting practices to reduce their balance sheet. Lehman’s strategy had increased the risk and leverage of the firm substantially. In 2008, after the near collapse of Bear Sterns, the attention of the markets turned to Lehman and its future viability. Lehman needed market confidence to survive, especially to lend in the interbank markets, so management devised a strategy to reduce their assets and ,in turn, their leverage ratio. Much of Lehman's balance sheet was made up of illiquid assets that were difficult to sell so they turned to financial innovation and used what were termed ‘repo 105’ transactions.

Lehman used repo105 transactions to move assets off balance sheet and decrease the leverage ratio before the end of the quarter. Repo 105 transactions were similar to other repos used to gain short term financing but instead of being reported as a loan they were accounted for as a sale which allowed Lehman to move the assets off balance sheet (Valukas, 2010).  Lehman could count these repos as sales because “the value of the securities Lehman pledged in Repo 105 transactions were worth 105 per cent of the cash it received” (De la Merced and Werdigier, 2010). Repo 105 actions were a type of “window dressing” of Lehman’s reports.

This simple illustration shows how Lehman used repo 105:

The repo 105 transactions used were never publicly disclosed, the financial regulators didn't discover them and Lehman’s auditors Ernst & Young also failed to disclose them. Through repo 105 transactions Lehman was able to decrease its leverage; the decrease in leverage is shown in the graph below.

(Composed from Valukas Report, 2010)

CDO – “An investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialise in one type of debt but are often non-mortgage loans or bonds” (Investopedia, 2013)

CDS – “A swap designed to transfer the credit exposure of fixed income products between parties” (Investopedia, 2013)

Bibliography

1.      De la Merced, M. and Werdigier, J. (2010) The Origins of Lehman’s ‘Repo 105’. The New York Times. Available at: http://dealbook.nytimes.com/2010/03/12/the-british-origins-of-lehmans-accounting-gimmick/.

2.      Financial Times. (2013). Financial Innovation. Available: http://lexicon.ft.com/Term?term=financial-innovation. Last accessed 17th February 2013.

3.      Investopedia. (2013). Collateralized Debt Obligations. Available: http://www.investopedia.com/terms/c/cdo.asp#axzz2LA9o5psS. Last accessed 17th February 2013.

4.      Investopedia. (2013). Credit Default Swaps. Available: http://www.investopedia.com/terms/c/creditdefaultswap.asp#axzz2LA9o5psS. Last accessed 17th February 2013.

5.      Lehman Brothers Holdings Inc., 2006. Annual Report 2006,New York: Lehman Brothers Inc

6.      Lehman Brothers Holdings Inc., 2008. Second Quarter 10-Q ending  May 31, 2008,New York: Lehman Brothers Inc.

7.      The New York Times. (2011). Collateralized Debt Obligations. Available: http://topics.nytimes.com/topics/reference/timestopics/subjects/c/collateralized-debt-obligations/index.html. Last accessed 17th February 2013.

8.      Valukas, A. (2010) LEHMAN BROTHERS HOLDINGS INC. CHAPTER 11 PROCEEDINGS EXAMINER REPORT. Jenner & Block, Volumes: 1-9.