Sigrún Davíðsdóttir's Icelog

It’s not illegal to own a hammer but it’s illegal to use the hammer to destroy or damage other people’s assets. – This seems to be the short version of how Lehman Brothers used the so-called Repo 105 transactions*: it’s a legitimate tool but they used it to bluff the credit rating companies and consequently the financial world. One of the consequences of using this transaction was that the bank was apparently insolvent earlier, probably much earlier, than Sept. 15 2008.

The Lehman report was ordered in January 2009 by the United States Bankruptcy Court for the Southern District of New York, put together by the Examiner, Anton Valukas and released this week. It concludes that Lehman’s CEO Richard Fuld, Lehman’s CFOs and possibly Lehman’s auditors, from Ernst & Young, might have something to answer for in court. No doubt, their names will be tied to Lehman over the coming decade or so as all and sundry will be bringing them to court in an array of Lehman-related cases.

Valukas states that although the Repo 105 transaction was perhaps not ‘inherently improper, there is a colourable claim** that their sole function as employed by Lehman was balance sheet manipulation. Lehman’s own accounting personnel described Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end.”  Lehman used Repo 105 “to reduce balance sheet at the quarter‐end.”  In 2007‐08, Lehman knew that net leverage numbers were critical to the rating agencies and to counterparty confidence.’

The report is based on a staggering amount of material, laconically described as: ‘The available universe of Lehman e‐mail and other electronically stored documents is estimated at three petabytes of data – roughly the equivalent of 350 billion pages.’ – Most appropriately, numbers parallel to those in the ‘Lehman universe’ are not often encountered except in astronomy.

Why is Lehman being scrutinised so thoroughly and not banks that governments in various countries have recapitalised? The UK Treasury had to intervene with Northern Rock, Bradford & Bingley, Lloyds Banking Group and Royal Bank of Scotland, banks that would have followed Lehman into bankruptcy if the Treasury hadn’t saved them. But as far as is known, the accounts of these banks haven’t been picked over like Lehman’s.

Recently, there were fleeting news that the Treasury had contemplated the idea in connection with Lloyds but then given up on it. It was thought, at the time, that there was no time to do it – but as a major shareholder the Treasury has all the time in the world to go into the banks’ universe and start reading. The same goes for Ireland: AIB, Bank of Ireland and Anglo have been recapitalised, they are still reporting huge losses – and their management in the months up to autumn 2008 hasn’t been scrutinised.

Icelanders are still waiting for their bank report, due in the coming weeks, put together under the auspices of a commission, set up by Althingi, the Icelandic parliament. High Court judge Pall Hreinsson is its chairman and the other members are the Parliament’s Ombudsman Tryggvi Gunnarsson and Sigridur Benediktsdottir associate chair in economics at Yale. In Iceland the commission is called ‘the investigative commission’, foreigners have dubbed it ‘the truth commission.’ The report will deal with events and development up to fall of the three Icelandic banks in Oct. 2008, scrutinise the regulatory and political environment and indicate possible improvement. The Lehman report is over 2200 pages; the Icelandic one will be around 2000 pages.

Icelanders have already had an insightful but short report on their banks, published in March 2008, written by Kaarlo Jännäri. The headlines it made at the time indicated that bad luck had been a major factor in their downfall. Interestingly, that’s the slightest cause, according to Jännäri. He concludes that the ‘collapse of the Icelandic banking sector resulted from a combination of several factors. An analysis of the Norwegian banking crisis in the late 1980s concluded that it was caused by bad banking, bad policies and bad luck. This saying can also be applied to Iceland.’

Jännäri doesn’t dwell on bad luck: ‘There might – just might – have been a possibility for the Icelandic banks to survive if the almost total freezing of the international financial markets had not taken place and confidence in Iceland had not been lost. Even in that case, they probably would have needed government support to maintain their solvency, as credit losses would have risen due to the deterioration of their loan portfolios. Now that the blaming game continues at high speed in Iceland, it is perhaps beneficial to bear in mind that most, if not all, Icelandic players in this game must also look in the mirror. Placing the blame solely on external circumstances is not appropriate.’

Jännäri points out weaknesses caused by the banks’ connected lending, lending to related parties, cross ownership, poor corporate culture and immature banking culture. An interesting point is large exposure: “At the end of June 2008, there were a total of 23 exposures over the 10% limit of own funds in the three large banks (6 to 10 in each bank). They constituted between 94 and 174% of the banks’ own funds. … In most cases, the assets pledged as collateral for these loans are shares in the companies in which these customers had invested the funds borrowed. Many of these companies are sound enterprises and thus the collateral has real value, but some are of more dubious quality, in particular in the present global circumstances. Even if the number of large exposures in these banks was small, it is still very unusual that banks as large as these should have so many large exposures of this nature. My judgment is that their behaviour in this regard has been very imprudent.’ (KJ’s emphasis)

No doubt, the coming report will expand on these and other issues in a story that, according to Hreinsson, will be a very bleak one. And unavoidably, the banks’ audits will be scrutinised in the coming report. Needless to say, the banks’ auditors were the large international auditing companies.

Banks that needed to be recapitalised by the state were for all intents and purposes insolvent – and insolvent companies are generally picked over. Bankruptcy can be compared to a train crash in slow motion. The attempts to salvage the train often leads to illegal actions, either to hide or delay the coming crash or to extract assets out of the company. Voters in the UK and Ireland and other countries where banks have been recapitalised with public money should be asking politicians and regulators loudly why the audits and practices of these banks haven’t been closely inspected.

*Explained on page 6 in the executive summary

** Meaning ‘seemingly valid claim’ (I had never come across this term before; interestingly, it stems from the 14th century)

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