Lehman Brothers Scandal

The Lehman Brothers scandal emerged after the collapse of Lehman Brothers in late 2008. It involved using a loophole in US accounting standards known as 'Repo 105' to hide substantial losses on the subprime mortgage market.
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Lehman Brothers Scandal

Definition

The Lehman Brothers scandal arose after the collapse of Lehman Brothers, the fourth largest U.S. investment bank, in late 2008. To conceal substantial losses associated with the subprime mortgage market, Lehman Brothers exploited a loophole in U.S. accounting standards known as “Repo 105”. This loophole permitted the firm to reclassify certain transactions in a way that masked billions of dollars in debt, thereby temporarily enhancing the appearance of its financial health.

Examples

  1. Repo 105 Transactions: Lehman Brothers used accounting techniques labeled “Repo 105 and Repo 108” agreements, which are short-term repurchase agreements that momentarily raised cash by selling assets with an obligation to repurchase the same assets shortly after. This maneuver enabled the bank to move assets off its balance sheet.

  2. Reduction in Gearing: By treating these transaction-induced reductions in assets and corresponding liabilities as outright sales rather than loans, Lehman Brothers lowered its reported leverage, giving a misleading picture of its financial resilience.

Frequently Asked Questions (FAQs)

Q1: What is Repo 105?
A: Repo 105 is an accounting technique used by Lehman Brothers to temporarily remove liabilities from their balance sheets by classifying short-term repossession agreements as sales.

Q2: Was the use of Repo 105 illegal?
A: While Repo 105 was legally permissible under certain accounting standards, the issue was Lehman Brothers’ failure to disclose the practice, which misled stakeholders about the true financial health of the company.

Q3: What impact did the Lehman Brothers scandal have on the auditing industry?
A: The scandal led to increased scrutiny and significant fines for Lehman Brothers’ auditors, Ernst & Young, and prompted regulatory changes aiming to enhance transparency and accuracy in financial reporting.

  • Subprime Lending: Lending to borrowers with poor credit histories who are considered higher risk for defaulting on loans. Lehman Brothers’ investments in subprime mortgages contributed to their financial collapse.

  • Sale and Repurchase Agreement (Repo): A form of short-term borrowing for dealers in government securities; the dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day.

  • Gearing: Also known as financial leverage; it is a measure of a company’s debt level compared to its equity.

  • True and Fair View: An accounting concept meaning that financial statements should present an accurate and unbiased picture of the company’s financial performance and position.

References to Online Resources

  1. Investopedia: Lehman Brothers Scandal Explainer
  2. SEC Document on Repo 105
  3. Summary of Impact on Auditing Standards

Suggested Books for Further Studies

  1. “The Collapse of Lehman Brothers: A Case Study” by Dr. Samiha Fawzy
  2. “When Genius Failed: The Rise and Fall of Long-Term Capital Management” by Roger Lowenstein
  3. “Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System from Crisis - and Themselves” by Andrew Ross Sorkin

Accounting Basics: “Lehman Brothers Scandal” Fundamentals Quiz

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