My Lehman Bullshit

no_bullshit Mike over at the Crime and Federalism blog (a good blog, by the way) thinks my explanation yesterday of Lehman Brothersí controversial repo 105 transactions is bullshit.

Well, Iím as full of bullshit as anyone, but my sense is that Mikeís analysis is flawed. Thatís not to say that the folks involved in reporting Lehmanís earnings to the marketplace after those repo 105 transactions didnít commit fraud. I donít know enough about the facts to know one way or the other.

The main point of my post is that a whole bunch of of executives, accountants, auditors, counterparties and governmental officials were swirling around Lehman at the time of these repo 105 transactions. As a result, the responsibility for any fraud is better allocated among the responsible parties in the civil justice system than in the criminal justice system, where guilt is adjudicated with a sledgehammer when a scalpel is more appropriate.

But one of the interesting aspects about Mikeís post is that he is very sure that he understands that Lehman committed fraud. So, letís take a look at his example of what he thinks happened with regard to Lehman and the repo 105 transactions (my observations are in italics below each of his statements):

I ask you to invest $100,000 in my new business. You ask me how much money I have in my business account. I only have $5,000, but do not tell you this.

Okay, as my prior post noted, I concede that Lehman may have misrepresented its true liquidity position through the repo 105 deals.

I can sell everything the business owns (including all of our inventory) to a pawn shop for $100,000.

If Mike can sell all the assets of the business to a pawn shop for $100,000, then the business owns much more than $100,000 in assets. Pawn shops – much like the financial institutions with whom Lehman was dealing ñ do not engage in repo 105 transactions unless they are darn sure that they can liquidate the assets that they purchase for more than they paid if the seller breaches his obligation to repurchase the assets.

The pawn shop will sell me everything back for $105,000 if I come up with the money within 48 hours.  They won’t even take possession of the property if I pay them within 48 hours.

I do not know of any pawn shop ñ or financial institution for that matter ñ that would be willing to leave property that they purchased in the hands of a financially-troubled seller, even for just 48 hours. Moreover, my understanding of the repo 105 transactions is that Lehman was not obligated to repurchase the asset for the sale price plus 5%. My understanding is that the ì105î in repo 105 relates to the fact that financial institutions require property at least worth 105% of the purchase price that the financial institution pays the seller for the asset. Iím sure that Lehmanís counterparties required a steep fee for engaging in the repo 105 sales, but not 5% of the purchase price.

I make the "sale" to the pawn shop. I show you a copy of my bank statement. You can see that I have $105,000 cash in my bank account. I’m, in other words, liquid 100 grand. You loan me $100,000.

Here is where Mike is confused. Prior to taking the $100,000 loan, his companyís balance sheet actually looks a bit worse because of his sale to the pawn shop. The company has sold assets worth more than $100,000 in order to increase its liquidity to $105,000. No rational investor would make a $100,000 unsecured loan to a company with assets of only $105,000 cash that the investor would not have been willing to make when the company had $5,000 cash and over a $100,000 in non-liquid assets. But , letís play along with Mike to get to his main point. After the loan, his company now has $205,000 in cash with a $100,000 liability.

I buy my stuff back for $105,000. I now have, thanks to you and some quick accounting fraud, $95,000.

No, thatís only part of it. The company now has repurchased its assets that are worth over $100,000, it has cash of $100,000 and a $100,000 liability. So, the companyís balance sheet is pretty much the same had the investor made his loan when the company only had $5,000 cash and over $100,000 of non-liquid assets. The only difference is that the investor feels deceived because he would not have made the loan under those circumstances.

So, maybe Mikeís investor in the example above has a good fraud case against the company (Iím not sure thatís the best way for the investor to recover his loan, but thatís another issue). But maybe not, too. And the situation that Lehman faced was far more complex than Mikeís hypothetical and involved a large number of well-intentioned people who were attempting to find any loophole available to save Lehman.

And thatís no bullshit.

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