It took a year of painstaking research and a door-stopper report to expose the failures that ruined Lehman, write FRANCESCO GUERRERA, HENNY SENDERand PATRICK JENKINS

SEPTEMBER 15th, 2008, is etched on the financial world’s collective memory. The day Lehman Brothers collapsed into bankruptcy was a pivotal moment in the most devastating financial crisis in generations, causing panic in capital markets and a virtual freeze in global trade.

Scores of books and magazine articles have chronicled Lehman’s rapid and ruinous fall from global investment banking powerhouse to the largest corporate failure in US industry.

It took a year of research and a door-stopper report by a Chicago-based lawyer to lift the lid on the management failures, destructive internal culture and reckless risks that sent Lehman to its grim fate. The 2,200-page tome released on Thursday by Anton Valukas – the examiner hired by a US court to inquire into who was responsible for the bank’s failure – could have far-reaching implications for former Lehman executives, including its former chief Dick Fuld, and its auditors Ernst Young.

It also sheds a damning light on the inner workings of Wall Street – or at least that part of Wall Street that was hell-bent on juicing profits and hiding losses during the boom that led to the crisis.

The report singles out Lehman as being one of the last Wall Street institutions to engage in “repo” deals, aimed at moving assets off its balance sheet. But the fact that it was able to find willing counterparties in the US and Europe that would, albeit unwittingly, help Lehman misrepresent its financial position will dishearten many observers, even if regulatory reforms now under way aim to clean up the most egregious pre-crisis practices.

“I almost threw up when I read the report,” a senior Wall Street executive said yesterday. “It makes me sick of this industry.”

The Lehman Brothers portrayed by Valukas is not the successful upstart presided over by an aggressive but inspirational Mr Fuld –a concept that had become part of industry lore. The company that comes out of the examiner’s nine volumes is an organisation prepared to take short-cuts and huge risks to boost earnings, where control and accounting procedures were found to be sorely lacking.

Valukas begins his story at a high point in Lehman’s 158-year history. On January 29th, 2008, the firm reported record yearly earnings of $4 billion (€2.9 billion) for the previous year. Within eight months, those profits – and the firm – had turned to dust.

“There are many reasons why Lehman failed, and the responsibility is shared,” writes Valukas, before adding that its plight “was exacerbated by Lehman executives, whose conduct ranged from serious but non-culpable errors of judgment to actionable balance sheet manipulation”. He concludes that, based on different metrics, Lehman and some affiliates were insolvent at various times in the months of 2008 leading up to its bankruptcy filing.

The crux of the report – which is based on the review of 34 million pages of documents, out of the 350 billion pages obtained by Valukas – is its portrayal of Lehman’s insatiable risk appetite and its alleged efforts to cover up the extent of its financial woes.

At the end of 2006, senior officials at Lehman’s decided to increase the ceiling on the firm’s risk limits, or how much Lehman could lose from its trading and investment activities, Valukas recounts.

The decision came just as the firm moved to expand its commitment to real estate investing, even though the US mortgage market was already starting to implode. Indeed, Lehman would increase its firm-wide risk appetite limit three times over the following year. Madelyn Antonic, then Lehman’s chief risk officer, resisted an increase in the limit from $2.3 billion to $3.3 billion but was overruled, according to the probe. By the end of 2007, it was $4 billion.

The report also provides a scathing picture of just how weak Lehman’s risk management practices ultimately became – and how they contributed to Lehman’s implosion.

For example, Lehman, like its peers, was required to stress-test its trading positions and investments. But Lehman excluded its principal investments in real estate, its private equity investments and its leveraged loans backing buyout deals, thereby leaving out its most risky assets from calculations.

A $2.3 billion bridge loan for the buyout of Archstone-Smith Real Estate Investment Trust in 2007 was never included in its risk usage calculation, though that transaction would have put Lehman over its already enlarged risk limit, the examiner notes.

Lehman’s practices meant that the firm did not have a true picture of just how vulnerable it was to swings in capital markets and, more importantly, in the markets for the illiquid assets it had invested in. The issue was all the more crucial to Lehman because the firm, with only $25 billion in capital, had far less of a balance sheet buffer than rivals such as Goldman Sachs.

In the aftermath of the near-collapse of Bear Stearns in March 2008, Lehman found itself unable to sell some of its most illiquid assets. With rating agencies and investors demanding a reduction in Lehman’s balance sheet, the company ramped up the use of an “accounting gimmick” it had been resorting to since 2001, according to the report.

Known internally as “Repo 105” – but never disclosed externally – the mechanism enabled Lehman to move up to $50 billion in assets off its balance sheet for just enough days to get through the end of the quarter.

That, in turn, helped the firm to reduce its leverage ratio (the level of indebtedness on its balance sheet), to avoid a rating downgrade and to appear healthier than it actually was.

“The examiner has investigated Lehman’s use of Repo 105 transactions and has concluded that the balance sheet manipulation was intentional, for deceptive appearances, had a material impact on Lehman’s net leverage ratio, and because Lehman did not disclose the accounting treatment of these transactions, rendered Lehman’s deceptive and misleading,” the report says. The device was so rare that Lehman could not find a US law firm to give it a legal opinion on it, using instead UK-based Linklaters, according to the report.

Linklaters has said it was “not aware of any facts or circumstances which would justify any criticism” of its opinions.

Lehman’s many counterparties in the trades also never appeared to have questioned them, or the fact they were receiving better terms than in traditional repo transactions.

Internal e-mails offer a revealing glimpse of how the rank-and-file saw the practice. In one e-mail in February 2008, a senior trader tells a colleague: “We have a desperate situation and I need another $2 billion from you either through Repo 105 or outright sales.” A few months later, the same trader urges a colleague: “Let’s max out on the Repo 105 for your stuff.”

A few managers were not so sure. Bart McDade, a Lehman executive who was worried about Repo 105, described it as “a drug”. Another executive ordered traders to “wean themselves off” Repo 105. One even pointed to the risks of covering up the practice, warning: “The more people that know the truth, the more dodgy it can be.” – (Copyright The Financial Times Limited 2010)