It’s Mine, Mine All Mine: Can Anyone Catch Lehman Stealing?

“late late night after the show at leeds university…”

Most of what’s been written about the financial crisis and the firms that were forcibly acquired, failed, or bailed out tends to focus on “fair value” as the feckless culprit.

Satyajit Das wrote for the site, Naked Capitalism:

“MtM [mark-to-market] accounting itself is flawed… There are difficulties in establishing real values of many instruments. It creates volatility in earnings attributable to inefficiencies in markets rather than real changes in financial position…Valuation for all but the simplest instruments today requires a higher degree in a quantitative discipline, a super computer and a vivid imagination. For complex structured securities and exotic derivatives, the only available price is from the bank that originally sold the security to the investor. Prices available from the purveyor of the instrument (a concept known as mark-to-myself) strain reasonable concepts of independence and objectivity…In the global financial crisis, with the capital markets virtually frozen, the extent of losses on bank inventories of hard-to-value products and commitments (structured debt and leveraged loans) was difficult to establish.”

We know that the banks’ “independent” external auditors had a hard time establishing both fair values and the “extent of losses on bank inventories of hard-to-value products and commitments.”  We know this because their clients did not tell us about the extent of the losses until it was too late.  There were no “going concern” warnings for any of the financial institutions that went bankrupt, were taken over, or were nationalized via bailout.

We also know that the auditors did a poor and inconsistent job of establishing fair values and forcing disclosure of the “extent of losses” on banks’ investments because their regulator, the PCAOB, told us so.

Inspection teams also observed instances where firms’ procedures to test the fair values of financial instruments, including derivative instruments, loans, and securities, were inadequate.  In these instances, deficiencies included (a) the failure to gain an understanding of the methods and assumptions used to develop the fair value measurements of financial instruments that were illiquid or difficult to price, (b) the reliance on issuer-supplied pricing information without obtaining corroboration of that information, and (c) the reliance on confirmation responses from third parties or counterparties that included disclaimers as to their accuracy and appropriateness for use in the preparation of financial statements.

How do the auditors, one step removed and ten steps behind, determine fair values of complex instruments especially in illiquid markets if even the super-bankers couldn’t get it right? This question supposes that it’s the auditors’ obligation to determine the values and that the bankers didn’t get it right.

Neither is true.

What are the auditors’ obligations with regard to clients’ fair value measurements and disclosures? Auditors do not establish fair values. Instead, their role is to, “test management’s fair value measurements and disclosures.” But that obligation is broader than just taking the word of the “masters of the universe.”

The auditor should consider using the work of a specialist if the auditor does not have the necessary skill and knowledge to plan and perform audit procedures related to fair value.[1] Observable market prices may exist to assist in testing fair values.  Where they do not and other valuation methods are used, the auditor’s substantive tests of fair value may involve (a) testing the significant assumptions, the valuation model, and the underlying data, (b) developing an independent estimate of fair value for corroborative purposes or, where applicable, (c) reviewing events or transactions occurring after the period covered by the financial statements and before the date of the auditor’s report.[2]

I say it’s outrageous to see ongoing material “disputes” regarding the fair value of complex derivatives between counterparties, especially if they are clients of the same auditor. Critics have suggested that I condone breaches of client confidentiality.  Without betraying client confidentiality, they ask, how can distinct audit teams compare the values assigned to either side of same transaction?

One of my commenters explained it:

Just how many PhD’s with CDS valuation expertise do you think PwC has lying around in New York? The valuation of these instruments and the testing of the assumptions would have been sent to a centralized derivative valuation group to review and test. Such a team would have had a fairly standard set of guidelines and testing approach regardless of the team sending it. After validating the inputs, they would have likely put it through their own sausage machine / valuation tool and compared the results. I think there would be a high probability that the same analysts would have been reviewing the same instrument for both GS and AIG. And when they notice that GS is using market derived inputs for the referenced MBS while AIG is using the historical average default rates and ignoring the market you would have hoped they might speak up. And when the partner (finally) heard the rumblings of a problem, even after it has been filtered through the manager / senior manager “make-it-go-away” screen, he would have asked “who else deals with this cr_p in the firm? GS… ah, [insert name of old white guy here] is an old buddy of mine, I’ll just give him a call and ask him what they do…”

When one excuses the auditors for not getting fair value right, there’s a follow-on argument that claims no one got it right. No one could possibly get it right. That’s why the crisis occurred. That’s what the scoundrels that benefited most from the crisis would like you to believe.

Reality is the opposite.

Much has been written about how well Goldman Sachs made out as a result of the crisis. But there are others.  Some are getting prosecuted like Bank of America’s Ken Lewis for hiding losses to further their interest in millions of bonus dollars. That’s why some are starting to use the word “fraud” when speaking of Lehman’s collapse.

On February 11th, Bloomberg’s Jonathan Weil asked why no one is prosecuting Lehman Brothers executives for fraud:

It is so widely accepted that Lehman Brothers Holdings Inc.’s balance sheet was bogus that even former Treasury Secretary Hank Paulson can say it in his new memoir. And still, the government hasn’t found anyone who did anything wrong at the failed investment bank…In his new book, On the Brink, Paulson doesn’t point fingers at specific Lehman executives for violating any rules. He displays amazing candor, though, in describing how Lehman’s asset values were a gross distortion of the truth. It doesn’t take much imagination to figure out they didn’t get that way all by themselves.”

A reader, I’ll call him David the CFE, repeats a story to me to illustrate this point:

“Casey Stengel probably said it best when he said after the Mets 40-120 season, ‘Gentlemen, not one of you could have done this on your own. This was a team effort.’ “

Losing $156 billion requires a team effort.

When former Lehman Managing Director Arthur Doyle reviewed Larry McDonald’s book on Lehman, he asked the same questions about fraud and Lehman executives:

“The most important questions of all are not even asked in “A Colossal Failure of Common Sense,” or in any other account I have so far seen of the Lehman failure. Simply put, how did Lehman’s published financial statements, as recently as its final 10-Q published in July of 2008, show a positive net worth of $26 billion, when the bankruptcy liquidators are saying that they are looking at a negative net worth of $130 billion? Doesn’t any or all this constitute securities fraud? And shouldn’t there be criminal liability for the executives who signed the firm’s 10-K and 10-Q’s, who under Sarbanes-Oxley are responsible for material misstatements made in those documents?”

Bloomberg’s Weil has a theory about why these crimes are not being prosecuted:

“There’s been much talk the past two years about moral hazard, which is the risk that companies and their investors will behave more recklessly when they believe the government will bail them out. Less has been made of a similar hazard: The danger that powerful companies won’t follow the law when their executives believe the government won’t hold them to it…The latter risk threatens not only our economy, but our democracy. There’s every reason to believe both kinds are growing.”

David the CFE and I have another theory:


The crimes are too numerous to prosecute without indicting the whole system and most of the major players. And because they were part of the problem before they were theoretically part of the solution, culpability also attaches to Paulson and Tim Geithner.

David the CFE’s theory is premised on some of the oldest tricks in the book for manipulating revenue recognition and, therefore, reported profits and incentive compensation payouts including stock options – roundtrips, parking, and channel stuffing. In another variation on the theme, global trading company Refco used a round trip loan to repeatedly hide a related-party transaction incurred to delay disclosure of significant uncollectible accounts.  It’s not like these techniques haven’t been used before (by AIG, for example) to offload risk and smooth earnings at quarter- and year-end.

This case shows that the Commission will pursue insurance companies and other financial institutions that market or sell so-called financial products that are, in reality, just vehicles to commit financial fraud,” said Stephen M. Cutler, director of the SEC’s Division of Enforcement.

With regard to the financial crisis, these revenue recognition fraud techniques may have been most useful in establishing “observability” of market prices for otherwise illiquid assets. Establishing “market prices” via fraudulent, sham transactions amongst the market participants before quarter-end and year-end reporting periods would have allowed assets to remain on the books longer at inflated values and, therefore, to inflate profits and bonuses. “Market prices” that appeared to support existing valuations sustained the myth. The investments were not written down until long after the market for subprime real estate securities started to wilt.

David the CFE explains this theory in the case of Lehman Brothers:

Nassim Taleb says about banks: “Banks hire dull people and train them to be even duller. If they look conservative, it’s only because their loans go bust on rare, very rare occasions. But bankers are not conservative at all. They are just phenomenally skilled at self-deception by burying the possibility of a large, devastating loss under the rug. Taleb further states: “Executives will game the system by showing good performance so they can get their yearly bonus.”

Lehman paid out $5.2 billion in bonuses in 2006 and $5.7 billion in bonuses in 2007.  Did this result from the executives at the bank gaming the system to increase their bonuses? An example of burying a large loss under the rug can be found in this excerpt from Lehman Brothers in its 2006 10-K:

We held approximately $2.0 billion and $0.7 billion of non-investment grade retained interests at November 30, 2006 and 2005, respectively. Because these interests primarily represent the junior interests in securitizations for which there are not active trading markets, estimates generally are required in determining fair value. We value these instruments using prudent estimates of expected cash flows and consider the valuation of similar transactions in the market.

Junior interests in securitizations. Lehman and other firms purchased mortgages that would effectively be resold by them as collateralized debt obligations.  Each of Lehman’s securitizations was broken into tranches in which senior interests received greater preference with respect to collections of interest and principal than junior interests that were entitled to greater profits, if such profits were realized. A junior interest in a securitization is the lowest level of the tranches for collateralized debt obligations. Generally, only the bottom 3% of a securitization was labeled as equity.

During 2006, housing prices dropped nationally by at least 5% from the spring of 2006 to Lehman’s Nov. 30, 2006 and the default rate was increasing as well. With prices of houses dropping and the default rate increasing, there was a risk of large losses when the buyer defaults. Thus, the junior interests in securitizations that Lehman was purportedly investing in were probably already worthless at the time that Lehman invested in them or at November 30, 2006.

An auditor would have to suspect a material loss is being hidden and that collusion between several departments at Lehman Brothers and management’s participation in the deception was possible. Ernst and Young, Lehman’s auditors, were probably unwilling to consider such a possibility because auditors accept as dogma that collusion between many employees and multiple departments is unlikely no matter what the motive, i.e., $5.2 billion in bonuses. Auditing standards also do not consider collusion likely. Apparently, auditors did not consider the possibility that two different groups at Lehman Brothers such as the underwriters who sold the securitization IPOs and the trading departments would collude to hide a $1.3 billion loss in a junior equity position that could not be sold.

Hiding losses on CDOs and mortgages purchased for securitization. A reasonable question to ask was:  If Lehman Brothers started the fiscal year ending Nov. 2007 with $57 billion of CDOs and held them for the year, what would their estimated loss be? Also: What would the additional loss be with $32 billion in CDOs and/or mortgages purchased?

Presumably, the losses would be in the range of $10 billion to $30 billion. By Nov. 2007, everyone knew of the problems with CDOs. Bear Stearns had already closed two hedge funds investing in CDOs. Merrill Lynch had made huge write downs and forced out its CEO. My guess is that Lehman Brothers engaged in schemes to fool the auditor in order to avoid disclosing losses from their securitizations and investments in CDOs.

Lehman probably pulled a variation of the old “telecom swap.” In the “telecom swap” cases, one telecom company would sell telecom capacity to another telecom and then purchase the same amount of telecom capacity from the other party. The firm selling the capacity would book the amount received as revenue and the firm purchasing the capacity would book the amount received as a fixed asset. It worked very well in creating fictitious profits for those firms.

That same trick could be used by financial institutions in the case of CDOs/CDSs. Let’s say Financial Institution A sells collateralized debt obligations with a true fair market value of 90 million to Financial Institution B for 100 million dollars in cash. Financial Institution B purchases collateralized debt obligations with a true fair market value of 90 million dollars from Financial Institution A for 100 million dollars in cash.

And then those phony trades are shown as the “observable” similar transactions in the market.

Did the auditors check for this item? Probably not. Why not? Because it’s an example of collusion between Lehman and other companies. Auditors don’t check for collusion no matter how many times they get fooled by it!

Incentivizing fraud. Auditors, especially inexperienced ones, think management has to actually tell someone if they want to overstate their income. Auditors and the judges that try these cases want to find “smoking gun” memos and emails that say, “Overstate income so we can all get our bonuses and keep our jobs.” But all top management really has to do is tell each unit head that: (a) you and your employees will get large bonuses if your unit reaches its profit goals and, (b) you will not receive a bonus if your unit doesn’t achieve its goals. Then management promotes only those who meet those goals – regardless of how they meet them.

In other words, each manager within the Lehman brokerage unit had a major incentive to reach his profit goals. And, each employee who worked for those managers also has that incentive because his bonus and promotions are based on meeting those goals, too. Thus, management doesn’t have to direct its employees directly to commit fraud. They can claim plausible deniability because they rather passively allow the employees create their own frauds. Employees who understand the system will game that system by working with others in the organization and outside the organization to produce fake profits.

Photo Source

[1] AU 328, Auditing Fair Value Measurements and Disclosures, paragraphs 20 and 23; AU 332, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities, paragraph 06.  Also, in December 2007, in response to the auditing challenges presented by the subprime credit crisis and the transition to the new fair value accounting standard, the PCAOB staff issued Staff Audit Practice Alert No. 2, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists (December 10, 2007), which provides auditors with information about auditing fair value measurements and disclosures.

[2] AU 328.23; AU 332.40

Here’s the real Jane’s Addiction with one of my faves, Dave Navarro. (We once rode up in an elevator together at the W Union Square, NYC):

28 replies
  1. Sara McIntosh
    Sara McIntosh says:


    I thought I read somewhere that you grew up in Beverly, on the south side of Chicago, which would be a good thing if you keep writing posts like this one. You may find you need a bodyguard you can really trust (someone from the neighborhood would be preferred).

    You do an excellent job of outlining how financial manipulation at Lehman Brothers crosses the line into fraud. I like the way you walk us through the T-account transaction analysis in English, as well. Thank you.

    I don’t know if you’re familiar with the work of Catherine Austin Fitts, (Assistant Secretary of Housing and Federal Housing Commissioner at the U.S. Department of Housing and Urban Development in the first Bush Administration). I’m including a link to her Voice of America public radio interview where she talks about frauds in the underlying mortgages in the bundled subprime mortgage securities.

    In particular she talks about duplicate (fictitious) mortgages on properties resulting in astronomical foreclosure and default rates in the mortgage securities as another massive fraud inbedded in these hot potato financial instruments that no one wants to audit.

    And, in my fiction novel, Shell Games, I outline in a similar fraud perpetuated by a Wall Street firm called Lemon Brothers. . . maybe the three of us can get a volume discount on some bodyguards!

    Bravo on another extremely well-written and researched piece!

    Ciao for Now,

    Sara McIntosh

  2. Francine
    Francine says:

    @Sara McIntosh

    Thanks Sara. Yes, I am originally from Beverly. Plenty of old grade school and high school boyfriends (and a few girlfriends) who are Chicago and Cook County Sheriff’s police and would be glad to keep an eye on me off-duty, if necessary. My dad’s brother, nicknamed ‘Dirty Harry,” is now retired from the force and one cousin is still active. My uncle actually has provided security for Sam Zell… My four very large brothers and my Rottweiler Rosie do day-to-day duty. But my secret weapon is my Sicilian mother. Nothing and no one gets past her.


  3. No static at all
    No static at all says:

    Sherrin Watkins could probably shed some light on how the bad guys work. Sherrin vs. Billy Tauzin, very intense thing to watch.

  4. BBC
    BBC says:

    Fascinating article, Fran. As an aside, read Watkins memo again. Basically an email to the CEO on how to best hide fraud. . . and now she gives speeches on ethics. It’s so very sad.

  5. Tony Metcalf
    Tony Metcalf says:

    The reason why auditors have to assume that collusion does not happen amongst departments and other institutions is because if they did notthey would have to coinsider all the possible ways that collusion could take place and the possible outcomes. In many cases the possibilities could be endless. Companies would not be prepared to pay the extra costsfor soemthing that probably never happened.

    However someone in the company probably did realise what was happening but decided not to disclose it. In addition they probably misled the auditors by not disclosing that information to them. If the auditors specifically asked the right questions to management but were misled the relevant heads should roll, but the blame does not necessarily lie with the auditors because they are not there every day. If this is not to happen again the right people need to be blamed and corrected.

  6. David
    David says:

    Response to Tony:

    Sometimes the results a firm reports just can’t be believed. What does Judge Judy say? I look at you and know you’re lying.

    Maybe the auditors can’t be that blunt but the Lehman audit should have been a Judge Judy moment. One of Lehman’s businesses was buying mortgages and converting those mortgages into CDOs. Lehman also invested heavily in CDOs. Even if the auditors weren’t that sharp, didn’t they realize that Lehman had to have huge losses from those activities by November, 2007 just as Bear Stearns and Merrill Lynch did. The only question for the auditor to answer at that point was how did Lehman hide the losses so that they reported profits? And collusion is clearly one way that they could have hidden the losses.

  7. esa
    esa says:


    The actions taken by Lehman and E&Y described in that article are truly disgusting. Yes I said that.

    I wonder how they rationalized it. Do you think they said “Enron did this with a couple of Nigerian barges so it must be ok”.

    You know your company has a problem when an employee is so good at obfuscating the company’s financial position that he earns the moniker “the balance sheet czar”.

    Hopefully, this will turn out better than the Nigerian barge case. To read a history of that from an attorney that believes the words “whitecollar” and “crime” should never be used in the same sentence, you can go here.

  8. Michael Gu
    Michael Gu says:

    What is amusing is E&Y two years ago sent a recruiter along with the rest of the B4 and a few mediums for a “Accounting panel”. I stood up and asked a question on how do each firm make a effort to prevent Enron #2

    The EY recruiter actually told me she was from Arthur A and the firm set up procedures to put shareholders a head of management, and everyone remember the lessons of Enron. Ethics comes first.

    Well, I tried to join E&Y’s Fraud group that fall, but was passed over for being “not mature enough” since I like telling jokes, apparently.

    Maybe they were right about me two years later, that I didn’t have the maturity to handle a audit.

    But it look like I was wrong about them being ethical #1 as well.

  9. esa
    esa says:

    What is interesting about the examiner’s report is that there is really nothing new. People clearly thought the practice was abusive but in large groups people will do things that they won’t do on their own, especially if they get paid a lot to do it.

    However, they set up a lot of hurdles for themself to try to meet the form of FAS 140. They got a “legal sale” opinion on the transactions but they couldn’t get it in the US so they did the transactions in the UK. They made the counterparties charge an extra 3 to 5 percent on the transaction to conform to the bright-line test in 140. That’s a lot of work to engage in an abusive practice.

    How utterly stupid was Lehman though? They needed another $50 billion of capital and the solution was to pay out $2.5 billion of capital every two weeks to create a facade of another $50 billion of capital. If they had stopped that stupid practice, they would have had the $50 billion they needed in the first place. How is an organization supposed to survive if it regularly loans out $50 billion of assets for seven to ten days and forces the couterparty to keep $2.5 billion of the $50 billion? That must have been an incredible company to survive as long as it did with traders throwing $2.5 billion out the window every two weeks.

    Can you imagine the counterparty. The phone rings at Deutche Bank and someone says, “Hello, Lehman UK calling. Could you do a repo? I need to place $8 billion but instead of the usual 2% I really need you have to take 5% this time.”

    The person that answered the phone at DB looks around and says “Hold on. Let me check. An extra 3% is $160 million and we are running a little short of space. I need to make sure I have somewhere to put it.” Then he hangs up the phone thinking the whole thing is a gag played by someone over in equities.

    The Lehman trader calls back a bit annoyed. “Why did you hang up on me? I need to do this trade. Will you take the $8 billion at 5% or not?”

    The guy at DB decides to play along “OK, I’ll do it but the collateral has to be US Treasuries with remaining maturities in even multiples of 144 days and the coupon rates have to be prime numbers. 3%, 5%, 7% and 11%. No 1’s, 2’s, 4’s, 6’s, 8’s, 9’s or 10’s. And if you can’t come up with $10 billion at 6% I can’t be bothered. Also, I need you to sell me $500 billion of CDS on Greek bonds and you have to buy $1 trillion of german CDS.”

    “Sure no problem” says the guy at Lehman.

    For the next 16 weeks the guy at DB does nothing. He just sits and waits for a call from Lehman and hopes and prays it comes. The phone rings and he answers it but its his mother. “Don’t call this number anymore” he screams. “I’m waiting for a very important call.” Finally, the end of the next quarter rolls around and it all happens again.

    Can you imagine receiving such a phone call? It’s like Ed McMahon showing up with a big check…twice. No, it’s better than that. It’s like 100 Ed McMahon’s showing up with a hundred big checks twice. And not the bankrupt, broken-necked Ed McMahon that was kicked out of his house by the bank and died. The jovial, drunk Ed McMahon that was Johnny’s sidekick. The one who invented American Idol but called it Star Search.

    No wonder the guys at Goldman make so much money. All they had to do was watch caller ID and answer the phone when Lehman London called.

  10. Geoff
    Geoff says:

    I wish I had more time this morning to read the article. That rendition of Been Caught Stealing is serious rock AND roll. Totally awesome! Great find Francine!

  11. Tenacious Truman
    Tenacious Truman says:

    Speaking as somebody whose 80-year old father lost $50,000 out of his retirement account when Lehman went under (which was roughly a fifth of his total assets at the time), I hope that those responsible are tried and, if convicted, punished to the full extent that the law allows. I don’t really care about civil restitution, I want some serious jail time. Make an example out of these people.

    (Looks forward to writing a letter to the judge if a sentencing hearing is ever held….)

    — Tenacious T.

  12. muysuave
    muysuave says:

    A lot of auditors at these large accounting firms have mighty big egos, which should not be surprising since they tail the Wall Street cash rich crowd. Auditors are promoted to partner way too soon and miss a lot of leadership (and knowledge ) skills along the way to the top. With these egos also comes a sense of invincibility, brains and privilege. So it should not come as a shock when Wall Street auditors are confronted with complex financial engineering they act like they know what is going on when nothing could be further from the truth. If you sound like you know what you are talking about then you must know what you are talking about. Everyone is convinced. Well, almost everyone.

  13. Ex Deloitte and PwC Consulting
    Ex Deloitte and PwC Consulting says:

    @mysuave I think you’ve raised one of the key failings of the current model in “Big 4 (for now)” firms — speed to partnership. Competition for talent is increasing. Gen Y is protrayed as materialistic and “in a hurry” and whatever the truth of this characterisation, the firms in their recruitment and career modelling, behave as if it is. The result of this _in my opinion_ is an increasing fostering of greed way beyond the threshold of what is healthy.

    Institutional knowledge, technical competence, a long memory, etc? Pshaw! Unless you can sell. Or so it seems to me.

  14. John A. Mozzer
    John A. Mozzer says:

    In the City of Los Angeles, many old landlords of rent-stabilized apartments were paid speculative prices for their properties during the recent real estate craze. Tenant evictions (via California’s Ellis Act) and apartment demolitions were widespread throughout the city, as developers applied for entitlements to develop new projects.

    This phenomenon consisted of speculators taking advantage of low hanging fruit, not good urban planning.

    Ellis Act eviction notices were served to myself and all tenants in over 70 units at three apartment properties on Albers Street in Valley Village, North Hollywood, on February 22, 2006. The developer/manager openly revealed plans to demolish the buildings for a new luxury condo project to the tenants. Over the following year, all tenants were offered extensions allowing them to remain in their units for another month, but finally had to vacate their apartment homes at the end of April 2007.

    County documents revealed LLC’s managed by Bryan P. Troxler as the primary investor. I wanted to see if I could find the names of other partners in the Troxler LLC’s, and I filled out a Business Entities Records Order Form, to obtain information of record with California’s Secretary of State. I had to do this numerous times, as I encountered one LLC nested in another LLC after another.

    Finally, I got down to LB Troxler Residential Ventures 38, LLC, with a 1100 Glendon Avenue, 11th floor, Los Angeles address. I researched that address, and realized the initials LB stand for Lehman Brothers (though they had moved from that address by that time).

    Now, the Albers Street property is empty land. Even the demolition appears to be unfinished. Please see my Before & After photos, starting here (browse forward):

    I drove by a couple of day ago. The site appears the same as in these photos.

  15. John A. Mozzer
    John A. Mozzer says:


    I drove by the site a couple of days ago. Although the site appears to have been cleaned up, it still appears essentially the same as in the After photos.

Trackbacks & Pingbacks

  1. […] Why did it take so long for the media, the regulators and the legislators to acknowledge what some of us have known for a […]

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