The Ghost Of Lehman Bros.

The SEC Corporate Financial Division sent letters to the CFOs of twenty financial firms today reqiesting extremely detailed information about their use of Repo 105 instruments. Bankruptcy examiner Anton Valukas recently wrote as part of a 2,200-page report on the Lehman bankruptcy that the failed firm used Repo 105s for off balance sheet transactions that were as high as $50 billion. Lehman made use of the practice to  report lower net leverage ratios than it actually had.

It took the SEC more time than expected to officially ask the question that the media has been asking for over a week. If Lehman used the Repo 105s so “successfully” why would other Wall St. firms not have done the same? Financial engineering that works well in one place should work well elsewhere.

The SEC has asked in specific if Repo 105s were used by the nation’s largest financial firms and if so, how often, in which countries and with which counterparties?

Valukas called the Lehman practice “deceptive and misleading”, but stopped short of saying it was illegal. That determination will be left to the SEC and Justice Department. Ernst & Young, the auditor for Lehman, has begun to argue in public that it did nothing wrong in its analysis of the investment bank’s figures and should not be blamed or shamed in public.

Ernst & Young, however, is not out of the woods yet as the SEC looks further into Repo 105s. This means the banks themselves are also still in trouble. The SEC will have to go back and recreate what the earnings of any of the financial firms that used Repo 105s would have been if the off balance sheet transactions had not been used . The issue is complicated by the fact that the federal government had “ownership” relationships with a number of large banks due to its TARP investments.

The audit firm participation may raise a series of liability questions. Auditors either were aware of Repo 105 transactions or should have been. Off-balance sheet transactions, if they are misleading, should have been flagged to CFOs, in writing, as a matter of concern, and those concerns should have been passed along the to audit committees of the boards of directors.

The Repo 105 issue is starting to look a bit like the mortgage-backed securities question. The cost of the Repo 105s will not be nearly as earth shattering as mortgage-backed troubles were, but it raises the question, once again, of where boards, auditors, and regulators were when bank executives decided, perhaps in a relatively benign way, to cook their books.

Douglas A. McIntyre