Why Ex-Lehman Executives Are Shaking in Their Wingtip Loafers

Short of the FBI knocking on the door, one of the worst things a criminal could possibly hear is: "I'm so-and-so from 60 Minutes, would you be willing to answer a few questions?"

Whatever doubts you have about the news media -- many of which are probably well-founded -- when 60 Minutes runs a segment, people listen. A recent example concerned the STOCK Act, an act prohibiting members of Congress from trading on insider information they obtained in the course of congressional work. While the Act was introduced in 2004, it wasn't taken up until late last year, after the weekly news program aired a segment on insider trading in Congress. President Obama signed a watered-down version of the bill into law earlier this month.

It's for this reason that ex-Lehman Brothers executives are likely shaking in their Italian wingtip loafers this week. In a segment last Sunday titled "The Case Against Lehman Brothers," the program's Steve Kroft made a compelling case for prosecuting the former investment bank's senior executives, including ex-CEO Richard "Dick" Fuld. Although most of the information contained in the report wasn't original -- my colleague Morgan Housel covered it extensively during the crisis and the segment itself was based largely on a two-year-old inquiry for the bankruptcy court overseeing the firm's dismemberment -- the mere fact that it's been brought back into the light of day is bad news for those concerned.

Desperate times call for illegal measures?
The allegations of illegality revolve around a series of transactions that ex-Lehman executives approved in the run-up to the financial crisis. In 2006, approximately two years before the downturn, Lehman decided to embark on an aggressive growth strategy involving greater risk and higher leverage. When the subprime residential mortgage business began its descent, in turn, Lehman doubled down on the market as opposed to limiting its exposure like others on Wall Street, including Goldman Sachs (NYS: GS) and JPMorgan Chase (NYS: JPM) , were doing at the time. By 2008, the firm was leveraged nearly 30-to-1, with $700 billion of assets and corresponding liabilities on capital of only $25 billion.

While leverage isn't inherently bad, the precise mix of assets and liabilities employed by Lehman to fund its operations turned out to be fatal. Namely, the firm's assets were predominantly long-term, while its liabilities were largely short-term. The firm funded itself via the short-term repo market through which it would post tens or hundreds of billions of dollars worth of illiquid mortgage-backed securities as collateral for overnight loans. Much like the mortgage REITs Annaly Capital Management and Chimera Investment, without this source of financing, Lehman literally couldn't operate on a day-to-day basis. Thus, any failure of confidence among its counterparties concerning the firm's financial position would quickly turn into a self-fulfilling prophecy.

To avoid such a fate, it appears that at least four ex-Lehman executives -- Fuld and three others -- approved the use of a creative accounting measure known internally as "Repo 105." As my colleague Morgan Housel discussed previously, under a traditional repo transaction, a borrower transfers assets like mortgage-backed securities to a lender in exchange for cash, but simultaneously agrees to repurchase them at a premium, often the very next day. Although this transaction resembles a sale, it's treated as a financing for purposes of accounting. And as a result, no assets are actually transferred from the borrower's balance sheet to the seller's.

Under a Repo 105 transaction, however, assuming the posted collateral is worth at least 105% of the loan's value, the assets are transferred for accounting purpose. This allowed a struggling firm like Lehman to temporarily remove toxic assets from its balance sheet when earnings season rolled around. And that's what it did. In the first two quarters of 2008, the ailing investment bank used Repo 105 transactions to remove a whopping $50 billion of assets from its balance sheet. This reduced its reported net leverage ratio from 13.9 to 12.1, and created the illusion that the bank was in better financial condition than it actually was.

When Richard meets Bernie
When you consider how much money investors lost and the damage Lehman's bankruptcy did to the American economy, it's surprising that none of the firm's ex-executives have been called to account in a criminal court. At least in the case of the Repo 105 transactions, the reason is that the accounting move, while controversial, isn't necessarily illegal. According to Morgan Housel:

Not only was this stuff legal, but lucrative. Many executives walked away rich. Filthy rich. This was heads they win, tails you lose, and in either case, jail remains elusive. You can almost hear them laughing now.

Although Morgan is correct regarding the legality of the Repo 105 transactions themselves, if the court-ordered report cited in the 60 Minutes segment is any indication, the legal issues don't stop there: "The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule. But the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements." For good measure, the report defined a "colorable claim" as "one for which the Examiner has found that there is sufficient credible evidence to support a finding by a trier of fact." In other words, there is sufficient evidence of fraud and/or misrepresentation for a jury to convict.

The law isn't blind
At the end of the day, of course, it remains to be seen whether Dick Fuld and his compatriots will be brought before a criminal court to answer for their actions. While I believe they should be, and I suspect many others do as well, this wouldn't be the first time in history that the rich and formally powerful would be given a pass for actions that the rest of us would already be in jail for. Sound off below if you think Fuld and his friends should hear the sound of a cell door slam behind them.

At the time thisarticle was published Fool contributor John Maxfield does not have a financial stake in any of the companies mentioned above. The Motley Fool owns shares of JPMorgan Chase and Annaly Capital Management.Motley Fool newsletter serviceshave recommended buying shares of Annaly Capital Management and The Goldman Sachs Group. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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