Layers of the onion

The Lehman collapse has been blamed as the crucial event in the credit crunch but now it is revealed that aggressive accounting had been hiding problems for some time. The device that it is alleged was used to manipulate the financial statements was accounting for repo (repurchase) transactions.

In a repo an asset (a block of loans, say) is exchanged for cash, and the exchange reversed some time later. In substance this is usually a short term loan with the asset being used as collateral.

It's alleged that Lehman's were accounting for these as sales so that the asset disappeared off the balance sheet and the cash was used to reduce net borrowing. The effect is to reduce the bank's reserve ratio to within acceptable limits.

How was Lehman able to count these transactions as sales rather than loans? How was it able to exploit the provisions of the relevant US accounting standard, SFAS 140? It is likely that Lehaman's did so by a piece of cheeky financial engineering whereby the transaction took three stages, with the asset going back and forth to the counter-party three, and ultimately, four times. The title link shows how this is done.

What we don't yet know, is why this had to be done in London, the role of fair value, whether the financial reporting in the UK reflected the same things as the American accounting, and whether the accounting was routed through off-shore vehicles.

This one will run and run.