Focus on ETHICS
Lehman Brothers' fall was perhaps the most stunning development of the financial crisis. Dating back to the mid-1800s, the firm had survived the Great Depression and numerous recessions to become a major player on Wall Street and around the world. Lehman's business included investment banking, sales, research and trading, investment management, private equity, and private banking. Lehman was also a major player in the subprime mortgage industry, which would ultimately lead to the firm's undoing.
In the years before the subprime mortgage crisis, financial firms borrowed heavily. Lehman was no exception. By early 2008, Lehman had $32 in debt for each $1 in equity. That much leverage implied that a small drop in the value of Lehman's assets could wipe out the firm.
Lehman's exposure to the subprime mortgage industry left it vulnerable during the crisis. As its financial health deteriorated, Lehman used off-balance sheet transactions to hide the extent of its indebtednesses. The transactions, known within Lehman as Repo 105s, were executed near the end of each quarter, just before Lehman filed its quarterly financial reports. In these repos, Lehman sold some of its assets with an agreement to buy them back (with interest) a few days later. Lehman used the cash from the asset sale to pay down other liabilities.
Asset sale to pay down other liabilities. The Repo 105 transactions enabled Lehman to reduce both total liabilities and total assets and allowed the firm to report lower leverage ratios. With the start of a new quarter, Lehman would unwind the transactions and restore the liabilities to their balance sheet.
The effects of Lehman's Repo 105 transactions were sizeable, allowing the firm to briefly remove as much as $50 billion in debt from its balance sheet. Because Lehman did not detail the Repo 105 transactions in their financial statements, outsiders were unaware of the transactions. Within Lehman, concerns were raised over the Repo 105 program. The firm's Global Financial Controller, Martin Kelly, warned of the "reputational risk" to Lehman if the public became aware of the firm's reliance on such transactions.
Assume that Lehman's Repo 105 transactions fall within the limits allowed by Generally Accepted Accounting Principles as Lehman's management has argued. What are the ethical implications of undertaking transactions expressly to temporarily hide how much money a firm has borrowed?