Repo 105 is “Round Trip” fraud, not just balance sheet manipulation.

I think this is number six in the Lehman Japan series. Yesterday, I explained how the accounting fraud “Repo 105” was used to move liabilities off the Lehman Japan balance sheet. I know that a few of the mainstream press sources say that the scandal moved assets off the balance sheet, but technically that’s incorrect. (See for example, this New York Times piece, saying):

[Lehman] routed [the repos] through its British subsidiary. That meant they came under the British legal system, and the law firm Linklaters was able to opine that the transactions counted as sales. United States accounting standards apparently did the rest, allowing Lehman to shuffle $50 billion of assets off its balance sheet. Regulators in different jurisdictions need to cooperate to close all such gaps that they can.

But as I showed yesterday, the cash that Lehman received as part of the Repo 105 repurchase agreement was very much real, and that’s what they used to reduce liabilities. They wanted to keep that right-hand-side of the balance sheet way down, so that the thin capital the firm had left would count for more with regulators, and particularly with the creditors (like Citibank and JP Morgan) that Lehman depended on for more borrowing.

This scandal is like if the everyday homeowner kept going after yet another home equity loan by telling his/her other lenders that he/she didn’t have all the other debt they did. I’m not keen on using the homeowner example because the kind of borrowing Lehman was doing was over a couple of days, and mortgages are meant to be more permanent. (Although you have to wonder in contemporary times.) But maybe it was like the $300,000 homeowner with a $200,000 mortgage going out and putting $50,000 on a credit card, using that money to pay the mortgage down to $150,000, then telling a new home equity lender he just had the $150,000 debt on the house. Not $150,000 plus the $50,000 credit card.

If you get the sense that it’s obvious when you see the break in the link (the borrower not showing the full cycle of the transaction), then you got it. This part of the scheme is as old as the hills. Lehman was doing what CPAs and other auditors refer to as “Round Trip” fraud. Repo 105 is at heart a Round Trip fraud as well as balance sheet manipulation.

It goes to show that despite modern computer technology, the Big Four are desperately weak on good auditing when it comes to spotting the old techniques in the new ways that are dreamed up. When America and the developed world had more of a manufacturing base, this fraud was apparent whenever a firm reported only a part of a transaction, and left an important piece out.

Like:

Buying inventory but not showing it was on credit.

Booking sales but not showing that inventory was being reduced at the same time.

Booking cash but not taking down the paid receivable on the books, too.

For each of these round-trip problems, there are of course related frauds that can be found. For example, “front loading” or “stuffing the channel” may also be present in the second example; “skimming” in the third. But they all have, at the heart, the idea that part of the transaction is not being booked.

When I was looking at the Lehman Japan FID (fixed income [division]/desk) blotter, one of the first things I did, once I had more control over the direction of the project, was to trace out the full transaction. This is how I knew that Lehman Japan, as a distinct facility, was not being paid interest for its lending facility, at least anywhere where I could see it. And what purpose of what now you would term the legitimate part of the repo trading was: to borrow yen, sell it, get a higher-yielding currency and invest in that currency’s short-term money markets.

Borrow yen at 0.5% short-term,

invest in Australian dollars at 6.0% short-term (2007 rates);

hedge the exchange-rate risk, (and sorry for the heavy technical jargon, but) usually by running a duration-matched set of long and short positions in yen bonds.

Lehman Japan showed all the parts of this as they occurred on Lehman Japan’s books. It was simply that Corsalini, Erik Addington and company, didn’t understand why the firm was doing the trading.

This is why I have said, when the federal investigators go knocking on their doors–and anybody else in local senior management in the Vaulkas Report’s footnotes–they are going to find more honest stupidity than conniving. If anybody outside of a small group knew the outright fraud, they did a pretty good act covering it up. But I imagine that the longer anyone stayed around the place, they must have gotten the sense something was amiss.

And if only for the fact that operating with “thin capital” as I showed yesterday meant that there was at least the incentive to fudge on other accounting to keep the Japanese regulators at bay.

All this would be on hard evidence, not gossip. What the general public needs to know is that all the records of a brokerage, even electronic ones, must be kept for a set number of years. Off the top of my head, I think it’s five, but might be seven. This is why there is a 2,200 page bankruptcy examiner’s report.

Provided there is/was a full turning over of the documentation, the government will data mine that evidence for every and any connection, even using the social networking tecnnology, like [a] Facebook, to see who, in the Repo 105 matter, “friended” who. [Not actual Facebook, but a similar model.]

When the prosecutors go to grab the Big Guy (and it might be a Big Girl like Erin Callan in that, too), they usually start lower in the pyramid. They shake up the lower ranks with, yes, the threat of prosecution, to get them to sing. During the shake-up, they usually find lesser offenses and regulatory shortcomings and that’s all these guys ever get stuck with if they weren’t knowingly part of the crime. At some point on the way up the management pyramid, they find the people carrying on the crime. Or at least the people with the heavy civil liability.

Lehman is not likely to disappear from the headlines for a couple of years. Many commentators and especially bloggers who focus on the financial crisis and/or lack of integrity in business practices are screaming from the keyboards that no enough is being made of this all. But really, these things take time; especially, if you want the criminals to do time.

A note about confidentiality. I am a member of two licensed professions, so I don’t break confidentiality. I keep it in mind and consider its different aspects. This makes a resume and interviewing very hard in Tokyo, because the hirer or headhunter wants details about “what you did in ‘x’ role”, besides the generic description. And I usually stay more to the side of not talking, even with the clear risk that it makes me look like a bullshit artist when I don’t fill in all the details.

“Where did Lehman’s confidentiality go?” Yes, Lehman had what I call a “clean” confidentiality form. (That is, one that only sought a promise of confidentiality and not 15 other contractual items like saying a contract end would be considered a “quit” for purposes of labor law, etc., etc.)

But, you know, Lehman (Lehman Brothers Holdings International, Inc.) is still around. Not everybody knows that. So the promise to Lehman (which of course does not extend to a promise to hide wrongdoing or even incompetence) is one that transferred to the trustee in bankruptcy on September 15, 2008. Even if a promise of confidentiality like that extended to things like wrongdoing or incompetence, the promise holder is the Trustee, not the people who used to work for Lehman.

Furthermore, Lehman was not my client, and the engagement was not an audit. So I am comfortable discussing particulars of business dealings that have already been made public by an officer of the U.S. bankruptcy court.

Not to mention the fact I still have 75 shares of what used to trade as “LEH” (now “LEHMQ”, the symbol for Lehman stock after the bankruptcy). And so these people’s business practices cost me money, and it would also make me one of the class-action “class” as a plaintiff in a civil action.