Outrage Over Lehman Should Shake Wall Street to Its Core

Bankruptcy examiner Anton Valukas's 2,200 page report detailing how and why Lehman Brothers collapsed is so damning that it should be a turning point in financial history. Whether it amounts to more than a footnote will be up to the lawmakers who have managed to delay reform of the financial markets. If this report, issued late Thursday, isn't enough to compel them to take action, nothing will.

The report lays out how Lehman Brothers used financial engineering to make about $40 billion to $50 billion of debt briefly disappear at the end of each of three quarters, the fourth quarter of 2007, and the first and second quarters of 2008. That allowed the company to misrepresent its debt levels to investors and the Securities and Exchange Commission.

The 158-year-old firm filed for bankruptcy protection on Sept. 15, 2008, in the largest bankruptcy ever. It had $613 billion in debt and $635 billion in assets. Most of its core assets were sold to Barclays on Sept. 20 for $1.35 billion. A few days later, Nomura announced it would buy Lehman's assets in Asian and Europe.

Valukas, 66, a former prosecutor, is the chairman of Jenner & Block, a Chicago-based law firm. He said that former Lehman CEO Dick Fuld was guilty, at the least, of gross negligence. Senior Lehman executives could be faulted for a range of things, from non-culpable errors of business judgment to actionable balance sheet manipulation. And he said that auditor Ernst & Young failed to exercise proper oversight of Lehman.

Much of the problems occurred in the repo market, which is short for repossession. The repo market is used by many investors who put up assets as collateral in exchange for short term loans, often just a day or two. Lehman used these transactions at the end of the quarters in question, offloading debt from its balance sheet and using cash from the loans to pay down even more debt. After the end of the quarter, it borrowed money to repay the repo loans and repurchase its assets, according to the report.

The biggest problem is that Lehman used a certain kind of repo, known as a "105," to make the repo loans look like sales. That is how it made its balance sheet look stronger than it really was.

The report raises plenty of troubling questions. At the very least, lawmakers and regulators should find out who the counterparties to these questionable trades were. And it should find out whether other banks or investment firms have used, or continue to use, similar tactics to disguise their debt.

Finally, the Senate needs to finish the task for financial market reform. Senator Chris Dodd is scheduled to make his recommendations on Monday, without the participation of Senate Republicans, who have failed to come to terms with the Democrats on this issue. Loopholes that allow banks such as Lehman to mask the true nature of their balance sheet must be closed immediately, and broader regulations governing the use of derivatives, proprietary trading, and hedge fund and private equity activity by banks need to be put in place right away. Otherwise, the outrages that brought down Lehman will continue, undermining tbe markets and the economy.