Overgrown Hedge

Yesterday’s column at American Banker digs into the accounting for JP Morgan’s reported “hedge”.  I was shocked – OK, not really – that no main stream media outlet had explained the stunning announcement made by Jamie Dimon last Thursday of a $2 billion loss on a series of trades made by the Chief Investment Office in accounting terms. CIO is the group purportedly managing the investment of the bank’s excess deposits.  In London. As in, the low risk sweep function. Uh-huh.

There’s lots of speculation about the nature of the trade itself. The best I’ve seen is the ongoing coverage at FT Alphaville by Lisa Pollack, in particular.

The gist of all the stories is that the CIO was selling protection on the CDX.NA.IG.9 (going long) to balance out the tranches on the high yield index that they’d bought (going short, which turned out to be profitable when Dynegy and AMR Corp defaulted).

In this way the trade would be both a curve play and across indices — one high yield, one investment grade, with the high yield play levered further because it was a tranche. The long on the IG.9 also would have helped to fund the rather expensive short on the high yield tranches.

If you are an expert in this stuff, please get in touch. I’d buy a big steak for someone who can walk me through it, maybe at a quiet table at Gene & Georgetti’s.

I took a long look at the 10K and 10Q and the first clue was the pretty stark statement, all over the place that the credit derivative number, “Represents the net notional amount of protection purchased and sold of single-name and portfolio credit derivatives used to manage both performing and nonperforming credit exposures; these derivatives do not qualify for hedge accounting under U.S. GAAP.”

So from a financial reporting perspective, all the media and trader chatter about “hedge or bet?” is moot.

The bank may now be calling the positions an “economic hedge” but, in hindsight, they look to me like a series of trades designed to generate income that spiraled out of control on incorrect or ignored risk information and lack of control over traders.

“It was there to deliver a positive result in a quite stressed environment,” Dimon said on the May 10 emergency conference call, “and we feel we can do that and make some net income.”

The rest of the American Banker column provides the details.

I left out a discussion of PwC and VAR and risk management and Sarbanes-Oxley because of space limitations at American Banker.  I have been getting a lot of questions about whether or not PwC “audited” the Value-at-Risk or VAR number.

Dimon also admitted on the conference call on May 10 that the bank’s primary risk management tool, Value at Risk or VAR, had failed to signal the magnitude of the looming losses. VAR is a statistical risk measure used to estimate the potential daily loss from adverse market moves. The results are reported to senior management and regulators and they are utilized in regulatory capital calculations.

The first quarter press release reported an average VAR of 67 for the CIO. According to Dimon, CIO implemented a new VAR model on its own recently, which it, “now deemed inadequate.” So CIO went back to the old one, which it “deemed to be more adequate.” The actual VAR number for CIO for the period was 129. There are now reports that the CIO used a different VAR model than the rest of the bank. That sort of negates the argument that CIO was aggregating risks via VAR from the rest of the bank and “hedging” that risk at a portfolio level. There have also been reports that another area of the bank was making the opposite trades that the CIO was making.

As a non-GAAP metric, JP Morgan’s the financial statement opinion provided by auditor PwC doesn’t cover the VAR number or the model that produces it. (The audit opinion doesn’t cover press releases or MD&A either although the auditor has an obligation to review disclosures to make sure they are not misleading or incomplete.) However, as the bank’s primary risk management tool, the VAR model and the policies and procedures around it are certainly reviewed.  It should be on the auditor’s radar as a key indicator of the quality of the bank’s risk management policies and processes. Changing the model for CIO after several years of “adequate” performance for the bank as a whole should raise red flags. Was the model change properly executed, reviewed and approved at the highest levels?

For more about how models can be used to perpetrate fraud or serve as an excuse for reckless negligence, check out the presentation I made earlier this year at the invitation of Emanuel Derman for Columbia University’s Masters in Quantitative Finance Seminar: Modeling For Fraud, Models Behaving Nefariously.

There were some parts we had to cut so I thought I would put them here.

“The men and women of Human Resources that I worked for during college taught me how to talk and dress like a businesswoman and how to eat donuts and bananas with a knife and fork.

One of the most memorable lunches in my life took place with my three female mentors at the end of my last summer before my senior year of college. I was twenty-one by then, drinking age, so we went to Nick’s Fishmarket, an enormously expensive and extremely formal place. We didn’t skimp on the cocktails. It was first time I realized how many obsequious waiters someone else’s money can buy…”

“Continental Bank shrunk in response to the money market’s continued lack of confidence in the bank after the May funding crisis. Federal regulators found no buyer so, in late July, the bank was nationalized. That contentious term was not officially used, however. The word “nationalization” was studiously avoided by regulators and the media during the current crisis, too. In April of 2010, Andrew Ross Sorkin, author of the book and HBO movie “Too Big To Fail”, and Nobel Laureate and fellow New York Times columnist Paul Krugman ended up in a public debate about whether what the federal government did to Citigroup, GM, and AIG was actually a “nationalization”.

They agreed to disagree.”

“The Congressional testimony of the OCC’s Conover in September 1984 also mentioned that the OCC had considered earlier whether it should have taken action much sooner to stop Continental from growing so quickly and, in hindsight, so recklessly. Conover testified that he believed such action would have been inappropriate but that the OCC could have placed “more emphasis on . . . evaluation and criticism of Continental’s overall management processes.”

Federal Reserve Board Governor Charles Partee is quoted in William Grieder’s 1987 book “Secrets of The Temple” saying: “To impose prudential restraints is meddlesome and it restricts profits. If the banking system is expanding rapidly, if they can show they’re making good money by the new business, for us to try to be too tough with them, to hold them back, is just not going to be acceptable.”

If that’s not enough foreshadowing of the policy prescription the Federal Reserve would deliver during the 2008 financial crisis, here’s Conover again during his testimony explaining to Congress why everyone but shareholders was made whole in the Continental Bank bailout: “…had Continental failed and been treated in a way in which depositors and creditors were not made whole, we could very well have seen a national, if not an international, financial crisis, the dimensions of which were difficult to imagine. None of us wanted to find out…”

The day after Conover’s testimony, the Wall Street Journal published an article by Tim Carrington, “U.S. Won’t Let 11 Biggest Banks in Nation Fail—Testimony by Comptroller at House Hearing Is First Policy Acknowledgement”. A later academic study by O’Hara and Shaw (1990) documented a rise in the share prices of the eleven banks identified by the Comptroller of the Currency that day as “too big to fail”.”

Many of the professionals who mentored me in the early 80’s are still working in banking, professional services, and private equity in Chicago.

One of the biggest and best banks of its time was also the first bank to be called “too big to fail.” I should know. I worked there.

Continental Illinois National Bank and Trust Co. of Chicago would have been 155 years old next year. You may be surprised to hear me praise this institution so highly. But it was my first real job and the place where I learned how to be a professional, including how to be professionally skeptical.

Continental Bank’s auditor was Ernst & Young.

Read the rest at American Banker.  And, please, leave a comment!

One of the wonders of Twitter is the people you meet.

You can write the tool off as talk, talk but it’s been a wonderful window to new worlds for me. People I would have never imagined knowing are in my life because we can gauge common interests passively. Which interests you reveal are entirely of your own choosing.

One of those people I now know but never could have imagined ever having the knowledge of, much less the pleasure of meeting, is Emanuel Derman.

He’s a character, a Saul Bellow character, said one writer when reviewing his first book:

That sense of being an intruder in outlaw territory lends an intriguing mood to Derman’sMy Life As a Quant, a literate and entertaining memoir of his two-stage career — in physics and then financial engineering. Wall Street looks quite different from a nerd’s-eye view: “Geeks were fair game,” Derman reflects. Once, a chief trader who passed between him and a fellow quant “winced, clutched his head with both hands as though in excruciating pain, and exclaimed, ‘Aaarrggh-hhh! The force field! It’s too intense! Let me out of the way!”‘

As one of Wall Street’s leading quants, Derman did throw off some intense gamma radiation. He worked at Goldman from 1985 until 2003 except for one year at Salomon Brothers. At Goldman, he moved from fixed income to equity derivatives to risk management, becoming a managing director in 1997. He co-invented a tool for pricing options on Treasury bonds, working with Goldman colleagues Bill Toy and the late Fischer Black, who co-invented the Black-Scholes formula for valuing options on stocks. Derman received the industry’s “Financial Engineer of the Year” award in 2000. Now he directs the financial-engineering program at Columbia University.

I had the opportunity to have dinner with Derman when he was in Chicago last week. Coincidentally – or not – it was the same day I posted my review of his new book at Forbes.com. Carl Jung says there’s no such thing as coincidence, only synchronicity – the experience of events which are causally unrelated, and yet their occurring together carries meaning to the person observing the events.

More than a description of what went wrong with models during the financial crisis, Derman describes what’s gone wrong with the use of them by those who infused models with omniscience. Derman says, “You can be disappointed only if you had hoped and desired. To have hoped means to have had preconceptions – models, in short – for how the world should evolve.”

The book starts by explaining the tragic social construct that Derman lived with as a child: apartheid in South Africa. “Racial classification was a tortuous attempt to impose a flawed model on unruly reality.”

An extensive biographical sketch of his childhood and youth in Cape Town, son of Jews who fled Poland in the mid-30’s ahead of the Holocaust, serves as an introduction to financial models and the crisis. Many of Derman’s extended family, including his maternal grandparents, were not as fortunate as his parents.

“Had my mother been certain her father was dead by 1945, I would have been named Nahum Zvi. Sixteen years later, in Jewish tradition, my nephew was given his name.”

Derman’s deep familiarity with unruly reality explains his disdain for financial models as all-knowing Gods. It also says a lot to me about why he’d rather teach than continue playing “master of the universe” at Goldman Sachs.

“You can count yourself lucky,” he says, “if your model of yourself survives its collision with time.”

We found out over dinner that we both enjoy Larkin, Nabokov, Joseph Cornell boxes, and Bellow.

Model that…

Professor Derman has invited me to speak February 6, 2012 at the Financial Engineering Practitioners Seminar at Columbia University. The seminar meets on Monday evenings from 6:00 p.m. to 7:30 p.m., and is followed by a reception and refreshments. The seminars are open to the public.

Tentative topic: Financial Engineering of a Different Sort – Using Models to Commit Fraud

The first column, “Deloitte Blurs The Lines To Court Mutual Funds,” discusses the appointment of SEC and Investment Company Institute alumni Elizabeth Krentzman as that firm’s new head of the U.S. mutual funds practice. Her responsibilities include business development and delivery of audit services as well as tax, financial advisory, and consulting.

Elizabeth Krentzman is a lawyer, not a CPA. She’s worked 11 out of the last 14 years at Deloitte, always on the consulting side of the house. But now auditors are reporting to her.

That’s because this month she got a new job leading Deloitte’s U.S. mutual fund industry practice. She oversees the auditors as well as the tax, financial advisory and consulting staff who serve that industry…

Read the rest here.

I have a “friend” whose service to my cause is to monitor CNBC for anything and everything that might be of interest. I typically get at least one video via email each day – lately more Hank Greenberg than Herb Greenberg, although both are interesting commentators on the Chinese reverse merger issues that are keeping the Big Four audit firms up at night.

On Wednesday my “friend” sent a Jim Cramer Mad Money video segment via email. This is especially helpful since I just can’t watch Cramer live. I hear enough of that obnoxious ranting in my dreams and at every wake, wedding and family picnic.

This time Cramer went off on the JP Morgan Securities settlement with the SEC. In his mind, someone, everyone got off too easy.

It’s a familiar lament. In fact, I’m starting to hear that crying and moaning in my dreams, too.

“Where are the prosecutions? ¡Ay Dios mío! ¡Libranos del mal!”

Unfortunately, like a lot of others, Cramer is “spitting into the wind” when it comes to expecting the SEC and the Department of Justice to make these cases. It’s almost too late and they don’t seem to have the “cojones.”

Cramer makes some good points about those that profit from doing evil. He says it’s not fair.

I hope the fellow who put together the deal also got a huge bonus, and I say that with all of the sincerity I can muster. Think about how hard it must have been to make sure you had bad mortgages packaged to hose the buyers so the more important client knew he had a home run. Sure, lots of mortgages were going bad in 2007 when this obnoxious bomb was cobbled together. Who knows, if they weren’t careful, maybe some of the mortgages might have been good. Catastrophic!

I’ve heard of only two enforcement actions related to Section 304 since the Sarbanes-Oxley Act was put into law in 2002. I’ve seen no Section 302 certification enforcement actions, in spite of some very clear-cut casesand the fact it’s a criminal rather than a civil charge.

Unfortunately, there is no law against corporate types keeping the bonuses they were paid, in most cases, even though the deals that generated the profits and their bonuses were a fraud. Edward Steffelin, the former GSC executive named in a separate complaint by the SECrelated to the J.P. Morgan Securities settlement may have to, “disgorge all profits that he obtained as a result of its conduct, acts, or courses of conduct described in this Complaint, and to pay prejudgment interest,” if a judge agrees with the SEC’s allegations or he settles with the SEC.

But the Sarbanes-Oxley Act, enacted after Enron, and the Dodd-Frank Act, passed last year at this time, don’t cover bonus clawbacks from Steffelin or any JP Morgan executives under these circumstances.

Sorry, Cramer.

The Sarbanes-Oxley Act included Section 304, a clawback provision that is only triggered if a company restates its financials as a result of accounting manipulation or fraud and the restatement is the result of misconduct. Section 304 only applies to the CEO and CFO – the ones that sign the Section 302 certifications – and seeks to recoup only those amounts received in the year following the first improper SEC filing.

Read the rest at Forbes.com in my column, Accounting Watchdog.

Here’s an excerpt:

In the US, the Big Four leadership is noticeably absent from any public conversation of audit or audit industry reform. It’s hard enough for reporters to get them to respond to actual litigation or other less positive news about the industry. No comment or a bland formulaic response about complying with all standards and doing quality work is the norm.

We do see the Big Four global chairmen savor the attention showered on them as bobble-head world-leader savants at Davos. There’s always a full retinue of interviews by clueless journalists in reindeer sweaters who can barely pronounce IFRS and PCAOB, let alone ask probing questions about the role of either. In addition, the audit firms do lobby strenuously by spending time and money on monitoring and influencing legislation, but that work is done under the radar. They loathe any attention to it.

Read the rest at Accountancy Age.

This article was originally published on GoingConcern.com October 7, 2009.

It’s been a while since an update on the PwC/Satyam fraud for re: The Auditors. Rest assured, it’s all still a big problem for PwC. Their partners are still in jail but the wheels of Indian justice turn slowly. I did receive reports that India’s accounting regulatory body has already found the partners guilty and the Indian government will soon sanction the PwC partners and PwC. PwC Global Chairman Dennis Nally, reportedly, will be in India next week to work the political angles to make sure the firm is not kicked out. Their new “cluster” structure implies a global organization but, still, in their minds, protects them from shared liability. Nevertheless, Dennis is going because the firm’s global future is clearly at stake due to the Satyam debacle.

Getting banned from India is a pernicious possibility – one PwC faced before in Russia and Japan. It’s one other audit firms may face. Take the Akai case. EY’s settlement is now reported as ~$400 million. Where does that money come from?  Certainly the Hong Kong practice alone can’t pay it. Recall… EY took the bold move about a year and a half ago to create a semi-unified half-global network.  Fortunately for those that did band together, Asia is not included.

I’ve been ruminating about these global engagements and the new organizational structures. I’ve been thinking about the communication approaches these firms use when a crisis hits. What was the reaction of the PwC partners last December when Satyam’s CEO confessed? PwC has its hands all over many of Satyam’s largest clients, either as their auditor or a trusted consulting advisor.  When they did discuss the case was it conferring, commiserating, or colluding? Were they concerned about the impact of a Satyam failure, given their clients were highly dependent on Satyam?

It matters not whether you buy my hypothesis that PwC partners were steering outsourcing business to Satyam and/or vouching for Satyam to their clients, perhaps in return for rupees. A Satyam implosion presents real risk to PwC and some of their clients.

Satyam’s clients are all over the world.  Many of these jurisdictions have privacy and confidentially laws that prohibit information sending/sharing data across borders.  How do professional services firms, organized in loose confederations of separate legal entities get around this issue in order to protect their clients and, perhaps, in some cases shield themselves and their firms from liability?

I asked some trusted friends and sources – professionals that work with global engagements in the audit firms and have knowledge of these restrictions. Every one of them said I was making an invalid assumption: Audit firm partners don’t give a rat’s ass.

Instead, they reminded me,  audit partners are sometimes arrogant, small minded, insular, stove-piped, managed loosely, provincial, non-passport carrying, self-serving, self-interested, smug, bad tippers who don’t care about anyone or anything not directly related to their annual draw. I was giving them too much credit, they told me. Partners bide their time, take their measly million or two out each year in cash and hope they don’t end up like one these guys.  I saw that attitude at PwC regarding Japan. But I keep refusing to believe it.

Is it possible I care more about the future of the audit firms and their clients than many of their partners do?

This post was originally published in GoingConcern.com on October 14, 2009.

It seemed like a good idea at the time.  Analyze a few numbers for an insurance industry lobby and write a report.  I suspect this was, at most, a $150k engagement. Small change.  But that’s what trusted advisors do.  Come, panting, when called.  Help clients make their case using numbers, charts, and well-crafted prose. Sometimes they also whore their “world-class, gold-standard” imprimatur to what, in this case, was essentially a biased political agenda.

Karen Ignagni, the president of insurance lobby America’s Health Insurance Plans…defended PricewaterhouseCoopers…“PWC is a world class firm,” Ignagni said. “They have a stellar reputation and they have proceeded to do this analysis in a thorough and comprehensive way.”

PwC agreed to help America’s Health Insurance Plans (AHIP) – the lobbying arm of the health insurance industry —warn Congress that the Baucus health care bill would increase health care costs. Unfortunately, the report had some very contentious components and the backlash started immediately.  The most controversial claim was that average family health insurance premiums would increase by approximately $4,000 a year if the legislation being voted upon in the Senate Finance Committee yesterday were to become law.

It’s no help to PwC that critics can easily dredge up numerous examples of PwC and the rest of the Big 4 selling their soul and performing “a textbook case of checkbook research.” I Tweeted a story yesterday of Ernst and Young providing paid cover to the payday loan industry, generally characterized in the media as a bunch of vultures. And I’ve written extensively on Deloitte allegedly earning hundreds of millions, especially under the previous administration, for providing cover for unusual and special covert operations in strange parts of the world. And, well, we all know KPMG’s history of accepting suitcases full of money to provide Big 4 cover for illegal tax shelters.

From The Guardian in the UK: “Read this important Jon Cohn post in which he brings scrutiny to bear on some of the assumption used in the report to reach the (desired?) conclusions. Cohn demolishes the report…The report is just a totally dishonest assessment.”

The PwC Healthcare Advisory leadership probably thought, “Hey this is a good way to keep stroking our insurance industry clients, both on the audit and the advisory side of the fence.”  I recently received an email asking about PwC’s desire to bulk up this practice, given that it serves one of the few industries expected to grow, change, and have enough uncertainty to drive bigger dollars to “trusted advisors.”

“I have been told that PWC, under the Global leadership of Dr David Levy is starting a new “high-level” recruitment campaign of consultants with a strong healthcare, pharma, and biotech backgrounds….It’s obvious to me that big pharma on one side and the biotech companies on the other have a lot at stake these days and could use some professional advice.”

PwC Advisory, in my opinion, is only capable of commodity-type consulting, not value-add big thinking that brings major insights and opportunities to clients. However, PwC has already picked up significant market share in this space and went from not even on the list to near or at the top according to Gartner, IDC and Kennedy. According to sources, PwC did a number of major projects for Grady Healthcare, State of Louisiana, Luxembourg, and the State of California.

So…

Nice start, PwC, in pumping up the public policy profile of your Healthcare Advisory practice. Discrediting your own analysis, leaving your client swinging in the wind, and backing down like a frightened puppy does not bode well.

The Lehman Bankruptcy Examiner’s Report is an aggravating example of, “Be careful what you wish for.” The mainstream media (MSM) is now paying attention to the Big 4 – Deloitte, KPMG, PricewaterhouseCoopers, and Ernst & Young.

The financial crisis is now about accounting fraud.

Every two-bit journalist and blogger on the business beat is spitting out stories to keep up and one-up each other. It’s not every day that the accounting firms provide so much gossip about spectacular criminal and civil penalties. Well, actually, it is every day. There’s almost a thousand stories in the re: The Auditors pointing to just such an outcome if any of the Big 4 ever looked down the barrel of a litigation shotgun like Lehman.

Ryan Chittum is a Staff Writer for The Audit, part of the Columbia Journalism Review where he critiques media coverage of business.

Yes.  It really is called The Audit.

On March 15^th Ryan claimed blogs are beating MSM on the Lehman story but lamented the short attention spans of most publications.

“Look, I know that Lehman collapsed a year and a half ago, but this is a major story—one that finally gets awfully close to putting the crimes in the crisis. I’ll go ahead and say it: If you’ve wanted to know about the Valukas report and its implications, you’ve been better served by reading Zero Hedge and Naked Capitalism than you have The Wall Street Journal or New York Times…”

Welcome to my world, Ryan.

On March 16^th, Ryan over-the-knee spanked John Carney, Managing Editor of Clusterstock, for tripping all over himself arguing against prosecutions for Lehman scandal actors.

“I suppose we shouldn’t be surprised that John Carney thinks “We Should Not Criminally Prosecute Lehman Executives.” After all, this is someone who is a fan of insider trading, which he says “harms no one” and ought to be legalized….”

I agree with Ryan. John Carney has it all wrong. Does being on TV a lot create the delusion that wishing can make it so?  John Carney practiced law.  He knows better.

Anton Valukas, the Lehman Bankruptcy Examiner and Chairman of law firm Jenner & Block, knows his way around white-collar and corporate defense. If Valukas points to “colorable claims,” I’m apt to believe there’s some colorful legal culpability to see. Jenner & Block had so many lawyers working long hours on the report, Valukas probably had Gene & Georgetti’s on speed dial.

But the Examiner’s Report is still developing. Valukas points to many areas where he had neither the time nor the stomach to explore further. He not so subtly tells other interested parties to go wild.

Is Ernst & Young going to fail like Arthur Andersen?

These are easy tropes to toss – Andersen, Enron and off-balance sheet shenanigans. But the Repo 105 discussion is a distraction. So is the “Sarbanes-Oxley failed us” whine. Repo 105 is not off-balance sheet accounting but good old-fashioned “round-trip” transaction shenanigans. This was garden variety accounting manipulation by the highest levels of the corporation, accomplished with the acquiescence of the impotent auditors. I described these techniques three weeks ago, “…Can Anyone Catch Lehman Stealing?” But finance bloggers often shine these turds to make them worthy of their dazzling quanty brains.

The biggest criminal exposure for the Lehman executives comes from their alleged lies about the use of the Repo 105 transaction as a “sale” or revenue recognition transaction versus a financing technique. This was not disclosed. They skipped it in the filings and confirmed these lies when signing false quarterly Section 302 certifications. These are criminal violations of law. We may also learn these sleights of hand with scienter were designed to provide cover for insider trading or options backdating activities. Those actions would also be criminal. And then there’s the possibility Fuld and others lied to Congress or other investigators. That could handcuff their attempt to avoid criminal prosecution.

Lehman executives are already defending against significant civil suits. I think more suits will be filed naming directors, especially audit committee members, in spite of the pass they got from Valukas. There are already tons naming executives, directors, Ernst and Young and others as defendants.

Ernst & Young is now vulnerable to more suits, better-drafted suits, bigger than $1 billion dollar suits. Civil suits won’t to kill EY right away. EY may die, however, from suffocation if their legal contingency numbers rise rapidly enough. Or they may suffer a slow death from a thousand cuts when the cost to defend the firm becomes overwhelming. But the public won’t know because the Big 4 audit firms do not issue audited financial statements and do not disclose their legal contingencies or their reserves for those contingencies. We’ll have to depend on the regulators to keep an eye and make a plan if the cookie starts to crumble.

Arthur Andersen died because a criminal indictment prohibited them from signing audit opinions. That’s the business they were in and they were forced to turn in the keys. But Andersen was already on life support because of the number of lawsuits they were facing prior to Enron, the overwhelming costs of that defending themselves and the inevitable settlements. The end was already near.

EY is not likely vulnerable to criminal indictment as a firm. There may well be something they should be indicted for. But the US Department of Justice has no appetite for throwing kerosene on this smoldering pile of dung. EY may be subject to criminal indictments outside of the US. The loss of the EY UK member firm would be as crippling to the network as loss of the US firm. The UK regulatory authorities are questioning EY due to the cross-border Repo 105 transactions and their use of UK law firm Linklaters as a “fixer.”

I would bet real money EY will have to testify before the House Oversight and Financial Reform Committee soon. Legislators may finally get heads out of the ratings agencies’ ass and realize that the accounting firms are supposed to serve the public interest. The Big 4 abandoned this public duty a long time ago, Sarbanes-Oxley or no Sarbanes-Oxley. Add lying to Congress to their list of sins if they screw this up.

Finally, the EY audit partners will be delivered to gallows by their firm. Regulators and the Department of Justice have signaled they will nail individuals for civil sanctions and penalties as well as criminal violations. It happened at KPMG. They tossed partners overboard to avoid a prosecution from their tax shelter scandal. EY recently disowned partners who went to jail for similar crimes. But we may see EY sheltering Lehman audit partners Schlich and Hansen until the firm cuts their own deal.

The formal definition of “professional skepticism” does not include the phrase, “pass the smell test.”  Nor does it include the phrase, “If it walks like a duck, and quacks like a duck, it’s probably a duck.”

Like most AICPA prose it’s pretty vanilla.

Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. The auditor should conduct the engagement with a mindset that recognizes the possibility that a material misstatement due to fraud could be present, regardless of any past experience with the entity and regardless of the auditor’s belief about management’s honesty and integrity.

When a new batch of Ernst & Young auditors arrived at Lehman Brothers each year, Repo 105 transactions must have caused debate. After all, a transaction that’s called a “Repo,” short for “repurchase”, but that’s actually recorded on the books as a sale, is a little odd.

It may have even quacked.

The Repo 105 transaction began with an exchange of $105 of collateral for a $100 loan. Because the Repo was structured that way, Lehman said it was a “sale” and, therefore, did not record the loan. That is, forget the CR “loan payable.” CR Assets to take the securities off the books, DR cash. Then CR Cash and DR Liab when the cash received is used to pay off other liabilities.

The actual transaction reduced assets in order to improve the leverage ratio for the ratings agencies. Lehman smartly realized a double benefit by using the cash to reduce liabilities for an increase net capital. Lehman “buys” back the security ten days later, pays an additional above-market amount in “interest” for this non-loan, and takes back the full collateral.

There’s been a lot of talk about the excess collateral, securities worth 105% of loan value versus typical 102%, as the cornerstone of Lehman’s position, supported by EY, that ‘control” of the assets passed from Lehman to the counterparties.  The excess collateral was a necessary condition for treating the transaction as a ‘sale” but not a sufficient condition for any US law firm to bless it.

Quack. Quack.

However, what really doesn’t smell right to me is Lehman continued collecting the coupon payments for these securities while they were temporarily not “owned” by Lehman.

Picture this….

Lehman “sells” the highly liquid government bonds and removes them from their system. The counterparty, UBS for example, “buys” these securities, and puts them on their investment accounting subsystem. But the coupon payment on the bonds is still recorded Lehman. How does Lehman account for this income?  There’s no asset to record it against, no CUSIP to match it with. How does the counterparty, UBS, account for the fact they will not be receiving any coupon payment for a highly liquid government bond they own?

Professor Roger Collins of Thompson Rivers University commented, “If I were teaching an Introductory Financial Accounting class I’d have a very hard time explaining to my students that a Repo 105 transaction represented a sale, especially given the coupon collected.”

Maybe Lehman never takes the bonds off their system. They are, after all, “Repo” transactions. There’s an intention and a contractual obligation to “repurchase” them. How, then, to run financial statements and leave these assets out of the numbers at quarter-end?

Who are we kidding?

Either way, sounds to me like a lot of string and sticky tape to make these transactions work each quarter on both ends. But UBS, one of Lehman’s counterparties for Repo 105s is also an Ernst & Young audit client and a pretty conflicted one at that. Maybe they all talked it over amongst themselves and worked it out.

Nothing would surprise me.