On Wall Street, massaging the balance sheet is a time-honored practice.

But did Lehman Brothers Holding Inc cross a line in the routine manipulation of its balance sheet, as described by an independent examiner?

That is the central question to emerge from the examiner's report, released late on Thursday by the bankruptcy court in Manhattan, which details examples of Lehman concealing assets and liabilities through accounting techniques.

Thomas Baxter, general counsel of the Federal Reserve Bank of New York, one of the main banking regulators, told the examiner, Anton Valukas, that he was generally aware of firms using balance-sheet window dressing, but had no specific information on Lehman.

Banks have wrestled with this issue for years. The old Bankers Trust, for instance, struggled to fend off bank clients that wanted to use BT to help conceal assets, said Ray Soifer, a consultant who previously worked at BT and sat on a task force designed to reduce that business.

Reducing leverage is something that banks do. It's cosmetic, Soifer said.

In 2003, an internal review into accounting irregularities at Freddie Mac found the government-sponsored mortgage finance firm had periodically rented out its balance sheet to a Credit Suisse Group AG mortgage trader.

The review found that Freddie Mac entered into a series of deals with Credit Suisse that allowed the investment bank's trading desk to park some $8 billion in mortgage-backed securities on the mortgage firm's balance sheet.

Over the years, one common trick has been to borrow money at the beginning of the quarter and invest it in short-term bonds that mature before the end of the quarter. When the bonds mature, the bank pays back its debt and it has fewer assets and liabilities.

The upshot is that the bank generates more profit off what appears to be fewer assets, giving it a better return on assets, a commonly watched measure of profitability.

One former chief executive at a bank noted this method can goose earnings higher, but is terrible for the company long term because it does not build the overall franchise.

For commercial banks, regulators caught onto this trick years ago, which is why banks typically report average assets during the quarter in addition to assets at the end of the quarter, both to the public and to regulators.

But major investment banks did not have that obligation and, even now, often do not report their average assets to investors.

Nobody knows if other banks are doing this kind of thing, said Brad Hintz, an analyst at Sanford Bernstein who was Lehman's Chief Financial Officer in the 1990s. But he said the question is sure to come up in conference calls for Morgan Stanley and Goldman Sachs Group Inc .

HOW IT WORKED

The mechanism that Lehman used for concealing assets and liabilities was much more complicated than borrowing at the beginning of the quarter and paying down debt at the end.

It involved a series of short-term transactions similar to repurchase or repo deals, which entail selling assets and agreeing to buy them back in the future, according to the examiner's

report.

Lehman's deals were known as Repo 105 transactions. But instead of treating them as financings, Lehman classified these repo deals as sales, which permitted the investment bank to keep the transactions off balance sheet.

Here is how it worked: Lehman essentially transferred assets to its London unit, which was the only jurisdiction where the bank could get lawyers at Linklaters to sign off on the deals. At the end of a quarter, Lehman would sell high quality assets to a counterparty -- the examiner's report mentions multiple European and Japanese banks -- for cash. The investment bank typically got cash equal to about 5 percent less than the face value of the asset. Lehman used the cash to pay down debt.

At the start of the next quarter, Lehman would buy back the assets and borrow funds again.

The net impact was the bank had lower assets and liabilities, making it appear to have less debt relative to its equity than it really did.

These transactions may have started out small in 2001, but by 2008 Lehman was using them to move big chunks of assets.

The bank did about $50 billion of these transactions in the second quarter of 2008, which reduced its reported assets by about 7 percent, based on the company's financial statements for that quarter. That reduced its leverage ratios by nearly 2 points.

The massaging allowed Lehman's leverage numbers to look much better than competitors. According to data compiled by Bernstein's Hintz, Lehman's net leverage ratio was 14.7 in the second quarter of 2008, compared with 20.8 for Goldman Sachs. Net leverage excludes repo assets and looks at assets compared with equity.

MORE MASSAGING

Lynn Turner, a former chief accountant for the Securities and Exchange Commission and now senior advisor to the consulting firm LECG, said the decision by Lehman executives to make greater use of Repo 105 is consistent with what companies do when they get themselves into trouble.

Companies never just fudge it a little bit, said Turner. They start out just doing it a little bit and over time it grows and grows.

While Turner said he was not aware of the Repo 105 transactions during this time at the SEC, he said it is fair to wonder if anyone else is doing it.

Turner added: No one is going to stand up and say so.

(Reporting by Dan Wilchins and Matthew Goldstein; editing by Andre Grenon)

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