There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate. Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non‐culpable errors of business judgment to actionable balance sheet manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by Government agencies, who by their own admission might better have anticipated or mitigated the outcome.The examiner describes how Lehman significantly increased its leverage (specifically, its short-term borrowing to finance long-term assets) starting in 2006. When the subprime mortgage market began to deteriorate, Lehman pursued the worst possible strategy (in hindsight), further increasing its leverage and "doubling down" on its subprime involvement. And then when this strategy didn't work, "Lehman painted a misleading picture of its financial condition."
The examiner reports that it did this through an accounting gimmick called a "Repo 105," in which it moved $50 billion of assets off its books and reported short-term financing agreements based on these as sales rather than as financing. This made Lehman appear to be less leveraged. Indeed, the examiner reports evidence indicates "their sole function as employed by Lehman was balance sheet manipulation." Nevertheless, Lehman's accountants from Ernst & Young signed off.
The examiner also reports that Lehman grossly overstated its liquidity pool.
These misstatements helped Lehman raise more capital to keep its schemes going and to increase investor losses by billions more.
The examiner also finds that unreasonable claims by two other investment bank creditors, JP Morgan - Chase and Citibank, in Lehman's final days hastened the firm's demise.
Government agencies, especially the Security and Exchange Commission (SEC) and the Federal Reserve Bank of New York (FRBNY), also appear to be culpable. Both agencies were aware of Lehman's problems. The examiner reports, "at the time of Bear Stearns’ near collapse in March 2008, it was widely thought at the highest levels of every relevant Government agency that Lehman could be the next investment bank to fail." Despite this, neither agency forced Lehman to disclose those problems, and the FRBNY, under Timothy Geithner, continued to lend to Lehman through the discount window.
The government also failed to clearly communicate its hands off approach, leaving Lehman executives and others to anticipate a bailout that never arrived. The government was also hampered by rules that made the SEC Lehman's primary regulator. When the SEC failed to act, the hands of other agencies were tied.
It looks like Lehman executives, some of its banks, its accountant, and the government were aware of its problems. However, none of them let the investing public in on the secret.