Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Friday, March 19, 2010

Repo 105: Fooled Again?

I'm still trying to figure this Repo 105 thing out. I read an interesting article in the Financial Times: Fooled Again, but it leaves many questions unanswered.

The paper version of this article has an inset called How Repo 105 Worked. Here is what it says.
Banks use repurchase agreements, known as repos, all the time for short-term financing. One borrows cash and gives the other securities, such as government bonds, as collateral. Both agree to unwind the arrangement on a set date. The deals, which run only for days or weeks, are accounted for as financings, and remain on the books with banks recording and asset--the cash--and a matching liability in the promise to buy back the collateral.

Lehman's 105 was different -- insteach of handing over securities equivalent to the cash it received, the bank gave more than was necessary. The point was to exploit a loophole allowing such over-collateralized deals to be accounted for as true sales. Lehman then reported its obligation to repurchase the securities at a fraction of the full cost, and used the cash it had received to pay off its liabilities, thereby "shrinking" its balance sheet.

Now, if you understand this, you are smarter than me!

The first paragraph seems OK, except that perhaps "matching liability" should be replaced with "corresponding liability."

The second paragraph seems just plain wrong to me. Lehman's 105 was not "different" in the sense the cash loan was over-collateralized. Over-collateralization (the "haircut") is normal in repo transactions.

And the point was not to exploit the "loophole" of treating the repo transaction as a "true" sale. After all, repo is short for "sale and repurchase agreement." There is a legitimate sense in which there was a sale.

And if one does treat the transaction as a sale, then I think there is a legitimate reason for why one should not have to record the corresponding liability to repurchase the asset (pay back the cash loan).

An example. Imagine that I have asset (capital) worth $100 and no debt. I am worth $100. Imagine that I repo my asset for $90 in cash: What does my balance sheet look like?

I am an economist (not an accountant); so I would say that your B/S should now look like this:
Assets: $100 (capital) + $90 (cash)
Liabilities: $90 (cash loan -- promise to repurchase asset)
Wealth: $100 (unchanged)

But as this is a repo, let's take the "sale" part of repo seriously. That is, imagine that I have "sold" my asset. In fact, there is a sense in which I have sold it: I have diverted control of the asset to my creditor, who holds it as collateral. It's not like I (or other shareholders) can access this asset in the event of default. If this is true (and it is), then why should I record the asset on my books? OK, suppose I don't. Then my B/S looks like this:

Assets: $90 (cash)
Liabilities: want me to record the $90 loan? Shouldn't I leave this loan off my books? After all, I am not counting the corresponding asset as something I own. And I do not have to pay back my loan -- I have the (legal) option of not doing so; in which case the creditor gets to keep my asset. Moreover, if I do include the $90 liability, then my reported net worth drops to zero! Let's be reasonable here and not include the liability; in this case...
Net worth: $90 ($10 less than prior to the repo, but still higher than zero, which would grossly underestimate my net worth)

If there was a problem with what actually transpired, it probably resides in the fact that the transaction was not disclosed (off balance sheet items were not reported). While this sounds like funny business (and it no doubt was), I do not think that any law was broken (and keep in mind that everything was disclosed to Ernst & Young, the accountants in this case).

As the Financial Times article explains, there are a lot of grey areas in the theory of accounting. If a firm exploits these grey areas to make their books look (temporarily) better, who is to blame? The firm, the "independent" accountants, or the accounting principles themselves?

If your answer is the firm, then be prepared to condemn most firms (and individuals too) of the practice of keeping some assets and liabilities off balance sheet. Be prepared to blame governments as well, since many important government liabilities are not recorded in "official" government debt measures. In short, this is not a problem that resides with just a few Lehman executives.


  1. David,

    I think your assessment is correct. I would like to add the point that off-balance sheet financing has become quite common. And, of course, it doesn't mean "not disclosed." It means "not directly recorded onto the balance sheet." It is still disclosed in the annual report (10-K). Airlines, gold mining firms, and many other companies that use derivative contracts to hedge various risks have been disclosing their use of derivatives in this manner for decades.

    The point is that off-balance sheet stuff is fine as long as it is still recorded in the annual report (10-K). It seems to me that the regulators are pitching a fit because they were lazy and didn't do the appropriate homework. If any of my students didn't know what was in the 10-K, and only relied on the financial statements for an analysis, they'd get an F. Professional analysts are the same. It's a recipe for making bad decisions. But why should Lehman, or even E&Y, be blamed for the mistake of lazy regulators? Or counterparties, for that matter?

  2. Does it matter what type of assets are being swapped? If you're talking about secure government debt or gold bars I see your point, but if you're swapping questionably valued mortgages or other derivatives for cold hard cash, for no reason other than to mislead investors, you don't see anything wrong with that? What possible "good" motives could they have in this case?

    Even given your example, should I read a financial statement and see $90 in cash instead of $100 in questionable paper, that's not an irrelevant difference in my view. Especially if someone is trying to understand the amount of leverage involved.

    Even if it doesn't violate the letter of the law, it's hard to imagine this doesn't violate the spirit.

  3. Prof J: Very interesting. I did not know that off balance sheet items are supposed to be reported in annual reports. Do you happen to know whether Lehman Bros. violated this principle?

    Pointbite: No, it does not matter (for the argument I make above) what assets are being swapped. It is up to the creditor to verify the quality of the collateral asset. And, indeed, if Lehman tried to pass junk off, it would have been given a huge haircut (this is in fact what happened in the repo market...huge haircuts on all sorts of assets). Do the exercise yourself. Imagine that I repo an asset that I know is junk for $90. I then report $90 cash as assets, and do not repurchase it (which I am legally allowed to do). The creditor takes the junk, I am up $90. Most people would call this a smart business decision.

  4. "which I am legally allowed to do" by going bankrupt, in which case the government is likely to pay the bill?

    What about leverage. How does this affect the headline "30:1" or "40:1" ratio CNBC likes to discuss so frequently.

  5. David,

    Lehman Brothers' Holdings does indeed disclose their repo activity in aggregate terms. The latest 10-K available is 2008, since they don't file 10-Ks anymore.... Also, in the 10-K, Lehman writes that they do not own, manage or sponsor any structured investment vehicles, and that all of their repo exposure was through the proprietary trading desk. They also have a lengthy discussion regarding liquidity risk in qualitative terms. For fun, here it is (not the whole thing):

    "To the extent that a liquidity event lasts for more than one year, or our expectations concerning the market conditions that exist during a liquidity event, or our access to funds, prove to be inaccurate (e.g., the level of secured financing “haircuts” (the difference between the market and pledge value of the assets) required to fund our assets in a stressed market event is greater than expected, or the amount of drawdowns under our commitments to extend credit in a stressed market environment exceeds our expectations), our ability to repay maturing indebtedness and fund operations could be significantly impaired. Even within the one-year time frame contemplated by our liquidity pool, we depend on continuous access to secured financing in the repurchase and securities lending markets, which could be impaired by factors that are not specific to Lehman Brothers, such as a severe disruption of the financial markets."

    I could go on and on here. I come back to the point that "off balance sheet" doesn't mean "undisclosed." And, of course, the fact that somebody with a journalism degree can't understand a modern-day bank's 10-K is hardly a regulatory issue.

    P.S. To pointbite: the repo collateral was usually Treasury securities or government agency securities.

  6. Prof J: Great stuff, thanks!


    [1] The act of not repurchasing your asset in a repo transaction is not a bankruptcy event. And indeed, in the example I gave, (which I suspect you haven't worked through), disposing your worthless asset for cash, and then not repaying the cash, will, if anything, *increase* your net worth -- reducing the risk of bankruptcy.

    [2] That an individual or firm has its creditors bailed out by the government in the event of bankruptcy is surely not the defaulter's responsibility.

    [3] As I mentioned in my earlier post (via example), the said repo 105 transaction does appear to lower the leverage ratio. But so what? As I'm sure Prof J would say, what serious investor would simply look at a leverage ratio?