What is Repo 105, Man?

And so it appears that Lehman Brothers cooked their books. Another example of capitalism run amok. (It is convenient here to ignore how governments cook their books all the time. Is anyone from the Greek finance ministry going to jail, by the way?).

The accounting trick, apparently, was the use of Repo 105; see here (or Google Lehman and Repo 105). I've never heard of this before, and I'm still not sure I understand it. Let's see...

Imagine that I own a home worth $105,000. That's the full extent of my wealth. I have no debt. My balance sheet records $105K in assets and net worth.

Now, imagine that, for whatever reason, I need $100K in cash for a few days. I could sell my house, but net of the realtor's fee, I am left with less than $100K. I could take out a home equity loan, but this is expensive too. By far the cheapest way to acquire the short-term cash I need is by repo (a sale and repurchase agreement).

That is, I "sell" my asset to the bank for $100K and promise to "repurchase" my house a few days later (with a little bit of interest, that I set to zero here) at $100K. If I default on my promise to repurchase "my" house, the bank gets to keep it. If the house is really worth $105K, the bank nets $5K. This is nothing more than a form of collateralized lending. Note that the loan has been "overcollateralized" in the sense that I only get $100K in cash for my $105K house (there is a 5% "haircut" on the collateral). The 105/100 ratio is what is meant by "repo 105."

So what is wrong with this? Nothing, so far: it is a standard repo transaction. The problem, apparently, is in how this transaction is accounted for on my balance sheet.

Suppose that the said transaction occurs near year end, and that I agree to repurchase my home at the beginning of next year. How do my books look at year end?

Well, I'm not sure. I've always been terrible at accounting. I suppose I could say one of two things.

Method 1. I am holding assets of $100K in cash and $105K in capital. I have a liability of $100K. My net worth is $105K.

Method 2. I am holding assets of $100 in cash. But as I have "sold" my home, I have no other assets. And well, it seems appropriate then to "ignore" my promise to repurchase my home in the future (i.e., I treat it as an "off balance sheet item"). My reported net worth is now $100K.

Method 2 is the alleged "repo 105 trick" used by Lehman and signed off on by their accountants, Ernst and Young. Clearly, I must have missed something.

Maybe the existence of leverage changes things? OK, assume that I have a mortgage on my home worth $50K (my equity is $55K). My leverage ratio (debt to equity ratio) is 50/55 = 0.9.

Question: can I still repo my home for $100K? Answer: while you would be put in jail for pledging other people's assets as collateral for your own loan, financial firms are evidently allowed to do so (rehypothecation). Maybe rehypothecation is important for the question at hand (but if so, why is it not mentioned?). Let us assume away rehypothecation for now.

OK, assume that I now need $50K in cash. I repo my home for $55K. There is a 10% haircut on my collateral in this case; a "repo 110" if you will. How do the different reporting methods affect my leverage ratio?

Method 1. I am holding assets of $50K in cash and $105K in capital. My liabilities consist of a $50K mortgage and a $50K obligation to repay my cash loan. My net worth is $55K. My leverage ratio is (50+50)/(50+55) = 0.95. That is, this transaction has increased my leverage ratio (from 0.9).

Method 2. I am holding $50K in cash, but as I have "sold" my home, I have no other assets. Having "sold" my loan, I no longer have a mortgage obligation. And, as before, consistency appears to require that I "ignore" my obligation to repurchase my house. My net worth is now reported as $50K. My leverage ratio is 0. Viola!

So, by using Method 2, I "evaporate" $5K in my net worth (10% of my equity). Call me crazy, but if I was a shareholder, I think I would be rather upset. On the other hand, my firm's reported leverage ratio now looks a whole lot better. Uh...OK...like I said, I never understood accounting.

The key to this whole scandal appears to be that "Method 1" is something of an industry norm for repo contracts, while "Method 2" is not. Nothing necessarily illegal about Method 2 (all sorts of items exist off balance sheet in private and public sector accounts), but perhaps its use should have been disclosed? And if so, by whom? Not Lehman Brothers necessarily; but surely their accountants?