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?

Will Federal Reserve Secrecy Conceal Incompetence and Corruption?

Having your own blog can be lot's of fun. I especially enjoy the spirited debates with some of my readers (from whom I have already learned a lot from).

I had a recent exchange with "Pointbite" where I challenged the sanity of Ron (Conspiracy Theory) Paul. The debate, however, was strangely aborted. I thought that Pointbite had given up. I realize now that there must have been a technical glitch that prevented him/her from posting a response. Happily (for me, at least), I accidently came across Pointbite's rebuttal here.

I think that Pointbite asks some good questions. I'm planning another post on the subject. But for now, let me briefly try to clear a few things up.

First, I am not saying that the Fed should never be audited. And I am not saying that the Fed should keep all things secret forever. What I am suggesting is that there are some types of information that should not be disclosed during a financial crisis. The identity of those banks making use of the discount window or emergency lending facilities is an example of such information that should probably not be disclosed; at least, not until the crisis has passed. Likewise, the terms of the lending arrangements should not be disclosed; again, until well after the crisis is passed.

The rationale for such a policy, whether it ultimately proves correct or not, is at least a plausible one for now. Releasing such information during a crisis is likely to lead to a run on the banks involved; exacerbating the crisis. Moreover, because of the stigma associated with using the window, disclosure of such information would prevent banks from participating. The rationale for encouraging participation, of course, assumes that it is socially desirable. This is debatable, for sure. But it is precisely this that should be debated. Gratuitous attacks on the Fed, like those served by Ron Paul, are absolutely of no help here (although he will find them useful for political reasons).

Some other things of note. The Fed has evidently never released information relating to its discount window lending. On routine lending as the normal term is very short (typically overnight, to healthy institutions, fully secured), I fail to see any purpose from disclosure at any time but if the lag were long enough, no real harm either -- just the burden/cost of publicly disclosing something that no one will much care about.

The Section 13(3) special facilities is a different matter from routine discount window lending. This section has not been used for such a long time that I don't think the Fed has any clear policy concerning the release of information here (except that it shall not be released during a financial crisis). I believe that such information should eventually be released, and Bernanke has evidently suggested as much in his testimony to Congress.

WSJ: Why Financial Reform is Stalled

Came across this excellent article today, by Peter J. Wallison. In case you haven't seen it, click here.

In a nutshell, he criticizes the standard explanation of political gridlock (an hypothesis that does not square well with the fact of resistance on both sides of the aisle in Congress).

Instead, he suggests the following entirely plausible explanation: The current proposals are not grounded in a valid (or persuasive) explanation of what caused the financial crisis. He goes on to give a lucid description of the power of moral hazard.

Should the Euro Have Slipped on Greece?

The United States and the Eurozone are both currency unions. Member states within each union are prohibited from issuing the common currency. Money creation is delegated to a central authority (the Federal Reserve in the U.S. and the ECB in the Eurozone). The US dollar and the Euro are both major world currencies.

Given these similarities, my question is this: Why is the recent Euro depreciation being explained by the fiscal problems experienced by a subset of Eurozone members?

Actually, let me put the question another way. Why are state-level fiscal problems in the American Union not associated with sharp depreciations in the USD? (California, by the way, is an economy larger than Greece, Portugal, and Spain combined).

One difference between the U.S. and the Eurozone is that the latter has no central tax authority to accommodate wealth transfers (bailouts). In fact, Article 103 of the Euro Treaty explicitly states that the EU shall not be liable for or assume the commitments of central governments.

Another difference between these two unions is that there is no counterpart to U.S. treasury debt in the Eurozone. Hence, while the Fed "monetizes" federal-level debt; the ECB "monetizes" state-level debt (in this case, sovereign debt).

So, perhaps the answer to my question is as follows. When California experiences a fiscal crisis, markets expect it to be bailed out by federal transfers; the market does not expect the Fed to monetize California state debt. This does not pose a direct inflationary concern, and hence is ignored in the FX market. The opposite holds true for the Eurozone; hence, the direct impact on the exchange rate.

There are several reasons why I am not satisfied with this answer. One has to do with my preferred theory of the exchange rate, but I'll leave this aside for now. The other has to do with the perceived credibility of the ECB. I doubt very much that the ECB will monetize Greek debt (and if it does, it will discount it heavily) and I don't think the market believes this either. The market likely believes that a bailout is coming (you don't actually believe that Article 103 is credible, do you?).

The bailout will be sold as "saving Greece;" but in fact, the bailout will in effect save the Germans and other Europeans holding Greek bonds. In short, a typical wealth transfer. Disgusting, perhaps...but inflationary, no.

Fiscal Multipliers in War and in Peace

It truly is breathtaking how certain some people are of what they know to be true about the way a macroeconomy operates. The Krugmans and DeLongs of this world really make it sound like everything we really need to know has been settled long ago. Yes, the science is "settled" (where have we heard this before?).

I recently came across this piece by Brad DeLong: A Guide for the Perplexed. Consider the following quote:

But when fiscal boost was tried on a large enough scale, it certainly did the job. And it is reasonable to infer (with all the caveats provided by the CBO) that what is true in the very large will be true in the merely large as well. Eugene Fama says that it is theoretically impossible for fiscal stimulus to boost output: World War II proves him wrong. Robert Barro says that the multiplier is zero: World War II proves him wrong. Benn Steil says that Jacques Rueff in 1947 conclusively proved that fiscal policy could not boost employment: World War II proves him wrong.

Implication: a WWII style fiscal stimulus will "do the job" in a peacetime recession. WWII "proves" it. Egad...how does he know this? Why do I not feel as confident that this is the case? Am I truly that dense? (an invite to some rather rude comments, I'm sure!)

In any case, I decided to gather my thoughts on the subject and post them here for public review and criticism. The piece is a bit too long for a blog posting; so if you're interested, please click here. Looking forward to any comments.

And the New Minneapolis Fed President is...

Narayana Kocherlakota; see here.

Hmm...his biography says that he was born in Baltimore. I seem to recall him mentioning that he was born in Winnipeg. Is he Canadian, or isn't he? Someone enlighten me!

In any case, he is an excellent choice. NK is a consummate academic: clear-thinking, articulate, and persuasive. Does he have what it takes to be a successful/influential Fed president? Yes, I believe so. Apart from his academic credentials, he has a very easy manner; not many people are likely to find him a boor. He has the gift of skewering lame-brained ideas to the wall, and then making you feel good that you've learned something useful (at least, this has been my experience).

Congratulations to NK...and good luck!

Kocherlakota on the State of Macro

A very nice piece by NK here. Unfortunately, you won't see something like this published in the NYT. But naturally, we can rely on DeLong to make a comment; see here: Narayana Leaves Me Puzzled. Consider this DeLong quote:

The models thus tell us that downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers develop a sudden extra taste for leisure, or a great rusting as the speed with which oxygen in the air corrodes speeds up and so reduces the value of large things made out of metal.

This is exactly how I would expect a first-year undergraduate to interpret a model that they've seen for the first time. And DeLong claims that he has a PhD in economics. Let me help the poor lad along.

Some macro models incorporate "news shocks." A news shock is the random arrival of information that leads people to (rationally) revise their forecasts of future events. These forecasts may be made, for example, over future productivity, future riskiness of investments, future policies, etc. These news shocks do not seem like an implausible impulse mechanism; unexpected news arrives every day.

Investment demand today depends on forecasted productivity of investment. These forecasts will change with news; leading to variations in investment that an econometrician might identify as "aggregate demand shocks." As the investment matures and comes online, its actual productivity may be higher or lower than originally forecast; its realization constitutes another "shock."

There is no need to appeal to DeLong's childish "great forgetting" interpretation of a negative technology shock. A negative technology shock occurs when the realized return on investment is lower than expected. The return on an important class of investments may turn out to be terrible (think of all the fibre optic cable planted across the world's oceans in anticipation of a demand that never materialized). And as Fisher Black has stressed, these types of errors are typically correlated across agents. In short, recessions may be explained, in part, by collective mistakes on investments made in the past.

In any case, what DeLong fails to offer us what he might propose instead as the ultimate source of the business cycle? I am guessing that he might say something like "animal spirits." So why did the recession occur? Because people thought that it would. Why did that boom occur? Because people believed that it would.

There may be an element of truth to the animal spirit hypothesis; but then, there do appear to be competing interpretations as well. If DeLong would spend less time writing his blog and more time reading the literature, he might one day be less puzzled with Narayana's observations.