Repo 105: Creative accounting at Lehman Brothers | 55 comments (55 topical, editorial, 0 hidden)

Nobody's talking much about how Repos 108 worked (4.00 / 4)

Except for the blog Financial Crookery in Scrabbling Around in a Repo 105 Haze?

Here's your handy extract from the Lehman Accounting Policy Manual in Anton Valukas' monolithic Lehman Examiners Report filing:
Repo 105 and Repo 108 transactions refer to repos with a counterparty in which we sell securities valued at a minimum of 105% (for fixed income securities) or 108% (for equity securities) of the cash received. That is, we sell fixed income securities with a fair value of at least $105 in exchange for $100 of cash for Repo 105, and equity securities with a fair value of at least $108 in exchange for $100 of cash for Repo 108. (Note that we allow Repo 108 to be done at $107 of fair value but we still refer to these transactions as Repo 108.) Repo 105 and Repo 108 contracts typically are executed by Lehman Brothers International (Europe) ("LBIE") because true sale opinions can be obtained under English law. We generally cannot obtain a true sale opinion under U.S. law.
Financial Crookery translation: "I want to lend you some stuff for a short time and also want you to give me cash collateral. But I only want $95.24 (per $100 of stuff) cash collateral as this gives me some ancillary benefits. Don't worry about that though."

That is, Lehman used debt instruments as collateral for Repo 105, and equity instruments for Repo 108.

I am not sure what true sale opinions can be obtained under English law. We generally cannot obtain a true sale opinion under U.S. law means. Is it that US law doesn't allow it or does the more ominous interpretation of Valukas' words "unable to obtain a true sale opinion from a U.S. lawyer", that is, "no lawyer would sign off on the practise" apply?

Financial Crookery also has the language from the accounting standards:

For a repo to be re‐characterized from a secured financing transaction to a sale of inventory, all the following SFAS criteria must be met:
● The transaction is a true sale at law (SFAS 140.9a).
● The transferee has the ability to pledge or exchange the transferred assets
(SFAS 140.9b). and
● The transferor is considered to relinquish control of the securities transferred
(SFAS 140.9c).
FC Translation: "Rightio, here are three hurdles to jump over. Erm I mean slide under. How do we satisfy all of these conditions to whip a bunch of stuff off our balace sheet temporarily, without actually using a market clearing price for it.

The brainless should not be in banking -- Willem Buiter

by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 03:44:17 AM EST
[ Parent ]

Re: Talking about how Repos 105 & 108 worked (4.00 / 2)

Thanks for sorting this stuff out. It is more nuanced than I had understood.

Baseline Scenario has a guest post by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts that shows some other interesting aspects of Repo 105. (I haven't copied her links.)

While hiding $50 billion off balance sheet is nothing to sneeze at, `Repo 105' may be an unfortunate distraction. We should focus our attention on a far more mainstream and dangerous use of repurchase agreements backed by securitized bonds to grow balance sheets. This practice, enabled by a 2005 legal change, directly destabilized the financial sector and led to the ultimate credit crisis of 2008. In other words, the approximately $7-10 trillion repo financing market created what Gary Gorton and Andrew Metrick call the "run on repo" or what Gerald Epstein describes as a "run on the banking system by the banking system."
....
Repos have been called the "oil in the industry of Wall Street" largely because, prior to the global financial crisis, investment banks financed up to 50% of their assets in the repo markets. One bank analyst notes that "repo markets are only one channel linking the "shadow banking" sector to the broader economy." Given its size and importance, the repo market is surprisingly obscure.
At its peak in 2007, the repo market in the US was estimated to be between $7 trillion to $10 trillion. Outstanding US repos today are estimated to be in the $3.8 trillion to $4.27 trillion range. Buyers (cash lenders) in the repo market are typically institutional investors like pension funds and mutual funds who need a liquid but relatively safe place to invest cash for the short term, often overnight. Buyers also include broker-dealers and banks that need securities to cover short positions. Sellers (cash borrowers) in the repo market are often broker-dealers and banks who use these arrangements to finance asset purchases and to leverage. With a matched-book repo, a dealer will act as buyer, bringing in collateral, then will with the same collateral act as a seller with a different counterparty, profiting on the spread.
Gorton observes that "The current panic centered on the repo market, which suffered a run when lenders [whom he likens to depositors during Depression-era banking runs] required increasing haircuts, due to concerns about the value and liquidity of the collateral should the counterparty `bank' fail." These repo lenders also refused to rollover existing repos. Both actions created "massive deleveraging . . . resulting in the banking system being insolvent."

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 17th, 2010 at 12:08:13 PM EST
[ Parent ]

Repo 105 as the dog that didn't bark (4.00 / 2)

The key to the whole scheme is the fact that prime collateral was used for Repo 105. Everyone is expecting accounting irregularities involving junk assets. FT Alphaville calls it counterintuitive and leaves it at that. Tyler Durden points out that this cements the case that the point of the exercise was entirely to reduce leverage at the time of reporting. And Financial Crookery gets the ability to pledge or exchange the transferred assets backwards, thinking it refers to Lehman's ability to dispose of the cash, not of the counterparty to dispose of the collateral.

The brainless should not be in banking -- Willem Buiter

by Carrie (migeru at eurotrib dot com) on Wed Mar 17th, 2010 at 01:14:43 PM EST
[ Parent ]

Re: Repo 105 as the dog that didn't bark (none / 1)

What I found of interest in Taub's analysis is this

"run on the banking system by the banking system."

And

"The current panic centered on the repo market, which suffered a run when lenders [whom he likens to depositors during Depression-era banking runs] required increasing haircuts, due to concerns about the value and liquidity of the collateral should the counterparty `bank' fail." These repo lenders also refused to rollover existing repos. Both actions created "massive deleveraging . . . resulting in the banking system being insolvent."

If I recall correctly, the total hole in Lehman's balance sheet was somewhere north of $300 billion, with Repo 105 accounting for ~$50 billion, unless that figure included both Repo 105 and 108. I got the impression that much of the rest was in held by The Fed as longer duration repos of some sort. Also that the Lehman bankruptcy was triggered by Morgan refusing to renew its transactions with Lehman. I do not know the nature of the transaction that Morgan refused to renew.

Unfortunately, I do not have all my sources individually bookmarked and don't have the time just now to look them up again.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 17th, 2010 at 01:55:37 PM EST
[ Parent ]

Re: Repo 105 as the dog that didn't bark (none / 1)

the total hole in Lehman's balance sheet was somewhere north of $300 billion, with Repo 105 accounting for ~$50 billion

Um, I don't think Repo 105 represents a 'hole' in the balance sheet in the usual sense. I mean it doesn't negatively impact on the solvency of the firm given it is a short-term swap of cash for good quality assets.

Granted, there is a 5% mismatch between the value of the cash and the collateral, which means the $50bn in Repo 105 resulted in an effective loss of $2.5bn - which 1) is recouped when the repo matures and you underpay by 5% when you repurchase the collateral; 2) is just 1% of the "hole" and, I suppose, 3) is a fair price to pay to reduce your leverage ratio.

If the amount of assets in the Repo 105 program had stayed constant (by rolling all the repos) rather than increasing at the time of closing the quarterly books the claim of intentional fraud would be much less plausible, and Lehman would just be taking a $2.5bn loss to permanently (as long as counterparties rolled the repos) shrink its leverage ratio.

The brainless should not be in banking -- Willem Buiter

by Carrie (migeru at eurotrib dot com) on Thu Mar 18th, 2010 at 04:33:16 AM EST
[ Parent ]

Re: Repo 105 as the dog that didn't bark (none / 0)

You are right if they were only using A rated securities for Repo 105, so I wonder where the hole came from.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Mar 18th, 2010 at 04:36:10 PM EST
[ Parent ]

A run on the banking system by itself (4.00 / 3)

is exactly what started in the summer of 2007, and lasted until TARP was approved. At the time we were commenting that what was going on was that banks looked at their balance sheets, saw ShitPile™ and wondered if my balance sheet looks like this, what does my neighbour's balance sheet look like?. They stopped lending to each other, which qualifies as a run.

Banks lend long-term assets, and fund themselves short-term (be it deposits or borrowing in the money markets). This is in the nature of things as is unavoidable. Therefore, any bank is vulnerable to a run, which is defined as an inability to secure short-term funding to meet maturing liabilities (in other words, an inability to roll maturing short-term credit). In August 2007 the 3-month interbank market completely dried up for weeks, taking Northern Rock with it. Lehman Brothers, being a broker-dealer, had no deposits and also funded itself exclusively in the short-term money markets (repos, not Repo 105, would be an example of this). The run on the money markets took with it Bear Stearns and eventually Lehman Brothers, which I seem to recall was the smallest and by far the most highly leveraged of the four big US investment banks (Goldman Sachs, Morgan Stanley and Merrill Lynch being the other three).

In the frame of Hyman Minsky's Stabilizing an Unstable Economy banks are by definition speculative, borrowing to pay the interest on their loans (this is what rolling short-term liabilities amounts to). When their leverage exceeds a certain threshold (which is lower if interest rates rise, which is what happened in the run on interbank credit 2 years ago) they become ponzi finance (ponzi finance is not a term of abuse in Minsky, just a name for a situation where you have to borrow to pay down the principal as well as the interest).

The brainless should not be in banking -- Willem Buiter

by Carrie (migeru at eurotrib dot com) on Thu Mar 18th, 2010 at 04:47:15 AM EST
[ Parent ]

Re: A run on the banking system by itself (4.00 / 2)

So if you look at the bell curve of banks pay out rates, You have a few at the top which are paying out at excessive rates, either because their staff are more skilled, or they are lucky or they are running Madoff style schemes. There's then pressure to push the peak of the bell-curve up towards those high pay-out rates to attract customers. If you look at the difference between the average on that bell curve and the rate at which GDP is actually growing (I know its a dubious figure at best) then the difference between the two could be called a ponzi gap

Any idiot can face a crisis - it's day to day living that wears you out.

by ceebs (ceebs (at) eurotrib (dot) com) on Thu Mar 18th, 2010 at 06:37:26 PM EST
[ Parent ]

Re: A run on the banking system by itself (none / 0)

That's actually a good insight.

Of course, as soon as you make it the basis for regulatory action, the thus regulated entities will try to figure out ways to game it. So we'd need to figure out whether it's robust against accounting gimmicks.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu Mar 18th, 2010 at 09:24:53 PM EST
[ Parent ]

Re: A run on the banking system by itself (none / 0)

The profit motive will ensure that, through "innovation", banks operate on the edge of regulatory compliance.

The brainless should not be in banking -- Willem Buiter

by Carrie (migeru at eurotrib dot com) on Fri Mar 19th, 2010 at 12:36:35 AM EST
[ Parent ]

Re: A run on the banking system by itself (none / 0)

Which is why it is so crucial to have simple and very clear rules without any complexity.

This is the opposite of the US financial regulation system, and in a large part depends on the political system, where banks can fund individual congressmen and senators to add complexity and exemptions.

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Fri Mar 19th, 2010 at 07:25:02 AM EST
[ Parent ]

Re: A run on the banking system by itself (none / 0)

Yes, but that just means that they will try to avoid reporting the parameter you're using to regulate them.

Which is why that parameter needs to be reasonably robust against accounting gimmicks.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri Mar 19th, 2010 at 09:42:51 AM EST
[ Parent ]

Repo 105: Creative accounting at Lehman Brothers | 55 comments (55 topical, 0 editorial, 0 hidden)

Top Diaries

Bidenomics made real

Energy (and Other) Events Monthly - October 2024

Of Childless Cat Ladies and other matters...

Recent Diaries

Zelenskyy's Dream of Victory over Russia

Gaza and Ukraine Wars Digging Gold for Profiteers

Yom Kippur and Genocide

Schizophrenic Disorder ICC The Hague

Building a Regional Superpower in a New Middle East

Brussels and Washington In Geopolitical Union

Starmer's Government Complicit In Gaza Genocide

Todd: The Disappearance of US Hegemony

Biden Willingly Entrapped by Netanyahu

Final Joint US-IL Assault On Iran

Hate Preachers Wilders-Ben Gvir-Smotrich

German Industrial Weakness in Charts

Gaza Massacre One Year On

America's Revenge On the Islamic State of Iran

Post Neoconic Wars, Hypocrisy Thrives In the West

Aysenur's Death a Targeted Murder by IDF

3rd Day Rutte Next Stop Moscow

1st Day on the Job - Mark Rutte

Harsh Lesson On Humanitarian Law and Israel

Bidenomics made real

Occasional Series