by Carrie
Tue Mar 16th, 2010 at 08:33:56 PM EST
The latest outrage gripping the financial blogosphere is the recently released report of the Lehman Brothers bankruptcy examiner. In it we learn that Lehman Brothers was cooking its books to make it appear that it was less leveraged than it actually was, given that analysts were paying particular attention to leverage ratios when assessing the health of bank balance sheets.
Let's start with Randall Wray's blog post Timmy-Gate: Did Geithner Help Hide Lehman's Fraud? where we read
Lehman used "Repo 105" to temporarily move liabilities off its balance sheet--essentially pretending to sell them although it promised to immediately buy them back. The abuse was so flagrant that no US law firm would sign off on the practice, fearing that creditors and stockholders would have grounds for lawsuits on the basis that this caused a "material misrepresentation" of Lehman's financial statements. (see here) The court-appointed examiner hired to look into the failure of Lehman found "materially misleading" accounting and "actionable balance sheet manipulation." (here) But just as Arthur Andersen had signed off on Enron's scams, Ernst & Young found no problem with Lehman. (here)
In short, this was an Enron-style, go directly to jail and do not pass go, sort of fraud. Lehman's had been using this trick since 2001. (here) It looked fine to Timmy's Fed, which extended loans allowing Lehman to flip bad assets onto the Fed's balance sheet to keep the fraud going.
It seems to me Wray mixes up two issues, one is extending loans with bad assets as collateral, and the other is the accounting misrepresentations going under the cute name of "Repo 105". I think this is unfortunate. Although there may have been bad assets involved in Lehman's bankruptcy, this is not what "Repo 105" is about, despite what the New York Times reports, quoting unnamed Wall Street sources in the piece Fed Helped Bank Raise Cash Quickly
They were considered the dregs of Lehman Brothers -- "bottom of the barrel," as one banker put it.
But as Lehman executives tried to keep the floundering bank afloat in 2008, they used these troubled investments to raise quick cash that helped mask the extent of the firm's troubles. And they did it with the help of the Federal Reserve Bank of New York.
The newly released report on the collapse of Lehman Brothers -- which lays out what it characterizes as "materially misleading" accounting at the bank -- also sheds surprising new light on Lehman's dealings with the New York Fed.
The only problem with this picture is that "Repo 105" did not involve "the dregs of Lehman Brothers", but prime
collateral, according to FT Alphaville's
What's in Repo 105But what exactly was Lehman Bros stuffing into the Repo 105 sausage?
Perhaps counter-intuitively it was not using the stuff on its balance sheet that was hardest to sell into markets.
Rather, it was the most liquid -- things like A- to AAA-rated securities, Treasuries and Agency debt, which you can see in the below table, from the Examiner's Report (Appendix 17):
The same point is made by Tyler Durden of Zero Hedge in
The "Repo 105" Scam: How Lehman Fooled Everyone (Including Allegedly Dick Fuld) And How Other Banks Are Likely Doing This Right NowIn August 2008, just before it was over, the firm allowed $55 million, or seven securities, rated CCC to be included in a Repo 105 transaction.
$55 million is about 0.1% of the $50 billion Lehman Brothers was able to move
off of its balance sheet in the second quarter of 2008 (link to HuffPo). Tyler Durden continues
The next chart makes it evident it that 105s were used simply to game the firm's assets into quarter end (yellow highlights), by reducing overall asset for leverage ratio calculations.
...
That this scam was going unsupervised (just who the hell were the counterparties?) for many years, and that many banks are likely using it right now to fool investors, regulators, rating agencies, and the idiots at the FRBNY (who certainly also know about this), is beyond criminal. Yet that nobody will go to jail for this is as certain as the market going up another 10% tomorrow. A full investigation has to be conducted immediately into whether existing Wall Street firms, and in particular those who use Ernst & Young as auditors, are currently abusing public confidence via such transactions.
The scam, it is clear by now, didn't involve overvaluing bad collateral to hide losses, but using repos to shunt good assets off the balance sheet in order to reduce leverage ratios. But how is it possible that repos were used this way? A partial answer is brought to us by NY Times blog Deal Book, in
In Lehman's Demise, Some Shades of EnronThe examiner's report gives us a new term for hiding problems on a corporate balance sheet that may become common parlance: "Repo 105." Starting in 2001, Lehman Brothers engaged in repurchase agreements, called "repos," which were described by DealBook as "what amounts to a short-term loan, exchanging collateral for cash up front, and then unwinding the trade as soon as overnight." Repos are a common method for investment banks to finance their operations and are neither illegal nor questionable, at least when clearly accounted for.
Lehman Brothers went a step further by having the collateral exchange under the agreement worth 105 percent of the cash it received -- hence, the "105" in the firm's nomenclature. By doing so, that turned it into a sale for accounting purposes, so that the firm could move the assets it exchanged in the deal off of its balance sheet, at least for a short while.
As explained by DealBook, "That meant that for a few days -- and by the fourth quarter of 2007 that meant end-of-quarter -- Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was." By timing Repo 105 transactions to the end of a quarter, the reports filed with the S.E.C. and reviewed by investors looked much better than what was going to be the case just a short time later. Enron did much the same thing with some of its assets, such as its notorious Nigerian barge deal.
A
repo is simply an agreement whereby A borrows an amount X from B in exchange for collateral valued at Y, and they agree that A will repay an amount Z to B (Z being X plus interest) at a later time, at which point B will return the collateral. Are we supposed to understand from this that the accounting treatment of such a transaction depends on the relative values of X, Y, and Z? Can US accounting regulations be really this Byzantine? This is explained by the WSJ's blog Market Beat in
Lehman's Repo 105: More Than You Ever Wanted to KnowFirst off, what's a repo?: Repos, or repurchase agreements, are transactions which banks use to borrow cash short term. The deals involve raising cash to fund operations by lending out high-quality assets (usually Treasury bills) for a short period of time. As part of the deals, the banks agree to repurchase their collateral within days or weeks.
What is the accounting?: In most circumstances, these transactions are accounted for as a loan on the books of the company. Accountants can treat these agreements as sales of assets rather than loans, only if the companies show that the company receiving the loan does not retain control over the securities used as collateral.
How do you know if the company controls the securities or not?: Guidance in the accounting rules suggests that an exchange of securities in excess of 102% of the cash value would show a lack of control. So Lehman exchanged securities worth 105% of the cash it received, which is why they were called Repo 105 deals, according to the Lehman examiner's report. So according to the report, Lehman would get these things off its books, report earnings, showing lower leverage rations, and then buy the assets back.
First off, an obligatory dig at accounting standards: the idea that an
overcollateralised loan is a sale is so harebrained it beggars belief. But this is not all that was going on. The hint is again provided by FT Alphaville in
What's in Repo 105Lehman's own accounting policy required assets used for Repo 105 "be readily obtainable" -- i.e. liquid -- according to the report. Lehman's lawyers also recommended they be liquid so that "the Buyer could easily dispose of the Purchased Securities and acquire equivalent securities if it wished."
I suspect in order to make the "loss of control" accounting argument legally watertight, Lehman Brothers must have written a clause into their repo contracts whereby the counterparty had the right to dispose of the collateral at will, and was under the obligation to return not the same security that Lehman posted as collateral but
an equivalent security. The only way to make this clause meaningful is for the collateral to be highly liquid, hence Lehman's internal legal recommendation to only use Repo 105 for prime collateral. And so, clearly, Repo 105 was not about hiding losses but about hiding leverage. Now, why did this go undiscovered until Lehman Brothers went bankrupt? And, as Tyler Durden put it, who were the counterparties to this? Well, as it turned out, this was a fraud hidden in plain sight and Lehman Brothers likely had no trouble finding willing counterparties. Think about it: you're a bank and none other than Lehman Brothers approaches you and offers you a 5% overcollateralised Repo for investment-grade assets. The credit risk of the transaction is negligible, not only because the counterparty is the highly-rated Lehman Brothers but also because the loan is overcollateralised with very liquid collateral. Who would say no? The deal is too good to be true. And, of course, when something is too good to be true, it usually is.
