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Home > Blogs > Anthony Harrington > Lehman Bros: Just an accounting gimmick?

Lehman Bros: Just an accounting gimmick?

Lehman Brothers Bankruptcy | Accounting Gimmick? Anthony Harrington

This is the third of a series of QFINANCE blog posts on the Anton Valukas’s report on the collapse of Lehman Brothers. See also: Time for Sarbox to be rethought post-Valukas, by Ian Fraser; The auditor’s dilemma, part 1, by Anthony Harrington; and Repo 105, the case for the defense by Anthony Harrington.

Imagine you owe a large amount of money to half a dozen creditors and that you need them to think well of you so that you can continue to borrow from them in order to ply your trade, which, by the way, is your only hope of earning sufficient money to pay off your creditors. Now imagine that these creditors have a definite view of what constitutes a tolerable amount of debt that a serious debtor to them might carry, and what constitutes either an intolerable amount of debt, or something precariously close to an intolerable level of debt. For the final part of the puzzle, imagine that you feel that you are probably already pretty close to that borderline over-indebted position that is going to cause your creditors to let the great axe fall. What do you do?

If you are Lehman Brothers, what you do, it turns out, is that you use your London office to take advantage of one of the neatest little loopholes in disclosure law you are ever likely to see, in order to pull the wool over your creditors’ eyes. The loophole rests on a technical point about when a repo agreement, or repurchase agreement, is, or is not a sale. Repo agreements between cash borrowers and cash lenders constitute a hugely useful liquidity tool in the market. In a standard repo agreement the cash lender takes high-quality assets as collateral from a cash borrower to cover the loan, which might be of very short-term duration, or might be for a longer term.

No one is confused about the nature of this transaction. It is a loan, not a sale, and is accounted for as a loan, with both sides getting their cash or securities back at the end of the transaction. The only time the collateral stays with the lender is when the borrower defaults, and that is not a desired outcome.

However, according to London market rules, if the borrower posts collateral to the value of 5% more than the value of the cash they are borrowing, that is no longer treated as a collateralized loan transaction. Instead it can technically be classed as a sale and this kind of transaction is given its own name: a Repo 105 transaction. Participants still behave exactly as they would on a standard repo contract, in that the borrower is absolutely expected to return the cash and redeem the assets but, for some bizarre reason, the accounting treatment is allowed to be different, possibly because the lender is a little bit better off than they would be if they simply got their cash (plus premium) back.

How this practice originated I really do not know, but doubtless its prehistory will now be scrutinized, for Anton Valukas, the examiner appointed to look into the failure of Lehman Brothers, has shone an exceedingly bright light upon Lehman’s use of Repo 105.

For the fourth quarter 2007, Lehman had deployed Repo 105 to shift $38.6 billion of assets off its books. In Q1 2008 it upped that to $49.10 billion and in Q2 2008 it upped it again to $50.38 billion. In each instance it was good quality assets that Lehman provided as collateral against the loan and in each instance it treated this as a sale, increasing the amount of cash on its books and decreasing its leverage by 1.7 percentage points, 1.9 percentage points, and 1.8 percentage points respectively. To put this in context, in its own internal risk management, Lehman regarded a movement of 0.2 percent of leverage as significant. In other words, this was window dressing on a grand scale, unless Lehman’s finance team can show that the Repo 105 device actually served some solid purpose other than to window dress the quarterly accounts. So far, no such alternative purpose has materialized.

This still has a long way to run, but it is clear that the accounting standards setters and audit firms in the US and the UK are going to have to address the ability Lehman’s had to arbitrage the regulatory regimes in the US and the UK, and auditors are going to have to step up to the plate and stop their clients from playing fast and loose with the books, even if it is legal somewhere or other…

Further reading for repos

Tags: auditing , Ernst and Young , Lehman Brothers , Repo 105 transactions , transparency , Valukas report
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