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Home > Blogs > Anthony Harrington > Lehman Bros: Repo 105, the case for the defense

Lehman Bros: Repo 105, the case for the defense

Finance Blogger: Anthony Harrington Anthony Harrington

This is the fourth 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 Just an accounting gimmick?, by Anthony Harrington.

In an earlier blog post on the theme of the Repo 105 accounting gimmick that allowed the failed Lehman Brothers to shift around $50 billion off its balance sheet for three successive quarter end interim reports, we highlighted the apparent abuse of trust involved in pulling the wool over the eyes of stakeholders by window dressing the accounts.

However, there is, apparently, another and completely different view to be taken of this, and it is a view that seems to be fairly common among securities lending specialists. For those who don’t know, a Repo 105 transaction is a special case of a standard securities lending transaction. The standard transaction is a loan, where the lender hands over money and the borrower hands over collateral. The transaction is then reversed a short period later and that is that. A Repo 105 transaction is treated as a sale and not as a loan.

This enabled Lehman to look as if it had beefed up its balance sheet with a load of uncommitted cash by selling long-dated investments. In point of fact, shortly after the quarter end the transaction reversed, just like a normal repo and the “free cash” vanished off Lehman’s balance sheet, leaving it just as highly geared as before.

From the standpoint of Anton Valukas, the court-appointed examiner into Lehman’s failure, this appeared to be a blatant abuse, and as such, Valukas suggests, Lehman’s auditors Ernst & Young have a “colourable claim” against them (i.e. it seems to Valukas that there could be a case there if someone decides to sue them).

However, a source from a securities lending firm told me: “I’m sick of all the blather and hypocrisy over Repo 105. Everybody did it. It was permitted by Financial Accounting Standard 140 and there were very good market reasons for doing it,” he said.

Why is this important? Because it provides some insight into why both Ernst & Young, Lehman’s auditors, and Linklaters, the law firm who provided it with the opinion that it was OK to treat a Repo 105 transaction as a true sale, continue to look and act as if they feel reasonably comfortable with their actions. Of course, if you are likely to be sued it is always a good ploy to look as if the other side doesn’t have a case, but it is oh, so much nicer to actually have a working defense, and the securities lending world seems ready to provide quite a good one.

The concept of “true sale” as set out in FAS 140 relies on the idea of the owner having “lost control” of the asset, in this case, their collateral. The question then is, what constitutes loss of control? The answer comes down to the way in which normal collateralized deals are marked to market. If you collateralize a loan in the normal way with 100% collateral, and the value of your collateral shrinks or grows, the collateral pool is adjusted to compensate for the movement.

In a Repo 105 transaction, mark to market is suspended until the market movement is violent enough to move beyond some hurdle, such as 112%. For the period where mark to market is suspended, the collateral provider is deemed to have lost control of their collateral, and so the transaction can be deemed a “true sale.”

The other proviso is that it cannot be an overnight loan. However, three days or more are considered “safe.”

It is clear how this benefited Lehman, but how does it benefit the markets generally? According to my source, the answer is simple. By shifting debt off their balance sheet, broker-dealers could engage in further lending, thus providing further liquidity to the market, and more liquidity is a good thing for markets. The point, my source says, is not, or should not be, leverage per se, it should be the quality of the debt. The problem with the Repo 105 discussion as it has run so far is that it is purely about “debt” and the propriety or otherwise of moving it off the balance sheet.

Others will feel that the point, actually, is transparency, and that what Lehman was doing with Repo 105 was muddying the waters big time. The courts, it may be, will decide who is right in the fullness of time…

Further reading on Repo 105

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