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Lehman Brothers: “Repo 105” recap

More than five years after Lehman Brothers collapsed, I decided to take a deep dive on the mechanics behind the derivatives world. One of the most interesting documents was the report by Lehman’s court-appointed bankruptcy examiner Anton R. Valukas, which runs 2,200 pages (disclaimer: I did not finish reading all!). The report shed light on accounting tricks and derivatives products that played an important role in the demise of Lehman, and in particular, pointed to an accounting trick now famously known as “Repo 105.” Named after a technical aspect of the gimmick, it helped Lehman temporarily remove about $50 billion of assets from its balance sheet, making it look better than it really was.

According to the examiner’s report:

Lehman did not disclose, however, that it had been using an accounting device (known within Lehman as “Repo 105”) to manage its balance sheet – by temporarily removing approximately $50 billion of assets from the balance sheet at the end of the first and second quarters of 2008. In an ordinary repo, Lehman raised cash by selling assets with a simultaneous obligation to repurchase them the next day or several days later; such transactions were accounted for as financings, and the assets remained on Lehman’s balance sheet. In a Repo 105 transaction, Lehman did exactly the same thing, but because the assets were 105% or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financings, so that the assets could be removed from the balance sheet. With Repo 105 transactions, Lehman’s reported net leverage was 12.1 at the end of the second quarter of 2008; but if Lehman had used ordinary repos, net leverage would have to have been reported at 13.9.

Similar to other repos (short for “repurchase agreements”), Repo 105 mechanics mirrors that of a short-term loan: exchanging collateral for cash up front, and then unwinding the trade as soon as overnight. Although repos and short-term loans have similar functions, they are vastly different from a legal perspective. A repo involves a sale — and later repurchase — of the collateral; the legal title of the collateral would be transferred. Accounting rules allow that Lehman to book the transactions as financings rather than sales as long as the assets were below 105 percent of the cash received. That was not what Lehman wanted, however: Lehman wanted it to be booked as a sale, so that on the balance sheet Lehman would appear that it was holding fewer assets, and hence less leveraged (given the same amount of capital).

Put these complex webs of transactions in one chart:

But what did the law say? According to the report,

Repos generally cannot be treated as sales in the United States because lawyers cannot provide a true sale opinion under U.S. law.

And hence there was no American law firm willing to sign off Lehman’s accounting practice. Here came Linklaters, a “Magic Circle” English law firm. According to the New York Times, Linklaters explicitly said:

“This opinion is limited to English law as applied by the English courts and is given on the basis that it will be governed by and construed in accordance with English law.”

Wow, it was really a well-carved caveat! The New York Times noted that Linklaters partner Simon Firth, who signed the document, is well known  in the industry for his work in securitization and derivatives, and has authored the textbook “Derivatives: Law and Practice.” No wonder he could have come up with such a brilliant idea. My guess is that even if Lehman had disclosed the use of Repo 105, it would take a microscope to read it or understand its impact. But guess what, Lehman did not even disclose it. According to the examiner’s report.

Lehman did not disclose its use – or the significant magnitude of its use – of Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board of Directors. Lehman’s auditors, Ernst & Young, were aware of but did not question Lehman’s use and nondisclosure of the Repo 105 accounting transactions.

Alas, the ordinary citizens are rightfully not happy.

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