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Repo 105: It’s Nothing, Really Nothing

graphic: Mike Licht, Notions Capital via Flickr

The first time most of us heard about the accounting tactic called Repo 105 was when the Examiner appointed by the Lehman Brothers Bankruptcy Court issued his report. It led to the filing of the third amended complaint in the class action litigation against officers and directors of Lehman. The amended complaint adds Ernst & Young as defendants for approving the Repo 105 accounting tactic. The defendants have filed motions to dismiss, explaining that this is nothing, really nothing. Really.

To review, in a repurchase agreement (the technical name for a Repo), a borrower sells securities to a lender who is obligated to sell the securities back a few days later, for an amount equal to the sale price plus interest. Typically the value of the securities the lender receives is greater than the loan. That protects the lender if the value of the securities changes during the term of the agreement.

Lehman took the position that if the amount borrowed is $100, and the value of the securities is $105, the transaction should be treated as a sale of the securities. The Examiner explained in his report (.pdf) at 778, fn omitted, quoting accounting standard SFAS 140:

The FASB determined that “to maintain effective control, the transferor must have both the contractual right and the contractual obligation to reacquire securities that are identical to or substantially the same as those concurrently transferred.” “[T]he transferor’s right to repurchase is not assured unless it is protected by obtaining collateral sufficient to fund substantially all of the cost of purchasing identical replacement securities during the term of the contract.”

Here is an example from my April post on this issue:  . . .

… suppose Lehman did a repo with Fannie Mae preferred stock. It gives stock with a value of $105 to lender and gets $100 back. It records the transfer as a sale, meaning its securities inventory goes down $105. It records an increase in an asset called “derivatives” of $5 to reflect the profit it will make when it pays off the repo at $100 and gets securities worth $105 back. Cash goes up $100. It uses the $100 to repay a short-term loan with its bank. Its liability to repurchase the securities is not recorded. After the repayment, assets are lower by $100, and liabilities are lower by $100, so net worth is unchanged.

In the usual repo transaction, the borrower is required to show the obligation to repurchase as a liability, but that isn’t the case for the Repo 105 transactions. Leverage is liabilities divided by net worth. The Repo 105 transactions reduce liabilities, but net worth remains the same. That results in lower leverage.

Lehman used the Repo 105 transactions at the end of the quarter to move up to $50 billion off its total assets so that its reported leverage was lower. Dick Fuld, former CEO of Lehman, told the House Committee on Financial Services that he had no recollection of Repo 105.

Lehman defends this accounting treatment by relying on Ernst & Young. It claims that it incorporated other materials into its reports and prospectuses, and those materials made general disclosures about the intra-quarter leverage figures. It claims that the differences are immaterial to investors.

Ernst & Young claims that the accounting treatment followed SFAS 140 so there’s nothing here to see, move along please.

Treating these transactions as sales is entirely consistent with the “control” model on which SFAS 140 is based: if the buyer in the Repo 105 transaction were to default at the end of the transaction’s term, Lehman would be forced to enter the market and purchase these highly-liquid securities from another party on arms-length terms.

Here’s a question for Ernst & Young: if the risk is that the lender won’t sell back, why does Lehman treat the $5 derivative as an asset at full value? Answer: there is no real risk.

Apparently the SEC agrees that something is rotten here. One of the rules the SEC scrapped in 1994 would have required that Lehman report its average daily and monthly debt and other useful information. The SEC now thinks maybe it should reinstate that rule. The SEC is also investigating whether other firms used similar accounting tactics to manage their balance sheets. Most amazing, it appears that the SEC and the United States Attorneys in New York and New Jersey are investigating Lehman executives.

The Wall Street Journal confirms the investigations (cached), and says that Ernst & Young is also under investigation.

Editorial aside: the defendant’s briefs show the futility of securities lawsuits. They cite numerous cases saying that no one can be held accountable for anything, especially CPAs. From Ernst & Young’s brief at 14:

… EY’s audit opinion regarding Lehman’s GAAP compliance was just that: an opinion.

I’m waiting for the First Amendment argument.

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