The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here). Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.
To the uninitiated, the term ‘Repo 105’ evokes the name of a basic finance course or perhaps an expensive perfume. However, the broader implication of Lehman’s corrupt accounting strategy is neither simple nor does it pass the smell test.
While hiding $50 billion off balance sheet is nothing to sneeze at, ‘Repo 105’ may be an unfortunate distraction. We should focus our attention on a far more mainstream and dangerous use of repurchase agreements backed by securitized bonds to grow balance sheets. This practice, enabled by a 2005 legal change, directly destabilized the financial sector and led to the ultimate credit crisis of 2008. In other words, the approximately $7-10 trillion repo financing market created what Gary Gorton and Andrew Metrick call the “run on repo” or what Gerald Epstein describes as a “run on the banking system by the banking system.”
A repurchase agreement or “repo” is a two-part arrangement. The seller (cash borrower) agrees to sell securities at a slight discount to a buyer (cash lender). Under that same agreement, that original seller agrees to buy them back at a future date at a higher price. The securities are known as “collateral.” The discount is known as the margin or a “haircut.” The ratio between the increase in price and the original price is known as the rate.
With ‘Repo 105,’ Lehman, according to volume III of the examiner’s report, acting as a seller (cash borrower), treated $50 billion in repo transactions as sales instead of financing transactions. Lehman did not reveal to investors that it was doing so. In contrast, standard practice was to record these transactions on balance sheet by increasing both cash (assets on the left side) and collateralized financing (liabilities on the right side). Thus a properly recorded repo transaction results in both a larger balance sheet and also higher leverage ratios.
Not wanting to issue more equity to boost leverage ratios, Lehman instead chose a cosmetic solution. With ‘Repo 105,” near the end of a reporting period, Lehman treated the transactions as sales and used the cash proceeds to pay down other liabilities. This made the firm appear to have a smaller balance sheet and less leverage than it truly had. The transactions were called ‘Repo 105’ and ‘Repo 108’ in reference to the size of the haircut. In other words, for ‘Repo 105’ transactions, Lehman would provide collateral purportedly worth 105% of the amount of cash it received.
As we blame the bad apples at Lehman, we fail to see how recent legal changes brought about bigger problems in the repo markets and how instead of reversing these missteps, the law may instead amplify it. Indeed, as discussed below, language in the Dodd draft released Monday, March 15th suggests we have not learned some basic lessons.
Lehman’s ‘Repo 105’ was blessed under UK law by a perhaps questionable legal opinion from the Linklaters law firm. However, the transformation of the broader repo market, from one backed by largely US Treasury and agency collateral to one backed by securitized bonds, was enabled by US law. As detailed below, changes to the Bankruptcy Code, through BAPCPA in 2005, expanded this vital financing market and made it far more unstable.
Repos have been called the “oil in the industry of Wall Street” largely because, prior to the global financial crisis, investment banks financed up to 50% of their assets in the repo markets. One bank analyst notes that “repo markets are only one channel linking the “shadow banking” sector to the broader economy.” Given its size and importance, the repo market is surprisingly obscure.
At its peak in 2007, the repo market in the US was estimated to be between $7 trillion to $10 trillion. Outstanding US repos today are estimated to be in the $3.8 trillion to $4.27 trillion range. Buyers (cash lenders) in the repo market are typically institutional investors like pension funds and mutual funds who need a liquid but relatively safe place to invest cash for the short term, often overnight. Buyers also include broker-dealers and banks that need securities to cover short positions. Sellers (cash borrowers) in the repo market are often broker-dealers and banks who use these arrangements to finance asset purchases and to leverage. With a matched-book repo, a dealer will act as buyer, bringing in collateral, then will with the same collateral act as a seller with a different counterparty, profiting on the spread.
Gorton observes that “The current panic centered on the repo market, which suffered a run when lenders [whom he likens to depositors during Depression-era banking runs] required increasing haircuts, due to concerns about the value and liquidity of the collateral should the counterparty ‘bank’ fail.” These repo lenders also refused to rollover existing repos. Both actions created “massive deleveraging . . . resulting in the banking system being insolvent.”
To be clear, though, the run did not appear to be on the whole repo market, but rather on repo agreements backed by non-government collateral–in particular, repo backed by securitized bonds. In other words, repo backed by Treasuries did not experience a run. Cash-rich buyers sought out opportunities to loan against US Treasuries. Perhaps the buyers did not trust the valuation of the securitized debt, including mortgage backed securities. Thus, it follows that haircuts got larger for non-government collateral – the amount of collateral posted for a loan escalated. And ultimately, some collateral simply could not be used at all. The average haircut on structured debt, according to Gorton and Metrick went from zero in early 2007, to 10% by March of 2008. In September 2008, the rate shot up from 25% to 45%.
Questions have arisen as to the wisdom in allowing a vast range off collateral to back repos. Some argue that the market needs more than Treasuries and agencies because of the demand for Treasury and agency bonds as collateral for derivatives trades. This, of course invites the question of whether a side-benefit to shrinking the derivatives market would be to make Treasuries more available for repo. For example, approximately 80% of the approximately $28 trillion credit default swap market (once closer to $57 trillion) is said to be contracts where the insured party did not own the underlying reference credit. Shrinking the derivatives market might decrease the demand for Treasuries, thus decreasing the reliance on riskier, less secure repo financing that is prone to dry up when asset values decline.
What enabled the tremendous expansion of outstanding repos were amendments to the US Bankruptcy Code in 2005 through BAPCPA. Prior to these amendments, it was clear that if a debtor filed for bankruptcy, a lender who had Treasury collateral, agency, certificates of deposit and certain bankers acceptances could hold onto that collateral. Unlike most parties with contracts with a debtor that have not been completed, the repo lender would not be subject to the automatic stay.
However, prior to the amendments (notwithstanding another possible provision to rely upon in the Code), it was not clear what would happen to the repo lender who had other types of collateral, in particular mortgage-related securities. BAPCPA made certain to protect these creditors who took in a new list of collateral types, including mortgage loans and interests in mortgage-related securities. It also was expanded to include foreign sovereign debt. These new types would also be free from the automatic stay. In addition interest paid on the repo would not be clawed back as a preference. This was affirmed in a subsequent court decision in early 2008 in the wake of the subprime crisis. Outstanding repos grew from $4.9 trillion in 2004 to $5.6 trillion in 2005 and ultimately to $7 trillion by first quarter 2009.
Repo contributed heavily to the maturity mismatch and interconnectedness at the center of the crisis. Maturity mismatch was at the heart of crisis as corroborated by investment bank leaders. For example, in the January FCIC hearings, Goldman Sachs CEO, Lloyd Blankfein noted that:
“Certainly, enhanced capital requirements in general will reduce systemic risk. But we should not overlook liquidity. If a significant portion of an institution’s assets are impaired and illiquid and its funding is relying on short-term borrowing, low leverage will not be much comfort.”
Little has been done to address the maturity mismatch associated with the use of short-term (overnight) repo funding by banks to finance longer term assets. Moreover, the recently announced SEC rules affecting mutual funds will only send more cash into repurchase agreements. This will likely increase now that the SEC is requiring taxable money market funds to hold 10% of total assets in instruments which the fund has the right to receive cash with one day’s notice and 30% that give the fund the right to receive cash in five business days.
Finally, language in the Senate financial reform bill, the “Restoring Financial Stability Act of 2010,” (see page 203, beginning on line 12) introduced on March 15 by Senator Dodd, appears to expand even further the rights of repo buyers (lenders) if a financial company is under an FDIC receivership. In the words of President Bush, “Wall Street got drunk.” The bartenders pouring the drinks were repo market buyers (lenders). We should impose some liability on these bartenders for the leverage and liquidity problems to which they contributed. However, instead, it appears we are going in the opposite direction.