The Repo 18: It’s Not the Collateral, It’s the Cover-Up

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.

Since reading portions of the report issued by Anton Valukas, the examiner in the Lehman bankruptcy and writing about the firm’s accounting tricks in “A Whiff of Repo 105,” I’ve been thinking about footnote 69.

Perhaps ‘obsessing’ is a better description of my state of mind. Consider that I possess a printed copy of the nine-volume, 2,200 page report. However, that obsession seemed justified, very early this morning, when the Wall Street Journal broke the story, Big Banks Mask Risk Levels, revealing the early results of the SEC’s probe of repurchase agreement accounting practices at major firms.

According to the WSJ, based on data from the Federal Reserve Bank of New York, eighteen banks “understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods.” These banks include Goldman Sachs, Morgan Stanley, JP Morgan Chase, Bank of America and Citigroup.

According to the story, these practices are perfectly legal. However, the full investigation is not yet complete. There remains still the possibility that this may be the “Watergate” of the financial crisis. If manipulation of balance sheets rises to the level of fraud, there may be convictions to follow. Thus far, levering up, binging on toxic assets and threatening the global economy have been protected within the bounds of simply bad business judgment. However, as we learned from Nixon, the cover up is a whole different narrative.

Upon spotting the WSJ story this morning, I remembered that fascinating footnote from the examiner’s report. It appears on page 19 and reads as follows:

69 Examiner’s Interview of Martin Kelly, Oct. 1, 2009, at p. 8 (Kelly told the Examiner that Lehman was the last of the CSE firms to continue using Repo 105type transactions to manage its balance sheet by late 2007); Examiner’s Interview of Marie Stewart, Sept. 2, 2009, at p. 4 (Stewart believed that Lehman was the last of its peer group using Repo 105 transactions by December 2007).” (Emphasis added)

These revelations by Martin Kelly, Lehman’s controller, and Marie Stewart, the global head of accounting policy, invited many questions.

First, how reliable are they? Recall that Kelly is the first addressee listed on the May 2008 letter from Lehman whistleblower, Matthew Lee. Second, how could they know what the practices were at the competitor CSEs (CSE was the regulatory designation from 2004 – 2008 of the five large independent investment banks – Bear, Lehman, Merrill, Morgan Stanley and Goldman)? Third, if there was no legal change at that time, what was the magic of 2007? In other words, if the examiner, Anton Valukas, is correct in suggesting the “repo 105” practice was actionable, are these other investment banks vulnerable to litigation for pre-2007 practices? Fourth, was it possible that the other investment banks had been hiding billions of dollars of debt off balance sheet? Fifth, what was the connection between these practices and the financial crisis? Sixth, was this still going on at the firms?

Prior to finding the answers to these questions, I noticed that the SEC had posted a sample letter that it sent to “certain public companies requesting information about repurchase agreements, securities lending transactions, or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets.” The illustrative letter was signed by the Senior Assistant Chief Accountant. Pleased that the SEC was on the job, I turned my attention to other matters, until this morning.

It is hard to predict what will happen next. However, it is quite possible, that the Valukas Report will be the global financial crisis analog to the Pecora Hearings, helping to energize robust regulatory reform. At the very least, this reinforces the need that all debt and all transactions that have the economic effect of debt or leverage must be on balance sheet. Only time will tell.

Note from James: This behavior by the banks seems similar to what John Hempton pointed out: if you compare some banks’ end-of-period balance sheets to their average balance sheets, you see a difference. The WSJ report deals with repo, while Hempton was looking at the total balance sheet, but the story is basically the same.

19 thoughts on “The Repo 18: It’s Not the Collateral, It’s the Cover-Up

  1. What would be the effect on information accessed by market investors? Also how does this relate to elimination of mark-to-market accounting rules? Could the effect be a masking of the real financial position of a bank using these tactics?

  2. Anyone know if FTAlphaville’s Trinidad correspondent has done any analysis on this??? Or is she still busy posting 20 FTAlphaville links per story???

    This is terrific post by Miss Taub, and kudos to James Kwak for getting her on this blog. Hope she can make numerous posts here on “Baselinescenario” in the future and becomes a regular here.

  3. I would really be fascinated to know how investors like Bruce Berkowitz and John Hempton (and I respect Hempton) rationalize investing in banks now when you can’t even trust their balance sheet and/or 10Q reports.

  4. I would like to know what ‘assets’ were involved; seems like a grand opportunity for short sellers to buy (instead of borrow) at a discount, dump large quantities to drop prices, and then buy back at an even steeper discount, reselling at the agreed-upon higher price.

    Wouldn’t this be market manipulation?

  5. Any liability for the bank or any individual seems very unlikely to stem sole from the act of engaging in the Repo 105-type transactions. In my opinion, I think it is even unlikely that anyone from Lehman is held liable for the “inaccurate” leverage levels that were reported (because based on Valukas, it seems that the accounting was correct, even though the practice was unseemly).

    Aside from what may be meaningless bluster about the lack of “business purpose” for the transactions, the issue that Valukas highlights is that Lehman apparently disclosed that it accounted for all repurchase agreements as financings. Which turns out to be untrue. One would have to look to see if other banks made similar statements.

  6. My guess would be that there’s one reason: unconditional government guarantees on TBTF.

  7. Keep in mind that the types of transactions referred to in today’s WSJ were not the Lehman-type Repo105s. Lehman was treating repo loans as sales, then using the money to pay off other loans, to make their balance sheet appear smaller.

    The transactions referred to here are standard repo loans that were paid back just before the cutoff for quarterly reporting. The institutions involved exercised great discipline over their traders to make them close out positions prior to the quarterly report. The result is that investors don’t necessarily see how leveraged the institution is — but regulators do (they have access to daily balance sheets to assess capital requirements). The implications for “clubbiness”, collusion between bankers and regulators to fleece unsuspecting investors, are tremendous.

    Giving the same regulators more authority to obfuscate the nature of the institutions under their purview is not a solution.

  8. “Thus far, levering up, binging on toxic assets and threatening the global economy have been protected within the bounds of simply bad business judgment.”

    Is there a reader of this blog that believes that the global economy was brought to the brink solely by “bad business judgment?” Holy cow, Batman!

    I am happy to read that someone is digging below the surface and not just posturing like our elected blowhards in Congress.

    These findings may be the Martha Stewart hook on which to hang a case. Just get a few of the miscreants from the TBTFs to lie to Federal investigators (which for some is a bigger crime than fraud) and make them spend millions defending themselves a la Skilling, Lay and Kozlowski, hopefully with the same result.

  9. unfortunately, the “result” was a public record of exactly how Skilling, Lay and Kozlowski did their creative accounting — essentially, a manual for those who followed them on how to hoodwink stakeholders.

  10. Obviously the government guarantee on TBTF is an important step. Once it was clear that there was that government guarantee buying DOMESTIC TBTF banks was a no brainer…

    Buying international TBTF banks (ie Citi) was still fraught because you had to trust the US guarantee on the streets of Asia where Citi raised its deposits. [Hint – why do you think Citi collapsed? Or more specifically ran out of liquidity?]

    But there is a second thing. There is no denying some types of banking are profitable. You can see it by how much fees you pay on credit cards – and late fees and the like… there is real revenue.

    The crisis made the competition go away. As an investor the thing I am most scared of is competition. Competition is a wealth hazard.

    I love the lack of competition now. Revenue goes up and up.

    Now – bizarrely – I spent three months reading the accounts of small regional banks (once market caps of $2 billion – now – well a few hundred million). Most of these have NOT participated in the rally.

    Their accounts are rubbery as hell – and it is easy to say that. The accounting frauds are major – not minor – they are hiding losses not the size of their balance sheet.

    Also they are not TBTF. It was – from my perspective – wasted time. I spent three months doing it and wound up with a few trivial high risk positions in the portfolio. Ugly.


  11. Many of these institutions raised capital in the last 18 months, the very period, according to the WSJ, these practices became most widespread. Did the Fed know the balance sheets were bogus when it was urging these institutions to raise capital? Weren’t issues like asset and risk levels material to potential investors (despite government guarantees)? Were the bogus numbers used to raise capital? Is the Fed so cynical and corrupt that it put the false appearance of safety and soundness ahead of investor protection? Was the Fed, in effect, a partner in fraudulent bond offerings? Stay tuned, boys and girls.

  12. This goes out to the Brooklyn Boys, MIss Taub, and Volcker. Sardines in the can, BUT LITTLE DO YOU KNOW ABOUT SOMETHIN’ THAT I TALK ABOUT!……..

    Brooklyn Boys won’t ruin the potential intelligence. play the guitar solo now…………

  14. No doubt we have witnessed the most massive fraud in recorded history. From insurance fraud that is AIG to the financial fraud that is Wall Street and the central bank.

    I fear the eventual fallout will be worse than the Great Depression. I’m hopeful it won’t be as bad or last as long as the Dark Ages.

  15. BOND GIRL,
    Again we disagree on many things, but you have your finger right on the pulse here, right on the pulse. I 100% agree with you here.

    You can feel the blood flow right through the veins there. You know it’s extremely dirty from that and also the insistence on 100cents on the dollar. Geithner should have lost his job immediately after the 100cents on the dollar came to light. Geithner wouldn’t insist on 100cents on the dollar to AIG unless he was corrupt from the beginning. GEITHNER SHOULD BE FIRED.

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