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.