Friday, March 12, 2010

The genesis of Repo 105

In 2001 Lehman Brothers held a meeting with its lawyers and auditors.

A new US accounting standard — SFAS 140 — had just come into effect, and the banking heads were keen to find a way to use it to their advantage. They settled upon something called Repo 105 and 108, which would allow it to essentially book repurchase agreements as sales rather than temporary transactions — thus massaging its balance sheet and net leverage figures.

That year, the firm sent around an internal accounting memo for what became known as Repo 105, which you can view here. A normal Lehman repo transaction can be seen here:

Under SFAS 140, repurchase agreements could be accounted as true sales but only if certain conditions proving that the transferer had given up control of the asset were met.

Lehman argued that its Repo 105s should be classified as sales based on the overcollateralisation, or higher than normal haircut (5 or 8 per cent as opposed to a `normal’ 2 per cent) in the transactions. That was meant to show Lehman had ceded `control’ of the assets and it was a true sale; the asset could then go off-balance sheet and Lehman’s leverage ratio went down.

There was just a small problem, however.

Even with the higher haircut, most of Lehman’s Repos did not meet SFAS 140 criteria for true sales; no US lawyer would sign off on their treatment as a true sale. Without true sale status, the things were pretty much pointless.

But there was a clever way to get around the US GAAP problem.

Lehman went abroad — to London and to `magic circle‘ law firm Linklaters specifically. They could do so by dint of their non-US operations, in particular, Lehman Brothers International Europe (LBIE), which ended up taking the lead on Repo 105 transactions.

From the Examiner’s Report (Section III):

“Repo 105 and Repo 108 contracts typically are executed by Lehman Brothers International (Europe) (‘LBIE’) because true sale opinions can be obtained under English law. We generally cannot obtain a true sale opinion under U.S. law.

Did other banks have the same SFAS 140 idea back in 2001?

Possibly, but the report suggests not.

Here’s an illustrative July 2008 e-mail exchange from two Lehman staff:

Vallecillo: “So what’s up with repo 105? Why are we doing less next quarter end?”

McGarvey: “It’s basically window‐dressing. We are calling repos true sales based on legal technicalities. The exec committee wanted the number cut in half.”

Vallecillo: “I see . . . so it’s legally do‐able but doesn’t look good when we actually do it? Does the rest of the street do it? Also is that why we have so much BS [balance sheet] to Rates Europe?

McGarvey: “Yes, No and yes. :)

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