Lehman Brothers, the evil Repo 105s and the danger of off-balance-sheet deals
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Bernanke will provide a brief version of the autopsy of failed financial house Lehman Brothers that was delivered last month by a group of consultants and that you can read here. You can also read my colleague Tomoeh Murakami Tse's story about the report when it was released by clicking here.
He will mention something that's worth going back over and that the March report wrote about in detail: a transaction Lehman used to hide its toxic assets it called "Repo 105."
The first thing you need to know about the Repo 105 is that it was an off-balance-sheet transaction. There are plenty of legitimate reasons for moving something off a company's balance sheet, such as efficiently accounting for operating leases. If you move something off your balance sheet, you have to comport to numerous accounting regulations that explain to your investors why you've done it and where it is.
Think of it this way: You want a loan to buy a car but you've maxed out several credit cards. On the day before a loan examiner checks your credit, you are able hide all of your credit card debt under a fictitious person's name for a few days. To the loan examiner, your credit report looks good. Once your loan has been approved, you bring your debts back to you.
Unfortunately, some companies -- such as Lehman, in its last days when it was trying to save its hide -- use off-balance-sheet transactions for one illegitimate reason: to hide problems from prying eyes.
In Lehman's case, the company used the Repo 105 as a sort of an underground parking lot for assets that drove up the company's leverage ratio. If it could drive these assets off of the company parking lot and hide them in an underground parking lot for a few days at the end of each quarter, the company's balance sheet would look much better to investors and, more importantly, ratings agencies. If Lehman got downgraded, then any chance it may have had at getting new investments and loans was wiped out.
Lehman used Repo 105s like a junkie uses meth, according to the March autopsy on the company, hiding its addiction from even its own board of directors:
"In this way, unbeknownst to the investing public, rating agencies, government regulators, and Lehman’s board of directors, Lehman reverse engineered the firm’s net leverage ratio for public consumption. Notably, during Lehman’s 2008 earnings calls in which it touted its leverage reduction, analysts frequently inquired about the means by which Lehman was reducing its leverage. Although [chief financial officer] Erin Callan told analysts that Lehman was “trying to give the group a great amount of transparency on the balance sheet,” she reported that Lehman was reducing its leverage through the sale of less liquid asset categories but said nothing about the firm’s use of Repo 105 transactions."
How much did Lehman rely on the Repo 105s? A lot. According to the autopsy: "Lehman temporarily reduced its net balance sheet at quarter‐end through its Repo 105 practice by approximately $38.6 billion in fourth quarter 2007, $49.1 billion in first quarter 2008, and $50.38 billion in second quarter 2008."
Even worse, Lehman had to go outside the U.S. to find an accounting that would allow it to use the Repo 105 transactions when it started them in 2001, leaning instead on a U.K. opinion.
I covered the collapse of Enron several years ago, and off-balance-sheet transactions played a big role in the downfall of the highflying energy-trading company. Enron set up several off-balance-sheet vehicles it used to hide billions of dollars in debt.
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April 19, 2010; 3:32 PM ET
Categories: The Ticker , Wall Street | Tags: Balance sheet, Board of directors, Business, Enron, Financial services, Lehman Brothers, Leverage, Repo 105
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