Lehman Brothers bankruptcy and Repo 105

I have been doing a little extra reading for my MBA macroeconomics class, for the sections on the U.S. financial crisis.  Lehman Brothers’ actionable fraud (resulting in settlements by Ernst & Young, their accounting firm) was for a strategy they called repo 105 where they would, shortly before financial statements were due, enter into repo agreements, where they would borrow money and offer collateral equal to 105% of value of loan.  But for accounting purposes the repo agreement could (maybe!) be called a sale, and then the cash could be used to pay off liabilities, so assets and liabilities dropped and so leverage ratios improved.  After issuing the financial statement, the repo is concluded and Lehman once again had the asset and the leverage ratio went up.  To simplify, imagine Lehman had borrowed $100m to purchase bonds.  It now has a debt of $100m on its books (as well as the assets).  In the repo it “sells” the assets and repays the debt the day before the financial statement snapshot is due.  So now it looks less leveraged.  After the statement, it borrows $100m again and repurchases the assets. So it is right back where it started in terms of leverage.  Indeed, the repo was clearly intended purely to fake the leverage ratio (because it was quite costly apparently for Lehman to do this, and there is no upside in the transaction).

Here is a nice accounting article on the ethics and practice of the repo 105.  A gated article on the magnitudes and importance is here.  A good case writeup is here.

About mkevane

Economist at Santa Clara University and Director of Friends of African Village Libraries.
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