Finance

Repo 105: Lehman's 'Accounting Gimmick' Explained

The big Lehman post-mortem released yesterday spills a lot of ink on a complicated accounting trick with an awesome name: Repo 105. Here's the story.

As the financial crisis grew in 2007 and 2008, Lehman knew it needed to reduce its reliance on borrowed money. But it was a bad time to sell stuff off and pay back debts. So Lehman made special use of something called the repo market.

Investment banks use the repo market all the time. It's basically a way for banks to borrow money from big companies that have extra cash sitting around.

To make the loan safer for the big company, the bank "sells" the company some asset — like a bond. That way, if the bank goes bankrupt before it repays the loan, the big company can sell the bond and get its money back.

As part of the deal, the bank agrees to buy back the bond at the end of the loan, minus some small amount that the company gets to keep as interest. ("Repo is short for "repurchase.")

The deals are short term — the bank often buys back the asset just days after it sells it. During the boom, there was about $12 trillion (with a t!) loaned out in this market at any given time, Yale's Gary Gorton told me.

Everybody knows the bank isn't really selling the bond to the big company — it's really borrowing money. So under accounting rules, the assets a bank uses in repo deals stay on the bank's balance sheet.

But when Lehman Brothers wanted to make it look like it wasn't borrowing so much money, the company used a special technique to get around this rule. It did repo deals where it took slightly less cash than the asset was worth.

For example: If Lehman owned a bond that was worth $105, it would "sell" it on the repo market for $100. (The "105" in Repo 105 refers to the fact that the assets were worth at least 105% of what Lehman was getting for them.)

This gap allowed the company to record the transaction as if it had been a true sale of the bond — despite the fact that, under the agreement, the company would repurchase the bond just a week or so after it had sold it.

Lehman would take the money it got from selling the bond and pay off some of its debts. Then, after it had issued its quarterly report, the company would borrow more money to repurchase the bond.

Lehman went big on this technique: In the second quarter of 2008 it used Repo 105 to move $50 billion off of its balance sheet, according to the Examiner's report.

"Lehman did not disclose its use ... of Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board," the report said. One senior official inside the company warned that the use of Repo 105 would present "reputational risk" to the company if the public found out.

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