ft.com/alphaville Blog - Repo 105

Posted by Tracy Alloway on Mar 12 08:05.

Rapport sur les techniques financières mise en oeuvre par LEHMAN Brothers avant sa faillite.

http://ftalphaville.ft.com/blog/2010/03/12/173241/repo-105/

Think window-dressing on a massive, and possibly misleading, scale.

Much of the 2,200-page Examiner’s report into the Lehman Brothers bankruptcy centres around an “accounting gimmick” used by the bank, and signed off by auditors Ernst & Young, to reduce leverage.

That would be Repo 105 and Repo 108 — or Repo 105 for short.

And it/they worked like this, according to Volume III of the report:

Lehman employed off‐balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008.

Repo 105 transactions were nearly identical to standard repurchase and resale (“repo”) transactions that Lehman (and other investment banks) used to secure short‐term financing, with a critical difference: Lehman accounted for Repo 105 transactions as “sales” as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction. By recharacterizing the Repo 105 transaction as a “sale,” Lehman removed the inventory from its balance sheet.

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet. Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851 Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios. Thus, Lehman’s Repo 105 practice consisted of a two‐step process: (1) undertaking Repo 105 transactions followed by (2) the use of Repo 105 cash borrowings to pay down liabilities, thereby reducing leverage. A few days after the new quarter began, Lehman would borrow the necessary funds to repay the cash borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet.

Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions . . .

You can see why Repo 105 would be a tempting thing in the midst of a brewing financial crisis.

Leverage had become a focus of the ratings agencies and was widely thought to be an indicator of bank risk, which meant Lehman would have been hell-bent on reducing its leverage — at least publicly.

At the same time prices for things like CMBS and subprime loans were falling and/or illiquid — Lehman could not have reduced its balance sheet simply by selling things off without incurring large losses.

Hence the Repo, which the bank increasingly used between 2007 and 2008 — even breaching its own internal cap on the Repo’s use (about $22bn as of summer 2006).

And the effect is pretty clear. From the report:

Hence the Examiner’s conclusion:

The Examiner concludes that there is sufficient evidence to support a colorable claim that: (1) certain of Lehman’s officers breached their fiduciary duties by exposing Lehman to potential liability for filing materially misleading periodic reports and (2) Ernst & Young, the firm’s outside auditor, was professionally negligent in allowing those reports to go unchallenged. The Examiner concludes that colorable claims of breach of fiduciary duty exist against [former CEO/CFOs] Richard Fuld, Chris O’Meara, Erin Callan, and Ian Lowitt, and that a colorable claim of professional malpractice exists against Ernst & Young.

And the response, as reported by the FT:

In a statement, Mr Fuld’s lawyer wrote: “Mr Fuld did not know what those transactions were – he didn’t structure or negotiate them, nor was he aware of their accounting treatment,” his attorney wrote in a statement.

“Furthermore, the evidence available to the examiner shows that the Repo 105 transactions were done in accordance with an internal accounting policy, supported the legal opinions and approved by Ernst & Young, Lehman’s independent outside auditor.”

E&Y said in a statement: “Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view.”

Mr Lowitt’s attorney said in a statement: “In the three months during which he held the job, Mr Lowitt worked diligently and faithfully to discharge all of his duties as Lehman’s CFO, Any suggestion that Mr Lowitt breached his fiduciary duties is baseless.”

Mr O’Meara could not be reached for comment. A lawyer representing Ms Callan declined comment . . .

Related links:
Repo 105 accounting in focus – FT
The Lehman potboiler – FT Alphaville
Examiner’s Report – Jenner & Block

This entry was posted by Tracy Alloway on Friday, March 12th, 2010 at 8:05 and is filed under Capital markets, People. Tagged with accounting, Lehman Brothers, Repo 105.

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1. Reportandrew thomas-woolf | March 17 9:23am |

   @kfunck1:
   To my knowledge, US GAAP does not (and at the very least historically did not) allow for a "true and fair view" override. The rules were the rules.
   This is the reason that the Qualfying SPE concept made easier *SOME* of the Enron shenanigans, with a "brightline" minimum outside equity % for QSPE's. The FASB's response to this? Increase the minimum amount of outside equity from 3% to 10% (and also introduce the concept of a variable-interest entity).
   The IFRS consolidation requirement relates to concepts, including exposure, through whatever means, to the majority of residual interest, the ability to control so as to obtain economic benefits and where the SPE conducts its activities primarily for the benefit of the sponsor.
   What exactly has your experience been that leads you to hold the views you do? I am intrigued and would appreciate reconciling the above to your statements.

2. Reportjames c | March 16 3:38pm |

   It's disingenuous to suggest that repo 105 isn't more acceptable under US GAAP than UK GAAP or IFRS. US GAAP is rules-based, and financial statements are prepared and audited under a rules-based approach regardless of the principles. Everything about the US approach to financial regulation is rules-based - look at SOX, another set of rules that would be superfluous in a principles-based environment (like old UK GAAP).
   Unfortunately, UK GAAP & IFRS are converging towards the US rules-based approach, regardless of the fact that they are technically principles-based. It's undoubtedly good news for accountants, but not for anyone else.

3. ReportWorsel | March 15 7:50pm |

   @/m - no cds available for this name (or the other big accounting firms) because it is not listed and has no publicly traded securities.

4. Reporteminence noire | March 14 12:10pm |

   perhaps the main outcome of significance will be policies controlling future rehypothecation activities
   imagine what would happen to the capital markets, if we brought our rules in line with the US way of doing business?

5. Reportkfunck1 | March 14 6:55am |

   " It is not entirely clear here that the accounts didn't comply with US GAAP even if they are against the spirit of the rules. US GAAP is less about spirit and more about the letter of the law - it one of its problems. IAS take a more substance over form approach."
   Your comment with regard to US GAAP is incorrect, as the overarching intention of GAAP is for financial statements to be "fairly presented," so there is no shortcomings to the extent that you are suggesting. Every single GAAP rule can (and should) be departed from if the rule produces misleading financial statements (and disclosed), and you can find those exact words in any number of FASB documents. EY will not be able to hide behind the defense of a strict interpretation of the accounting rule if it can be proven that they understood this to be purposefully misleading.
   From purely an accounting standpoint, this issue is not a GAAP issue. The report states numerous times that the LEH management (Lee) recognized that the Repo 105 transactions had no business substance, and just like any other transaction, under GAAP, the substance is indeed what matters, not the form, as you are suggesting. If EY wasn't captured by LEH and the massive revenue that that audit generated, I have no doubt that they would not have gone along with it. As previously stated, going along with it, when it is clearly misleading, despite being potentially technically correct, is itself a violation of GAAP. Unfortunately for EY, shtf, and they're going to pay for it now.

6. ReportSEBASTIAN | March 13 4:07am |

   At least in the HK bankruptcy case the falsified evidence was exposed. Probably the only difference these days is that instead of shredding they simply press a delete button. What really is the difference between the Raptor and these Repo transactions? - both within the accounting standards but way beyond the spirit. Beradino was driving the get-away car - what was Turley doing? - entertaining entrepreuneurs in Monte Carlo probably.

7. ReportSEBASTIAN | March 13 3:54am |

   Ah - when will it all end.
   Ernst & Young's US$200m snag
   The global partnership of Ernst & Young is unwilling to help its Hong Kongoffice fund a legal settlement of about US$200 million agreed with theliquidators of Akai Holdings, the accounting firm's bankrupt former client,according to people familiar with the firm's operations.This would hurt partners' take-home profits for years, they said. Thesettlement, which was struck on September 23, marked the end of anaudit negligence case where Ernst & Young Hong Kong was accused ofturning a blind eye while Akai's disgraced founder James Tingbankrupted Akai in the late 1990s. Akai's liquidators, Borrelli Walsh, said in court that Ernst & Young HongKong staff falsified legal evidence to shield the firm from the negligenceclaim. The liquidators had originally demanded US$400 million fromErnst & Young Hong Kong, expecting that even if the local office couldnot pay this, the global partnership would step in to help. But John Ferraro, Ernst & Young's global chief operating officer whotook part in the settlement negotiations, managed to halve the figure bymaking it abundantly clear that the global partnership would not dig intoits own coffers to bail Hong Kong out, people familiar with the situationsaid. They said Ferraro argued that the global practice would rather jettisonthe Hong Kong office than help to fund a US$400 million claim. Instead,he told the liquidators to reduce the figure to one that the Hong Kongpartners could manage to borrow, insiders at the accounting firm said. Ernst & Young Hong Kong audited Akai and its subsidiaries right upuntil the electronics conglomerate collapsed in 2000 owing creditorsUS$1.1 billion. In contrast, the accountant's US and Canadian practicesresigned from auditing Akai companies in 1997, citing a breakdown oftrust with Ting and saying they did not fully understand theconglomerate's financial statements.
   Ting was jailed in 2005 for false accounting but his conviction wasoverturned on appeal a year later after errors in the prosecution's case.Ernst & Young's defence collapsed in the audit negligence case whenBorrelli Walsh accused the firm's local staff of falsifying and doctoringAkai audit files, then relying on the questionable papers in legalevidence. The Hong Kong police's commercial crime bureau is investigating thatclaim. On September 29, the police raided Ernst & Young's Hong Kongoffices, seized documents from Borrelli Walsh and the liquidator'ssolicitors, Lovells, and arrested an Ernst & Young partner who hadaudited Akai, Edmund Dang. Now, police are questioning other staff members at the accountant'slocal office. Ernst & Young Far East co-managing partner David SunTak-kei said on Thursday: "We have reached a manageable settlementthat does not create a current or future financial burden for the practice."Sun was the independent review partner on the Akai audit when thecompany collapsed, and Dang was a junior manager on the account.Sun relinquished his role as Ernst & Young's China chairman onSeptember 30, the day after the police raided his employer's offices.Dang was freed on bail without being charged. The people familiar with the firm's operations added that Hong Kongpartners who were not involved with auditing Akai now felt resentfulabout paying for others' past mistakes, and that the embarrassinglypublic nature of the faked evidence allegations had hurt staff morale atErnst & Young Hong Kong. Apart from Sun and Dang, there are very few people left in Ernst &Young's local office who had anything to do with Akai. Chee Tat Kwok,another of Akai's former senior audit partners, has retired. Anotherperson named in court as having worked with Akai in a senior audit role,Andrew Lam, is now a partner at the Hong Kong practice of accountantGrant Thornton. Lam did not response to e-mails asking for comment. Alawyer familiar with Ernst & Young's insurance arrangements said theglobal partnership had a self-funded insurer, called a captive, whichmay be able to fund part of the settlement. But the captive had just US$50 million available to fund negligenceclaims for 1997-99, the period in which Ernst & Young Hong Kong wasaccused of inadequate auditing work. Another lawyer, who specialises in insurance, said the captive may notbe allowed to pay anything towards the Akai settlement.

8. ReportStacy-Marie Ishmael, FT | March 12 7:59pm |

   Heurtasm - sadly, I've read those papers. Other good 'academic' Lehman reading here -http://ftalphavill...11/69361/academia/
   On rehypothecation and LEH - http://www.ft.com/...-0000779fd18c.html
   and http://www.ft.com/...-0000779fd2ac.html
   And on rehypothecation broadly -
   http://ftalphavill...s-hedge-fund-hope/

9. ReportHuertasm | March 12 7:40pm |

   The Repo 105 Transactions are only one side of the equation that led us to the precipice of financial Armageddon, the other side was another word beginning with R namely "rehypothecation" a financial tool used rather excessively by Lehman's and simply put is robbing Peter to pay Paul. Rehypothecation was conducted by LBIE (as US regs limit the activity whereas the UK regime doesn't). Many of Lehman's clients also failed to even know (partly down to their own fault) that there assets were rehypothecated and then used by LBIE to enter in to back to back repo or other fee generating transactions.
   When the house of cards came crashing down it was apparent that Lehman's systems had insufficient knowledge as to A) where the rehypothecated assets were, and B) how to get it back to the original client by untangling the web of competing claims.
   For an academic discussion please see: http://papers.ssrn...bstract_id=1411609
   which will form the basis of an upcoming PhD in the area.
   Another good paper is:
   http://papers.ssrn...bstract_id=1366171
   In any event there still to this today remains a far too limited discussion of this important area requiring regulatory reform and greater transparency.

10. ReportDCB | March 12 4:46pm |

    Linklatters would be the last firm I would turn to for a racy opinion, and I imagine that EnY will be able to argue that they audited to the standard, implying that the fault is with the standard, and there are many with US GAAPs tick the box approach.
    One partially nationalised UK bank used to be very fond of doing something similar; they would sell assets over their year end with a gentelmans agreement to buy them back. Nothing would be documented to spur the blushes of the auditors.

11. Reportfatdaz | March 12 3:27pm |

    This is very similar to what happened at Refco (albeit on a smaller scale there) . A non performing loan was switched off of the balance sheet each month to flatter the figures- that carried to and through the float I wonder how many other instances there have been of this sort of thing that may never come to light .

12. ReportThe Real Limey | March 12 2:48pm |

    Like that idea!
    Know where my bets are...

13. Report/M | March 12 2:18pm |

    a CDS type market in auditing firm survivability is evidently required so everyone can place their bets.

14. ReportMonkey | March 12 2:06pm |

    Carlomango - I agree it is possible - I just dont think it is likely in this case. Unless it can be conclusively proved that E&Y were aware that they were breaking the rules when they signed off the accounts. It is not entirely clear here that the accounts didn't comply with US GAAP even if they are against the spirit of the rules. US GAAP is less about spirit and more about the letter of the law - it one of its problems. IAS take a more substance over form approach.
    But you are right - it is conceivable but I dont think anyone wants to see it happen. Not the competition (who are probably in glass houses), not the regulators and probably not the multinationals who want some choice in the market

15. ReportJHToronto | March 12 2:04pm |

    I love the FT's reporting on things like this. But I am beginning to wonder why the lawyers involved in these deals are handled with such kid gloves. In most articles on this, there is a mention that US law firms wouldn't go along with Lehman - but that "a London firm" would, which is why they had to be done from London. At least here we know those lawyers were Linklaters. But the legal advice was important - perhaps as important as the E&Y advice. And yet we hear nothing about Linklaters, what they were asked and what their advice was. We can't allow lawyers to get away with the consequences of their advice this easily, especially in the financial services area.

16. Reportpegnu | March 12 1:46pm |

    so we have a endemic problem of balance sheet fraud and as usual the regulators are nowhere to be seen. In fact one of the main regulators who presided over the fraud got promoted. I'm referring to Tiny Timmy here of course. Was he complicit and aware of this going on?

17. Report/M | March 12 1:14pm |

    David Einhorn should consider suing as well. Two people to sue. (1) Dick Fuld. (2) Erin Callan.

18. ReportCarlomagno | March 12 12:29pm |

    @Monkey: Re: E&Y v. Andersen: I take your point about the circumstances of the Enron/Andersen case. And yet... This is purely hypothetical and speculative, but other mechanisms could have a similar effect. In worst case scenario, Lehman's administrator could sue E&Y into insolvency. Or, if E&Y is dragged into the courts and sufficient naughtyness is exposed, some clients may decide that sticking with their current auditor implies unwelcome reputational risk. If a few blue-chips leave, herd behaviour could do the rest of the damage even if the licence is not withdrawn.

19. ReportFlashBang | March 12 11:30am |

    My recollection is that these kinds of transactions by IB's, not just Lehman, were common over reporting periods and had been for many years. In essence, it wasn't much different to market makers getting their inventory down at the end of account periods in the old days. Just the scale was on a whole different level.

20. ReportSam Jones, FT | March 12 11:11am |

    agree with monkey. Quite apart from anything else there is just not the political appetite to bring down one of the world's big auditors. Enron was such a powerful saga because it was at once idiosyncratic, from a legal pov, but at the same time emblematic, seemingly, from a moral one. The latter sold the story, the former sealed the fate of those involved as crooks.
    In the current climate, repo 105 doesn't seem so much a Lehman-specific abuse, as just the kind of thing everyone was doing, everywhere. In other words, while it's still emblematic of a problem, it's not idiosyncratic. If that makes sense?
    Consider: when you get your head around it, how could rating agencies possibly retain a shred of credibility? Over the past two years theyve downgraded more securities then in the previous century of their existence. That's an astounding pointer to egregious failure. Will they be brought to book? No, because the problem is being judged systemically, not idiosyncratically.

21. ReportMonkey | March 12 9:57am |

    Re: Ernst and Young being the next Andersen I think it unlikely. What brought down Andersen were 2 critical misteps. First the fact that Jo Beradino decided to apply a touch of honesty in front of the Senate Committee rather than plead the 5th like the banks did. Never admit any wrongdoing. Secondly, Andersen were undone by breaching their duty to an investigation when they attempted to shred thousands of documents. It was this that led to the withdrawal of their licence to audit which quickly brought down the firm as client exodus followed. Working capital is pretty tight at these professional places and whenthe cash flow coming in stops you have about 2 months before wages dont get paid!
    I think they will tough it out. Enron came hot on the heels of Worldcom for Andersen. In addition the big 5 becoming the big 4 caused such controversy around effective competition that the powers that be will be extremely reluctant to see it become the big 3. I seem to remember various statements to that effect following Andersens breaks up/absorbtion into other accountancy firms around the world.
    There is a final difference re: set up. E&Y is a limited liability partnership I believe. Andersens was not. The partners not involved with Enron suddenly saw themselvs staring down the barrell of a very big hit to their personal fortunes and the in-fighting started immediately. Not sure what harmony is like at E&Y but the threat of personal bankruptcy is presumably less

22. ReportThe Real Limey | March 12 9:25am |

    @DB:
    From what I've heard the exact treatment got signed off by EY. As such, they're probably going to argue that the accounting was in line with standards and therefore the only thing that could be questioned is their judgement - which is not (usually) actionable.

23. ReportDavid Brent | March 12 9:19am |

    @TB - Couldn't agree more! More just pointing out a reason rather than an excuse! From what I remember sometimes understanding is lacking in these places right up to partner level and it is easy for these guys to stay one step ahead. Also you are right that there's always a slight uncomfortable feeling with auditing - you're being paid to do a job required by law, but potential for conflicts of interest are always round the corner. Don't want to be too hard on your client if they are just going to drop you as an auditor and use someone else do you!! Of course I'm being harsh on my ex-business - vast majority are very professional and have the integrity and skills to do a good job appining on finanicals - but it's a problem that's not going to go away. My point is are we going to have a case for sueing due to negligence or if they were complicit and people are charged then will we have another Arthur Andersen on the cards?

24. ReportTB | March 12 9:03am |

    @David Brent - Absolutely, but not understanding something is not an excuse. If you don't understand you don't sign off. Simple as that.
    I think all those expensive lunches and champagne evenings seems to have (again) confused the partners at E&Y over exactly who they actually where went to work for.....
    @Oswald - if you're struggling with that do you think it's maybe not such a good idea to be surfing the internet on your own? :-)

25. ReportDavid Brent | March 12 8:45am |

    agreed - If the auditors are signing off that the financial statements are free of 'material mis-statement' then there is a very good argument that they have missed a huge trick here. Part of their job (and my old job I may add several years ago) is to identify and appine on exactly these types of tricks - unfortunately those that structure such asset/liability transfer transactions to game the accounting rules tend to hire smarter people that the auditors. They pay a lot more than auditors do on average! How much of this is due to incompetence and/or lack of understanding and how much is due to complicitness of the auditor in what's going on will be interesting to find out.....

26. ReportTracy Alloway, FT | March 12 8:43am |

    Oswald - seriously?

27. ReportEdward Oswald | March 12 8:39am |

    Do you mean the Examiner's Report is "window dressing on a massive scale" or that use of Repo 105 is that?

28. ReportYorkie | March 12 8:28am |

    I am sure there are filing cabinets full of legal regal reasons as to why it was ok to do this but surely 'substance over form' is there to stop these very things
    Ernst and Young have some serious explaining to do .

29. ReportNJS | March 12 8:20am |

    Ignorance is no defence, surely? It seems so much effort went into window dressing that they neglected to run the store. I fear that form over substance is the prevailing culture of our age.

30. Reportpraxis22 | March 12 7:33am |

    Going to be grim at Ernst & Young today I'll wager, Enron's auditors did well didn't they...

31. ReportTB | March 12 2:50am |

    Huge story developing this - could seriously bring down E&Y in the US. Did partners at the (remain) big firms learn nothing from Enron / Andersens debacle??