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The “Repo 105″ Scam: How Lehman Fooled Everyone (Including Allegedly Dick Fuld) And How Other Banks Are Likely Doing This Right Now

Submitted by Tyler Durden

Presenting a detailed look at “Repo 105″ – the next soundbite sure to fill the airwaves over the next weeks and months, as more and more banks are uncovered to be using this borderline criminal accounting gimmick to make their leverage ratios look better. This is the first time we have heard this loophole abuse by a bank, be it defunct (Lehman) or existing (everyone else). There should be an immediate investigation into how many other banks are currently taking advantage of this artificial scheme to manipulate and misrepresent their cap ratio, and just why the New York Fed can claim it had no idea of this very critical component of the Shadow Economy.

From 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. 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, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these  transactions had on the firm’s publicly reported net leverage ratio. According to former Global Financial Controller Martin Kelly, a careful review of Lehman’s Forms 10?K and 10?Q would not reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its Repo 105 practice even though Kelly believed “that the only purpose or motive for the transactions was reduction in balance sheet;” felt that “there was no substance to the transactions;” and expressed concerns with Lehman’s Repo 105 program to two consecutive Lehman Chief Financial Officers – Erin Callan and Ian Lowitt – advising them that the lack of economic substance to Repo 105 transactions meant “reputational risk” to Lehman if the firm’s use of the transactions became known to the public. In addition to its material omissions, Lehman affirmatively misrepresented in its financial statements that the firm treated all repo transactions as financing transactions – i.e., not sales – for financial reporting purposes.

And here is the Fed punchline, as it once again implicates Tim Geithner:

From 2003 to 2009, Treasury Secretary Timothy Geithner served as President of the Federal Reserve Bank of New York (“FRBNY”). The Examiner described to Secretary Geithner how Lehman used Repo 105 transactions to remove  approximately $50 billion of liquid assets from the balance sheet at quarter?end in 2008 and explained that this practice reduced Lehman’s net leverage. Secretary Geithner “did not recall being aware of” Lehman’s Repo 105 program, but stated: “If this had been a bank we were supervising, that [i.e., Lehman’s Repo 105 program] would have been a huge issue for the New York Fed.”

And even though the Fed should have been fully aware of any shadow transaction be they “matched book” repos or the “105 variety, nobody had any clue. Just who the hell was regulating banks???

Jan Voigts, who was an Examining Officer in FRBNY’s Bank Supervision Department, had no knowledge of Lehman removing assets from its balance sheet at or near quarter?end via a repo trade treated as a true sale under a United Kingdom opinion letter.

Arthur Angulo, who was a Senior Vice President in FRBNY’s Bank Supervision department, likewise was unaware that Lehman engaged in repo transactions at quarter?end, under a United Kingdom true sale opinion letter, where the assets would be returned to Lehman’s balance sheet following the end of the reporting period. Angulo said that the described repo transactions appeared to go “beyond other types of [permissible] balance sheet management.” Angulo also said that he would have wanted to know about off?market transactions where Lehman accepted a higher haircutthan a repo seller normally would accept for a certain type of collateral.

Thomas Baxter, FRBNY General Counsel, had no knowledge of Repo 105 transactions, either by name or design. Baxter was generally aware of firms using quarter?end and month?end “balance sheet window?dressing,” but did not recall this being an issue linked to Lehman specifically.

Stunningly, nobody at the SEC was aware of Lehman’s Repo 105 program. And guess what: NEITHER DID DICK FULD. This is unbelievable – the criminality reaches to the very top, yet the very top denies all knowledge.

Richard Fuld, Lehman’s former Chief Executive Officer denied any recollection of Lehman’s use of Repo 105 transactions. Fuld said he had no knowledge that Lehman treated any kind of repo transaction as a true sale or that Lehman ever removed from its balance sheet assets transferred in a repo transaction. In addition, Fuld did not recall having seen any reports referencing the amount of the firm’s Repo 105 activity. Fuld further stated that he did not know that Lehman removed approximately $49 and $50 billion in inventory off its balance sheet at quarter?end
through the use of Repo 105 transactions in first quarter 2008 and second quarter 2008, respectively. Fuld said, however, that if he had learned that Lehman was temporarily cleansing its balance sheet of assets at quarter?end through Repo 105 transactions, it would have concerned him.

Evidence, however, suggests that Fuld is blatantly lying:

Fuld’s denial of recollection must be weighed by a trier of fact against other evidence. Fuld recalled having many conversations with his executives about reducing net leverage and emphasized to the Examiner how important it was for Lehman to reduce its net leverage. The night before the March 28, 2008 Executive Committee meeting, Fuld received materials for the meeting, including an agenda of topics including “Repo 105/108” and “Delever v Derisk” and a presentation that referenced Lehman’s quarter?end Repo 105 usage for first quarter 2008 – $49.1 billion.  The materials also were forwarded by Fuld’s assistant to other Lehman executives. It appears that Fuld did not attend the March 28 meeting, but Bart McDade recalled having specific discussions with Fuld about Lehman’s Repo 105 usage in June 2008. Sometime that month, McDade spoke to Fuld about reducing Lehman’s use of Repo 105 transactions. McDade walked Fuld through the Balance Sheet and Key Disclosures document (reproduced in part below) and discussed with Fuld Lehman’s quarter?end Repo 105 usage – $38.6 billion at year?end 2007; $49.1 billion at first quarter 2008; and $50.3 billion at second quarter 2008.

Based upon their conversation, McDade understood that “Fuld knew, at a basic level, that Repo 105 was used in the firm’s bond business” and that Fuld “was familiar with the term Repo 105.”3524 McDade recalled that when he advised Fuld in June 2008 that Lehman should reduce its Repo 105 usage to $25 billion, “Fuld understood that this would put pressure on traders.”3525 McDade also recalled that “Fuld knew about the accounting of Repo 105.”

Combing through the Appendix on what collateral was actually “sold” (only to be promptly bought back) in Repo 105s:

Most securities Lehman used in Repo 105 transactions were “governmental” in nature, implying a certain level of liquidity. While representing a relatively small percentage of Lehman’s total Repo 105 assets/securities, at times the nominal amount of non?”governmental” securities Lehman used in Repo 105 transactions was quite large. For example, as of February 29, 2008 (the end of Lehman’s first quarter 2008), Lehman utilized over $1 billion of highly structured securities, i.e., CLOs and CDOs, private RMBS, CMBS and asset?backed securities, in Repo 105 transactions. In the market environment that existed for Lehman in early 2008, these structured securities were likely relatively illiquid as indicated by declines in origination volumes, wider bid?offer spreads, and higher margin requirements.

In August 2008, just before it was over, the firm allowed $55 million, or seven securities, rated CCC to be included in a Repo 105 transaction.

The next chart makes it evident it that 105s were used simply to game the firm’s assets into quarter end (yellow highlights), by reducing overall asset for leverage ratio calculations.

That this scam was going unsupervised (just who the hell were the counterparties?) for many years, and that many banks are likely using it right now to fool investors, regulators, rating agencies, and the idiots at the FRBNY (who certainly also know about this), is beyond criminal. Yet that nobody will go to jail for this is as certain as the market going up another 10% tomorrow. A full investigation has to be conducted immediately into whether existing Wall Street firms, and in particular those who use Ernst & Young as auditors, are currently abusing public confidence via such transactions.

Full report

Repo 105

 Lehman Part II

Presenting The Lehman Bankruptcy Examiner Report

Submitted by Tyler Durden

We present the first two volumes (out of 9) of the massive 2,200 page compendium that represents the just declassified examiner’s report in the Lehman bankruptcy case. We will post the other volumes shortly. Below are the key findings from a quick perusal of Anton Valukas’ report, which we will be combing through over the next week. Pay particular attention to the Repo 105 scam which allows banks to materially misrepresent their leverage ratios whenever they so choose, thank you FASB, corrupt auditors (in this case E&Y) and Federal Reserve.

Some observations:

Lehman actively misrepresented its capital ratio with the benefit of Fed complicity, because instead of using traditional Repo transactions, it used “Repo 105″ which allowed repos to be treated as asset sales instead of financings. Will someone please ask uberregulator Fed how many other banks are using this borderline illegal accounting scheme RIGHT NOW to misrepresent their net leverage ratios?

• Lehman was forced to announce a quarterly loss of $2.8 billion – resulting from a combination of write?downs on assets, sales of assets at losses, decreasing revenues, and losses on hedges – it sought to cushion the bad news by trumpeting that it had significantly reduced its net leverage ratio to less than 12.5, that it had reduced the net assets on its balance sheet by $60 billion, and that it had a strong and robust liquidity pool.
• Lehman did not disclose, however, that it had been using an accounting device (known within Lehman as “Repo 105”) to manage its balance sheet – by temporarily removing approximately $50 billion of assets from the balance sheet at the end of the first and second quarters of 2008.  In an ordinary repo, Lehman raised cash by selling assets with a simultaneous obligation to repurchase them the next day or several days later; such transactions were accounted for as financings, and the assets remained on Lehman’s balance sheet. In a Repo 105 transaction, Lehman did exactly the same thing, but because the assets were 105% or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financings, so that the assets could be removed from the balance sheet. With Repo 105 transactions, Lehman’s reported net leverage was 12.1 at the end of the second quarter of 2008; but if Lehman had used ordinary repos, net leverage would have to have been reported at 13.9
• Lehman did not disclose its use – or the significant magnitude of its use – of Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board of Directors. Lehman’s auditors, Ernst & Young, were aware of but did not question Lehman’s use and nondisclosure of the Repo 105 accounting transactions. [And why should auditors question anything even remotely shady? After all they need to feed the monkey too.]

The case for why the Fed would be a truly horrible systemic regulator. Here is what happened at Lehman according to Valukas

• Lehman decided to exceed the firm?wide risk appetite limit at several junctures.
• First, though Lehman dramatically increased the limit for fiscal 2007, Lehman nevertheless approached the new limit by May 2007.
• Then, in early October 2007, when Lehman’s risk appetite excesses were at their peak, at least some members of Lehman’s senior management discussed the limit breaches and decided to grant a temporary reprieve from the limits  based on the difficult conditions in the real estate and leveraged loan markets.
• Rather than reduce its risk usage, Lehman cured its risk appetite overages by increasing the firm?wide risk appetite limit yet again.

The firm cooked its books:

• Lehman also failed to apply its balance sheet limits in late 2007. Application of these limits would also have restricted Lehman’s risk?taking. Instead, Lehman dramatically increased the size of its balance sheet, and used increasingly large  volumes of Repo 105 transactions to create the appearance that the firm’s net leverage ratio remained within a reasonable range of such ratios established by the rating agencies.

The SEC was aware of the BS going on at Lehman:

• Lehman’s stress tests suffered from a significant flaw. Although Lehman made a strategic decision in 2006 to take more principal risk, Lehman did not modify its stress tests to include the risks arising from many of its principal investments – including its real estate investments other than commercial mortgage backed securities (“CMBS”), its private equity investments, and, during a crucial period, its leveraged loan commitments.
• The SEC was aware that Lehman’s stress tests excluded untraded investments and did not question the exclusion, because historically it had been the norm to limit stress tests only to traded positions.

The firm overindulged in speculative garbage LBO loan positions:

• Lehman’s principal investment strategy also included participating in leveraged loan transactions. This business grew spectacularly in 2006 and the first half of 2007. Many of these loans were made to private equity firms, or sponsors, who were purchasing companies as part of leveraged buy?outs.
• These transactions were risky for Lehman because they consumed tremendous amounts of capital, were made on terms that strongly favored the borrowers, and often involved bridge equity or bridge debt that Lehman hoped to distribute to other financial institutions (but was committed to keep for itself if it was unable to do so).

Lastly, Lehman directors can sleep well. Once again, nobody in the world is guilty for the biggest corporate bankruptcy in history:

• The Examiner Does Not Find Colorable Claims That Lehman’s Senior Officers Breached Their Fiduciary Duty to Inform the
  Board of Directors Concerning the Level of Risk Lehman Had Assumed
• The Examiner Does Not Find Colorable Claims That Lehman’s Directors Breached Their Fiduciary Duty by Failing to Monitor
  Lehman’s Risk?Taking Activities
• Lehman’s Directors are Protected From Duty of Care Liability by the Exculpatory Clause and the Business Judgment Rule
• Lehman’s Directors Did Not Violate Their Duty of Loyalty
• Lehman’s Directors Did Not Violate Their Duty to Monitor

On the much prevalent conflict of interest of selling portfolios that one has originated (especially as pertains to Goldman’s assorted CDOs held by AIG):

• In one memorandum, Lehman’s Head of Global Strategy expressed the concern that “the team responsible for selling down these positions is the same one that originated them.”628 But several witnesses denied there was any incentive not to sell down the portfolio because they knew that no one in GREG would be getting a 2008 bonus

Attached are Volume one of the report (just the first 240 pages, including the 45 page table of contents) and Volume two. We will upload the remainder shortly.

Deutsche Bank estimates that Dubai’s property prices, both commercial and residential, have halved since August last year, and could fall a further 15-20% this year.

U.S. Banks Less Exposed

Most analysts believe U.S. banks are probably less exposed than European rivals to a potential debt default by Dubai World, but a lack of transparency and the interconnection of the modern financial system make it difficult to know which institutions are ultimately exposed.

Dubai World’s largest creditors are reportedly domestic banks in Dubai and Abu Dhabi. MarketWatch noted data from the Bank for International Settlements which put cross-border banking exposure for the UAE as a whole at $123 billion at the end of June. Of that total, European banks hold 72%, with the United States and Japan only holding 9% and 7% of the exposure, respectively. The United Kingdom is by far the biggest creditor with a share of 41%.

Reminder of Other Risks

As pointed out in my previous article that the commercial real estate sector posed a much greater threat than the over-hyped “mother of all carry trades.”  The Dubai debt crisis further reinforces this viewpoint.

As commercial property values fall, debt defaults rise. The $3.4 trillion outstanding in debt backed by commercial real estate poses a real threat to the recovery. Trepp LLC reported that last month, delinquencies on U.S. commercial real estate loans that were packaged into commercial mortgage-backed securities reached 4.8%, more than six times the year earlier level. Hotel loans, at 8.7% distressed, have begun falling into delinquency faster than any other kind of commercial real estate debt.

Write-downs and losses at banks around the world have risen to more than $1.7 trillion since 2007 as the credit crisis undermined the value of assets owned by financial institutions, according to data compiled by Bloomberg. Any further deleveraging and the resulting credit tightening from commercial real estate would impede the financial sector and probably derail the U.S. economy sending it into another recession. 

Housing Market Mortgage Crisis

Based on a study released by Zillow.com, the foreclosure crisis has moved beyond subprime mortgages and into the prime mortgage market. (Fig. 3) While subprime borrowers are still a factor in the current foreclosure epidemic, it’s becoming increasingly apparent that the weak labor market is the driving force behind the mortgage crisis we face today.

According to the Mortgage Bankers Association, one in seven U.S. home loans was past due or in foreclosure as of Sept. 30, putting that quarterly delinquency measure at its highest level since t

he report’s inception, 1972, and up from one in ten at the beginning of the year.

The continued surge in delinquencies suggests that a recovery in the housing market could be hindered by the weak job market as well as by further fallout from the easy money and loose lending practices of the past. The foreclosures and delinquencies are expected to keep rising well into 2010, not leveling off until the unemployment rate starts to moderate.

In a study by First American CoreLogic found that one in four of all U.S. mortgage-borrowers owe more than the value of their properties in the 3rd quarter. And many experts didn’t expect U.S. home prices to hit bottom until early 2011, perhaps falling another 5-10%, as more foreclosures get pushed onto the market.

Negative equity is another outstanding risk hanging over the mortgage market.

Dubai Is No Lehman

The circumstances behind Dubai’s moves are murky, making it hard to gauge the exact risk to the pertaining bonds and Dubai’s own general creditworthiness. UBS cautioned that Dubai’s overall debt “might be higher than the generally assumed $80 billion to $90 billion, due to potential off-balance sheet liabilities. These could include unlimited and unquantifiable amount of credit default swaps (CDS) and other derivatives against the underlying assets, and once unraveled, could potentially erupt into a subprime-like crisis.

The current expectation; however, is that there’s a good chance that Dubai’s problems will probably prove a local issue. Most likely, Dubai, or its neighboring emirate, Abu Dhabi, won’t risk tarnishing their images and reputation further, and will come up with a reasonable resolution.

Even if Dubai goes into sovereign default, the amount is probably not enough on its own to threaten the financial system since any actual losses would be a fraction of the total. So, the problems in Dubai are unlikely to be as serious as last year’s Lehman Brothers collapse, nor is it a reflection on the ability of emerging markets to lead a global economic recovery.

Rational Expectations?

But Dubai could well spur a broader crisis of investor confidence in overly leveraged economies as market confidence world-wide is still fragile from the severity of the financial crisis.  The debts of many emerging markets have risen even further as the countries governments have fought the ravages of the global recession by issuing more stimulus debt to fill the gap voided by private investment.

The spread of credit-default swaps on developing-nation’s bonds jumped 14 basis points after the Dubai news broke, the most in a month, to 3.24 percentage points, according to JPMorgan Chase & Co.’s EMBI+ Index. There is also a clear sign of potential contagion effects of global risk aversion on basically all risky assets, with the dollar and yen being the prime beneficiaries.

Rational expectations or not, for now, the Dubai crisis is simply a reminder that the severe global recession has relegated much debt to near junk status, and there still remains a high degree of uncertainty as to the percentage recoverable on all outstanding debt which is going to be coming due over the next 5 years.

Despite some seminal signs of green shoots in the news headlines during this 9 month liquidity driven rally in many asset classes around the globe, we should be reminded that all that glitters is not gold, and that the global economic recovery is still on shaky ground.

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