Monday, March 15, 2010

What Exactly Is Repo 105?? (and Repo 108??)

Well occasionally this blog attempts to educate the broader public (or the 3 people who visit this site, my Mom, my dog, and an imaginary friend).  Seriously, I like to think I can explain some more complicated things without being condescending or "talking down" to people.  So if I can achieve this today I'll be quite happy.

So the latest buzz word in finance talk is this "Repo 105".  What the hell is this about??  Well the reason Repo 105 has caused a stir is because it was a tool used by Lehman Brothers to hide liabilities on its balance sheet, and by hiding these liabilities, to appear more sound and solvent to regulators and the general investing public.  A type of "window-dressing", if you will, to make Lehman Brothers look more solid financially.

Where did the troubles start??  It started in the year 2001 after a new (and shabby) accounting standard came into affect called SFAS 140.  Some banking leaders were salivating to see if they could use this to cut some corners.  So what does "repo" here mean?? "Repo" is short for repurchase agreement.  What is a repurchase agreement??? A bank, it can be any bank, but let's say Lehman Brothers, gives some securities to a counterparty as collateral (something of value to be forfeited if they don't pay the loan).  That counterparty then gives Lehman some cash as a short-term loan.  The transaction (or "short-term loan") ends when Lehman returns the cash and an agreed upon interest payment to the counterparty, and the counterparty returns the securities (collateral) to Lehman Brothers.  

So what did Lehman do with this "Repo 105"???  Essentially Lehman Brothers told a big fat lie.  What should have been counted as a short-term transaction (or short-term loan) was carried on the balance sheet as a "sale" because they paid a higher interest rate on the short-term loan.  They refer to that higher interest rate paid on the short-term loan (or "repo") as a "haircut".  These transactions or short-term loans lasted only about 7 to 10 days.  So Lehman would transact these Repo 105 transactions very close to the reporting periods in order to hide liabilities and leverage on their balance sheets.  What makes it much worse is Ernst and Young, a famous accounting firm, signed off on these transactions which were intended to mislead the general public and mislead regulators.  "Mislead" of course being a kind and generous term for what many people might call A BIG FAT LIE.  

So.....  hope that helps explain what Repo 105 is, and a large part of what caused Repo 105 and that is the shabby SFAS 140 accounting standard.  You can read more about that here at one of Tom Selling's blogs.

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