The quickie on “Repo 105” (Lehman scandal)

I wrote a lot about Lehman Japan yesterday without putting in anything explaining “Repo 105”.

Here it is in my best version of layman’s terms:

– The health of a bank, like any company, depends on how much it owes compared to how much it owns. The more a bank relies on its own capital, the better it can survive any bad economy or other setback. But realistically, a bank borrows money and then lends or invests it elsewhere. That’s the business model. That’s what they do.

– Sometimes when banks borrow money, they do it with collateral—in some ways like going to the pawn shop. But probably more like borrowing to buy a house. Nah, more like the pawn shop that only takes very high quality merchandise. You get money, but you have to put something up in exchange. If you don’t pay back, the lender gets to use whatever you put up to satsify the debt.

– These “repos”, or repurchase agreements, are that. A borrower puts up a security for collateral. They put up a government bond that they own or have control over in exchange for getting cash money that they can use.

– In normal circumstances, this goes on all the time. I think it was popularized in the 1970’s, right before the New Deal regulations began to be watered down or eliminated. But the idea itself is probably as old as the hills. “I want money, I have something of value for you to hold in the meantime, please lend me money.”

– A repo is not a sale. It is a borrowing. This means, you have to pay it back. The critical thing is, in accounting, you have to show this as a “liability”. You, as a company, are obligated to come up with money in the future.

– What Lehman did was, in order to get this money, made an agreement in such a way that they thought they could fool people into thinking the repo was a sale. In a sale, you give the “thing of value” over and you get cash. That is that.

– What the trick involved was finding a law firm (Linklaters in England) to write an “opinion” or a letter saying that the law firm believed that a repo where Lehman did not get a big loan for the collateral could be construed as a “sale”. They felt that if Lehman only got $1 for every $1.05 in collateral, then that was more like a discounted sale than than a loan on collateral. (This is where the “105” comes in, by the way.) The backwards logic was, it wasn’t a repo since no one would do a repo that way: they would want something near $1.05 for that amount of collateral. So if you ask for less of a loan, it must not be a repo!

– With this opinion letter, Lehman began to do repos with lower cash back for whatever collateral they put up. THIS PART IS CRITICAL: This enabled them NOT to book a liability. The cash they got was really a loan, but it was “balance sheet cash” and could be used to pay down other liabilities. The fact that they owed it to the repo counterparty in a couple days got to be hidden from the public.

– Say, you have $40 billion that you owe other companies. You could take a $3 billion security that you own and do a “Repo 105”. The counterparty would give you $2.85 billion. Under Repo 105, you would not have to show that you owe this $2.85 billion–[but] it’s really not yours! Then, you could use it to knock down the $40 billion liabilities to something closer to $37 billion. (Lehman did tens of billions that way, using many securities.)

– Basic sense, if it looks like your company owes fewer creditors, your company looks healthier. Just like a person. If you owe every Tom, Dick and Harry, you aren’t too solvent, are you?

So at the heart of “Repo 105” was a lie. The lie was that Lehman still had a big obligation with every Repo 105 that it did. But they didn’t feel that they had to let the public know, and they ran their affairs in such a way that the public would not know. Nor the regulators. Their excuse was the Linklaters letter.

– When Lehman started to run out of capital in late 2007, they began to rely on this lie more and more. To the point where they had run out of capital (that is, they ran out of the shareholders’ own money and not something borrowed from outside) probably several weeks before they actually filed for bankruptcy.

– Like many lies, the liar needs to construct an excuse around it to make it seem not as bad as it is. So with Lehman, “Repo 105” became this excuse unto itself. “Let’s do some more Repo 105 to take care of this” sounds so much better than, “Let’s borrow some money on collateral, and then pretend that we don’t have to pay it back. And don’t tell anybody outside our circle!”

– In the end, Lehman had no capital, no value. All it had was people it owed money to. It’s like if you or I had nothing and decided to set up trading desks and pretend that we were a big international business.

What is hard for people in that small community of Lehman big wigs to appreciate is that their little “Repo 105” was one of the factors in the current economic suffering of hundreds of millions of people. I mean, how far removed were these guys from John Law? I mean, “let’s create a bunch of fictional capital, and tell the public to ‘trust us’ with borrowing, even though we’ve burned through all the actual money we had?”

Probably Linklaters didn’t foresee that their opinion letter would be taken to such extreme. Maybe they should rename themselves “Stinkletters”, but that’s an aside. But the person who authored the letter, didn’t they realize that at the heart of it was a lie? That in the end, it was money borrowed that would have to be paid back, and thus was something that had to be revealed in a financial statement?

This is the sickness of our times. The people in positions of trust think that they can come up with clever ruses, or that they’re oh-so-powerful that whatever the fantasize can become reality.

Rules?? Ha ha ha ha ha!! Like that.