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Monday, March 15, 2010

Repo 105

In Lehman's bankruptcy trial, the creditors and judge hired a lawyer to write a report on Lehman's bankruptcy. The report was published here. In particular, the section on "Repo 105" was very interesting.

The US financial system is one big scam. Repo 105 is a scam, even if you believe that the financial system is legitimate. This post explains the Repo 105 scam in a way that even a pro-State troll should understand.

The report was in mostly plain English, rather than legal jargon. The lawyer preparing the report probably did a good job. It wasn't that hard to read.

Before getting into details, here's a one sentence summary of Repo 105. "Repo 105 is an accounting loophole very similar to the one Enron used." Lehman executives used Repo 105 to falsely report their leverage ratio.

Repurchase agreements were reported as sales instead of as loans. One leg of the repo was at the end of the quarter, and the other leg was at the start of the next quarter. This made the end-of-quarter balance sheet snapshot fraudulent.

One of the accounting rules is "Don't look for loopholes in the accounting rules." An accountant has an obligation to follow the intention of the rules in addition to the actual rules. By that standard, Lehman's use of Repo 105 is clear accounting fraud. The Repo 105 trades had no other purpose than to manipulate the leverage ratio published in the earnings statement.

The purpose of the lawyers' report was "Who might be liable, if Lehman's creditors want to sue for fraud/negligence?" Lehman's management might be sued by the bankruptcy creditors. Lehman's auditors Ernst & Young might be sued. They probably will get off with at most a slap on the wrist, unlike Arthur Anderson.

Ernst & Young executives will probably use "We're stupid!" as a defense. That might be accepted. If you're a professional, "I'm stupid!" should never be a valid defense. Unfortunately, that isn't the way corrupt State law works.

Ironically, Lehman's board of directors gets off scot free. Lehman's management never told them about Repo 105! Also, Delaware law gives the Board of Directors nearly absolute immunity!

That's the reason most corporations incorporate in Delaware. Delaware law is very favorable to the corporation's management. Due to some bizarre legal loophole, Delaware law protects the executives, even when the corporation does business in other states. As another example, Delaware law favors executives, when they enact a "poison pill" provision to protect themselves from a hostile takeover.

The Repo 105 transactions were conducted through a UK subsidiary. An accountant in the UK had previously issued an opinion allowing this Repo 105 treatment, albeit not on this large a scale.

Lehman executives hired several law firms to discuss Repo 105. All of them refused to issue an opinion letter, saying that Repo 105 is legal in the USA. That is surprising, since lawyers will usually do anything for a paycheck.


Thus, Lehman executives did all their Repo 105 trades through a UK subsidiary. Assets were shifted to UK, solely for the purpose of Repo 105-ing them.

Repo trades do have a bona fide purpose. Suppose a bank needs to borrow a lot of money for a short period of time. Suppose you're buying mortgages, packaging them as bonds, and then selling them. You need to borrow a lot of money for a short period of time, between when you buy the mortgages and when you sell them as bonds.

A repo trade enables the bank to borrow a lot of money briefly, putting other assets as collateral without selling them.

Here's how an honest repo trade works (ignoring the fact that the US financial system is one big scam). Suppose you want to borrow $1B for a week. You have $1B of assets on your books. You don't want to sell them, because that would lead to transaction costs and capital gains taxes. (Alternatively, the assets aren't really worth $1B, but you're carrying them on your books for $1B.)

You sell the bonds for $1B and agree to buy them back in a week for $1.001B. This transaction has an implied interest rate of approximately 5.3%. Effectively, you have borrowed $1B for a week. The lender is willing to lend you the money, because he has $1B of bonds as collateral.

There's one further refinement. The bonds are usually worth more than the amount borrowed. If you borrow $1B, you need to put up $1.02B in collateral. This can be called "Repo 102". The collateral is 102% of the amount borrowed.

For a "Repo 105" trade, you put up $1.05B of collateral instead of $1.02B. Also, you pay a higher interest rate compared to a regular repo. The collateral rate is 105% for bonds, 108% for equities.

If you make a "Repo 105" (bonds) or "Repo 108" (equities) trade, then the UK accounting rule says you may count it as a sale instead of as a repo. This means the trade is reported as a sale instead of as a repo (borrowing). This creates the false impression that Lehman had deleveraged. The obligation to repurchase the bond in a week is not disclosed.

Lehman had sold $1.05B of bonds for $1B. Instead of claiming the $50M loss, they created a phony derivative asset of $50M, representing the obligation to repurchase the $1.05B of bonds for $1B in a week.

There was not even a footnote mentioning the use of Repo 105. Someone who read Lehman's financial statements would have been totally fooled. There was no evidence of the Repo 105 gimmick.

Would a Lehman investor/creditor have wanted to know about Repo 105? Would a bank regulator have wanted to know about Repo 105? Definitely. Therefore, Lehman executives committed accounting fraud.

Lehman used $50B of "Repo 105" trades to fudge their leverage ratio. Someone else said "That's the same amount that Bernard Madoff stole!" Lehman executives committed accounting fraud on the same scale as Bernard Madoff! Because Lehman executives lied about their leverage ratio, they kept their high credit rating. They were able to borrow more money than they would have otherwise.

For a bank, keeping a high credit rating is *VERY* important. Suppose you have 30x leverage and you borrow at 4% to buy bonds yielding 5%. This is profitable. Suppose your credit rating is lowered, and now you have to pay 5% when you borrow. Your business is no longer profitable. The Federal Reserve credit monopoly and negative real interest rates encourage accounting fraud.

Lehman executives knew they were committing fraud. Lehman's COO Bart McDade said:

I am very aware . . . it is another drug we r on. (p. 742)
There are a whole bunch of quotes in that report by Lehman executives. They knew they were doing something dishonest.

For Repo 105/108, there is a rule that says the underlying bonds/equities must be liquid. Lehman almost definitely ignored that rule. If the underlying bonds were liquid, then Lehman could have sold the bonds outright and genuinely deleveraged.

Suppose a bond has a book value of $1B but a fair market value of only $50M. If Lehman executives sell it via a Repo 105 trade, it looks like they sold the $50M bond for $1B. Repo 105 trades were used to move illiquid assets off Lehman's balance sheet, at a phony sale price.

The traders at Lehman who executed the Repo 105 trades knew it was a fraud. The Repo 105 trades were a worse deal for Lehman than regular repos. The traders were annoyed that they were forced to make money-losing trades.

Anyone at Lehman who did a Repo 105 trade knew it was a fraud. More people than just the executives knew about the scam. Via limited liability incorporation, most of those people are protected from personal accountability. Without limited liability incorporation, everyone at Lehman who handled a Repo 105 trade would be partially responsible for the fraud. Limited liability incorporation encourages dishonest behavior.

If you have a job, and your boss demands you commit fraud, you should be partially responsible. That isn't the way insane State law works. According to natural law, everyone is individually responsible for what they do.

Limited liability incorporation gave Lehman executives an incentive to commit fraud. They loaded up on leverage, gambling that the recession would be short and mild. If that occurred, they would have made huge profits. Via limited liability incorporation, Lehman executives had a free put option to declare bankruptcy and cheat their creditors. If their gamble was right, Lehman executives would keep the profits. When they were wrong, they merely declared bankruptcy.
LBHI’s Global Consolidated Balance Sheet, for example, showed securities inventory levels pre‐Repo 105 usage and with Repo 105, and contained columns for “Repo 105/108 added back” as well as balance sheet targets. (p. 864)
That's hilarious. Lehman was keeping two sets of books! There was a "with Repo 105" and a "without Repo 105" column in their statements. That's a clear tipoff that you're committing accounting fraud. You have one set of books that you disclose to the public. You have another set of books that you keep internally that show your real earnings.

Who were the counterparties for the Repo 105 trades? Anyone who did a Repo 105 trade with Lehman, should have figured out that someone at Lehman was committing accounting fraud.

For example, suppose a trader at Goldman Sachs did a Repo 105 trade with Lehman. This would be a tipoff to Goldman Sachs that Lehman was committing fraud. After making the Repo 105 trade, then other traders at Goldman Sachs could make bets that Lehman would go bankrupt soon.

If you make a trade whose sole purpose is fraudulent, *BOTH* parties of the trade should be held legally responsible. Whoever made the Repo 105 trades with Lehman should also be held partially accountable.

Even though the Repo 105 trades were fraudulent, as long as Lehman doesn't go broke within the next week, the Repo 105 counterparty makes a profit. The money market fund that famously "broke the buck" probably was stuck with a bunch of Lehman repos or short-term debt.

This Repo 105 gimmick shows one problem with traditional financial reporting. It would be more honest to require executives to provide a cashflow statement every day, rather than just a quarter-end snapshot. With computers, such disclosure is easily organized. Even then, there still would be loopholes.

Reform will not occur. Insiders make too much money off the way things are now. Insiders like the fact that they can play games with accounting statements. Almost everyone does it. Lehman and Enron crossed the line too far, got too greedy, and got caught.

No matter what rules you create, there will always be loopholes. The big problem is the Federal Reserve credit monopoly and limited liability incorporation.

The Federal Reserve keeps interest rates negative. The Fed Funds Rate is currently 0.25%, while true inflation is 20%-30% or more. This provides executives an incentive to borrow as much money as they can. Insiders have an incentive to lie on their accounting statements, so they can borrow more money.

Inflation makes borrowing profitable. Lehman executives made a big bet that the recession would be short and mild. If they were right, then they would have made huge profits, salaries, and bonuses. When they were wrong, they just declared bankruptcy.

Right now, banks are making huge profits via inflation and bailouts, while the rest of the economy is still stuck in a recession/depression. If Lehman could have survived until the next inflationary boom, they would have made huge profits.

Limited liability incorporation encourages fraud. It gives insiders a free put option to declare bankruptcy and cheat their creditors. It makes no difference if you go bankrupt with a net worth of -$1B or -$200B. If an executive sees that the corporation is almost broke, then the incentive is to load up on leverage rather than deleverage.

The two main evils are the central bank credit monopoly combined with limited liability incorporation. No matter what other reforms State comedians implement, those two lynchpins of fraud will not be touched.

There was another interesting bit. Lehman executives were asking "Are other banks doing this Repo 105 trick?" The presumption was that, if other banks were doing it, then it was OK. They knew that they were the only one abusing Repo 105.

Lehman went broke just before the Federal Reserve opened up its policy, regarding how banks can borrow. Some people say that Lehman was forced into bankruptcy just before the Federal Reserve changed its policy, so they wouldn't benefit.

Now, banks can move assets off-balance-sheet to the Federal Reserve. Instead of doing a Repo 105 trade via a UK subsidiary, banks can do a repo trade with the Federal Reserve. That's the reason there's a fuss about "the growing Federal Reserve balance sheet" or "The Federal Reserve should disclose how much it lent to whom!"

Large banks can now do, completely legally, what Lehman did with Repo 105. Large banks can repo assets to the Federal Reserve.

There were two big questions that report left unanswered:
  • What bonds were the actual collateral for the Repo 105 trades? Were they really liquid? Were they illiquid bonds with book value much greater than fair market value?
  • Who were the counterparties to the Repo 105 trades?
The main points of "Repo 105" are:
  • Repo 105 is an accounting gimmick that Lehman executives used.
  • Repo 105 fraud is the same as Enron's fraud. Sarbanes-Oxley and other reforms were completely useless.
  • Lehman executives did $50B of Repo 105 trades. That's the same amount that Bernard Madoff stole.
  • Because Lehman executives committed Repo 105 fraud, they were able to borrow more money than they would have otherwise.
  • Lehman asked several law firms for a Repo 105 opinion letter. No lawyer in the USA was willing to give an opinion letter, certifying that Repo 105 was legal. Not even for a huge paycheck, was a US lawyer willing to write such a letter.
  • All Repo 105 trades were done through a UK subsidiary.
  • Repo 105 demands that the assets are liquid. Lehman executives almost definitely ignored this rule. If the underlying Repo 105 bonds were liquid, then Lehman could have sold them and genuinely deleveraged.
  • Repo 105 trades had a higher collateral requirement and higher interest rate compared to a regular repo.
  • Whoever did the Repo 105 trade with Lehman, knew that the trade was fraudulent.
  • Everyone at Lehman who was involved with Repo 105 knew it was a fraud. A lot of people, and not just high-ranking executives, were in on the scam.
  • Lehman kept two sets of books internally, one "with Repo 105" and one "without Repo 105".
  • It is pointless to have bank regulators when executives can lie to the regulators.
  • One of the accounting rules is "Don't look for loopholes."
  • Lehman executives did not mention Repo 105 anywhere on their financial statements, not even in a footnote.
  • The insiders who committed fraud at Lehman will probably get away with it.
  • The Federal Reserve credit monopoly and negative real interest rates provide an incentive to borrow as much money as you can.
  • Lehman executives bet that the recession would be mild. If they were right, they would have made huge salaries and bonuses. When they were wrong, they cheated their creditors by filing for bankruptcy.
  • Limited liability incorporation gives an incentive to lie about earnings. You can always declare bankruptcy and cheat your creditors.
  • Due to recent Federal Reserve policy changes, banks can now repo underwater or underperforming assets to the Federal Reserve, rather than doing the Repo 105 trick.
  • Inflation fuels illegitimate bank profits. Inflation enables the banksters to earn huge profits, without doing any real work.
  • The US financial system is one big scam.
As long as the Federal Reserve and limited liability incorporation exist, fraud like this will occur. It's very predictable! There's a huge accounting scandal every few years!

The negative hype regarding Lehman is itself an evil fnord. Lehman executives were dishonest and got caught. Therefore, everyone who is dishonest gets caught. That is false. Lehman was an extreme example of abuse. Other insiders do the same thing, albeit on a smaller scale.

There are no loopholes or laws to patch a fundamentally corrupt system. No matter what new rule you make, there always will be a loophole.

The only way to protect people from fraud is a really free market.

Even if you had no relationship with Lehman, you still paid the cost of the bankruptcy. The cost of Lehman's bailout was paid by everyone else via inflation. For example, AIG/Goldman were bailed out due to bad bets on Lehman credit default swaps. Creditors with good connections, like Goldman Sachs, made a bundle. Other creditors may have been cheated.

The only way to protect yourself from theft via inflation is to buy gold and silver and take physical delivery. In order to fully boycott the Federal Reserve, you must also boycott income taxes. Agorism is the best strategy for fighting evil like Lehman's executives.

Don't bother writing your Congressman. They don't care what you think. The financial industry bailout passed even though a vast majority opposed it. The system is completely broken and must be replaced.

I'm not just whining, because I'm also proposing a reasonable alternative and how to get there from the current mess. Agorism and really free markets are the only philosophy of economics and politics that makes sense, once you really think about it. It's a hard mental shift for most people, due to their pro-State brainwashing.


Scott said...

This is an amazing analysis. I really appreciate your work here.

dionysusal said...

Yes-- truly amazing analysis, FSK. Do you mind if I ask how you came to be so knowledgeable about the financial system/economics? It seems like you could have been an "insider" if you wanted to, but have chosen the virtuous path instead. Bully for you.

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