What are Repos?
Sale and repurchase agreements (“repos”) are agreements in which one party transfers assets to another party as collateral for a short‐term borrowing of cash, while simultaneously agreeing to repay the cash and take back the collateral at a specific point in time. When the repo transaction matures, the borrower repays the funds plus an agreed upon interest rate or other charge and takes back its collateral. Repo transactions are widely used by financial institutions and are a legitimate tool for raising short‐term funding.How does accounting treat repos?
Lehman accounted for ordinary repo transactions as financing transactions, which is the correct accounting. Under this accounting convention the transferred securities remained on Lehman’s balance sheet during the term of the repo (incoming cash boosted assets, and total liabilities increased).
What would be the impact of an ordinary repo (by ordinary we mean one classified as a "financing transaction") transaction on the balance sheet?
Assume this is the starting Balance Sheet:
If the company, Lehman in this case, executes $50 Billion of typical repo transactions the result would look like this.
Notice that assets increased (cash), and liabilities as well (collateralized financings increased by the same amount as cash).
Now what would happen to the Balance sheet if the company were to use the proceeds under an ordinary repo transaction ($50 billion) to pay down debt?
Now we are right back where we started -- assuming the company were to use the $50 billion cash borrowing from an ordinary repo transactions to pay off current liabilities, the effect on the balance sheet would be neutral – no net increase in total assets/liabilities, and no effect upon leverage
Ok, this isn't really telling me how Lehamn exploited its balance sheet. What happened there.
The problem, according to the Examiner, was that "although Lehman publicly reported that it treated all repo transactions as financing transactions for accounting purposes, Lehman booked “Repo 105” transactions as sales under the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 140 (“SFAS 140”), Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." In other words there was a change in the accounting convention employed on some repo transaction away from conservatism.
I won't get into the nuances of SFAS 140, which does allow for repo transactions to be booked under "sale" if certain criteria are met. However, almost all repo transactions are "financial transactions" and not "sale transactions".
What's the accounting difference between a financial and sale repo?
I'll quote from the examiner...
The recharacterization of a repo transaction from a financing or “borrowing” transaction to a “sale” transaction pursuant to SFAS 140 leads to several consequences:
The transferred securities inventory are derecognized, i.e., considered sold and removed from the transferor’s/seller’s balance sheet during the term of the repo even though the transferor/seller is required to repurchase the inventory at a future date.
Additionally, when a repo transaction is recharacterized as a sale, the transferor/seller does not record a liability representing its obligation to repay the borrowed funds.2927 In other words, the “borrowing” is not reflected on the balance sheet, even though the economic substance of the transaction is a borrowing, and thus, the transferor’s total liabilities do not increase.
Although the transferor’s inventory decreases, at the moment of the transaction the transferor’s total assets remain unchanged because the transferor receives cash borrowings in exchange for the securities inventory.
Basically, classifying Repo transactions as "sale" removed securities inentory from Lehman's Balance sheet for a short duration (typically around the end of a quarter right before financial statements -- which are point in time snapshots -- are compiled). At the moment of the Repo 105 transaction, Lehman received cash.
Thus although Lehman reduced its inventory, the incoming cash resulted in no change to the volume of Lehman’s total assets. Because Lehman booked Repo 105 transactions as sales under SFAS 140, rather than as financings, it did not record any liabilities arising from the obligation to repay the short‐term funding secured by a Repo 105 transaction. Consequently... Lehman was also able to borrow tens of billions of dollars without disclosing the borrowing.So what did classifying repo 105 transactions as "sale" do to Lehman's balance sheet?
Not much interesting happens... Lehman receives $50 billion in cash, exchanging one form of asset for another, so total assets are unchanged; no liability is recorded to return the cash borrowing so liabilities likewise remain unchanged; at the moment of the Repo 105 transactions and leverage is unaffected.
However, now if Lehman uses that cash received ($50 billion) to pay down short term liabilities, they can manipulate the size and leverage in the balance sheet and this is exactly what Lehman did.
Under this circumstance (using the cash received to buy back Collateralized Financings) the balance sheet would look like this:
Why did Lehman do this?
According to the examiner:
Lehman’s primary motive for undertaking tens of billions of dollars in Repo 105 transactions at or near each quarter‐end in late 2007 and 2008 was to temporarily remove the securities inventory involved from its balance sheet in order to report lower leverage and net leverage ratios than Lehman actually had...Numerous witnesses told the Examiner that Lehman’s motive for undertaking a Repo 105 transaction, as opposed to an ordinary repo, turned solely on Lehman’s need to manage the firm‐wide balance sheet and effect the publicly disclosed leverage.
Lehman Examiner's Report