The recent examiner's report on the Lehman Brothers' bankruptcy has introduced the world to Repo-105's. If you're just a little confused about repos, nevermind repo-105's, here's a fictitious example that might be helpful.
We will use gold because its easy to imagine, and we will use the Bank of Keri (me) and the Banc You (you)! For the record, repo's use securities, not commodities because commodities are too volatile, but I'm just using gold so we can visualize it better (and no, I don't have a Bank and I don't have 10,000 oz of gold!)
The Bank of Keri will be originating the transaction, so it will be a repo from Bank of Keri's perspective. Banc You will be the counterparty, so it will be a reverse-repo from Banc You's perspective.
1.) Bank of Keri has 10,000 oz of gold, and gold is at $1,000/oz. Therefore, Bank of Keri has $10 million "in" gold--but wants cash, for whatever reason. Bank of Keri doesn't want to sell the gold outright, for whatever reason--plus, Bank of Keri needs cash now.
2.) Bank of Keri calls Banc You and says, "Hey there, Banc You, if you want to give me $9,900,000 for this here gold, I will sell it to you, it will become yours, but I'll also agree to buy it all back from you next Tuesday for $10,000,000 cash. Whattaya say?"
3.) Banc You thinks about it, considers the gold "collateral" and the market price and whatnot, and thinks about whether or not Banc You is going to need that $9.9 million between now and Tuesday, and finally decides, "Yeah, that's an easy $10,000, I'll do it."
4.) We agree--Banc You gives Bank of Keri the cash, and Bank of Keri sells Banc You the gold. Bank of Keri signs a contract that I'll buy the gold back--no matter what--next Tuesday for $10 million. Now, Bank of Keri has the cash and Banc You has the gold.
5.) Banc You can go sell that gold, if you want to, because its yours--you bought it. Maybe all your Banc You's people say that gold is surely going to go down between now and Tuesday, so you plan to get the most cash for it right now, and when its lower on Tuesday morning, you'll buy it back for cheaper, and increase your profits off the deal even before I, over at Bank of Keri, have to buy it back from you. Or, maybe your Banc You's people all think that gold is going to go up, and you plan to use it for your own repo deal on Tuesday morning when gold is worth $1,100/oz, and you'll use the same amount of gold as collateral for a $11,000,000 repo as I over at Bank of Keri did for $9.9 million.
6.) Whatever Banc You does, you just need to have it back Tuesday so Bank of Keri can buy it back from you and close the deal. It works nicely for both of us: you at Banc You get $10,000 just for playing, plus whatever plan you have, and I at Bank of Keri get cheaper financing than I would have otherwise been able to get, faster than I would have otherwise been able to get, and don't have to sell my gold.
So now let's flesh this out: why would these banks do this?
Scenario 1: Banc You is happy with the $10,000 off the repo. Banc You takes the gold and puts it in a footlocker. Tuesday comes by, and Bank of Keri comes over and buys it back for $10 million. Banc You makes $10,000, Bank of Keri gets the cheap cash financing. Everyone's happy.
Scenario 2: Banc You wants to make a little more money off this deal. Banc You's people all think gold is going down, so Banc You sells the gold the moment it gets it from Bank of Keri. The gold goes for $1,000--the high for the day--and Banc You pockets $10 million. Gold prices start to slide, and by Tuesday morning, spot is $950. Banc You needs the 10,000 oz to sell to Bank of Keri at noon. You buy it off the market for $9.5 million. You have the gold ready for Bank of Keri to buy back for $10 million--and you have a nice $500,000 profit.
Scenario 3: Just as above, but Banc You's people are wrong. You sell the gold at $1,000 today, and tomorrow you are looking at $1010. By Tuesday, gold is at $1,025. Banc You should not have sold that gold--you have to eat the loss, and buy it back to meet your side of the repo so Bank of Keri can buy it back.
Scenario Lehman Brothers: Bank of Keri (read: Lehman Brothers) did the repo because Bank of Keri knew gold (read: toxic RMBS) was going decline, but it needed to show the $10,000,000 (read: $50 Billion!) as a positive part of its balance sheet Monday morning or else it would be downgraded. Bank of Keri (Lehman) sold the gold (toxic securities)--temporarily--to avoid the mark down. When Bank of Keri buys the gold back from Banc You on Tuesday, it will decrease capital on the balance sheet, but that's okay, because the end-of-the-quarter number-crunching will be over, and Bank of Keri (Lehman) will have another month to figure it out, when it will very likely just repeat the same scheme! Moody's slaps Bank of Keri with a shiny AAA rating, and shareholders know nothing! (Insert Dick Fuld's evil laughter here.)
Now, how many times do you think Banc You is going to have to be approached by Bank of Keri (Lehman) to buy this same gold every month before Banc You figures out what Bank of Keri is up to? And what do you think Banc You is going to do once it figures out what Bank of Keri is up to, hum? Banc You is going to up the ante from repo, to the now famous "repo-105."
Repo-105 is when Banc You (Barclays) says to Bank of Keri (Lehman), "Okay, Bank of Keri, you want to do this again? We'll, we've made some good money off you in the past doing this, but we just realized what this is all about, you see. So, indeed, we can do it again, your deal still sounds good...well, almost. Because actually, what you're going to do for us now is give us not $10 million in gold, but $10,500,000 in gold (100% collateral plus 5%), and we'll give you the same $9,900,000. And come next Tuesday, Bank of Keri, you're gonna buy it back for $10,500,000--come hell or high water. Got it?"
Now Bank of Keri (Lehman) is fronting 105%: it's tying up $10.5 million in gold for $9.9 million in cash, while Banc You is getting 5% overcollateralization on Bank of Keri's promise to buy it back. As you can see, this is a sign something is really bad. Banc You is demanding overcollateralization because:
1.) You know what Bank of Keri is up to, and they know they have a blackmail card, and
2.) You are really, actually taking a risk because Bank of Keri is really, actually in distress.
Under normal circumstances, if Bank of Keri was giving Banc You more collateral, Banc You would at least reduce by rate, as their risk goes down. But not with this, and not with Lehman Brothers. If Bank of Keri was really in straits, and Banc You could see this through analysis of the un-window-dressed balance sheet (as you knew was Bank of Keri was up to), then it also might be a good strategy to consider shorting Bank of Keri at some point. Did Barclay's do this is Lehman? I don't know. But they certainly knew about the repo-105's because they were half the contract.
So that's the short story on repo-105.