Friday, March 12, 2010

Examiner finds Lehman Brothers' dirty little secret: Repo-105

An bombshell report on the Lehman Brothers fiasco released this week demonstrates the level of financial shenanigans--and perhaps fraudulent misrepresentations--taking place behind the doors of 745 Seventh Ave. The report is a court document, prepared by the court-appointed Lehman Brothers bankruptcy examiner, Anton Valukas, as the bankruptcy resolution still winds its way through New York Supreme Court today, some 18-months after bankers were last seen leaving the Lehman headquarters with boxes the day the firm went belly-up on September 15, 2008. Most of those Lehman employees clearing their offices had no clue that the firm was up to--and neither did shareholders until this week's report.

While the examiner does not have any prosecutorial authority, the report is apparently a blueprint for creditors still trying to get their pieces back, and an expose on what the executives at Lehman were up to--including signing off on materially misleading statements, which, the last time I checked, was in violation of Sarbanes-Oaxley. Here's an article from Bloomberg, which is worth reading in full:
Fuld "Negligent" as Lehman Hid Levage, Report Says. If you'd like to read the examiner's entire 2,200 page report for yourself, you can do so here.

Central in the report is the discovery that Lehman Brothers was surreptitiously using a special type of repurchase agreement (repo) known as a "repo 105." Regular repo's are very commonly used by banks, and serve the purpose of allowing a bank to access cash as a low rate in return of exchanging collateral that it cannot sell or does not want to sell, usually yield-bearing collateral.

A crude repo example between two persons could be explained if I need $50,000 liquid cash, but didn't have the liquid cash. Let's say I have, however, $50,000 in a CD that is bearing 5% (back when CD's used to do that). I can't access the $50,000 because I don't want to incur the penalty, and the cheapest rate I can get for short loan is 6%. I devise a repo plan and approach you: I offer you the CD as collateral for an advance of $50,000, agree to let you collect the interest it bears while you own it for a month (about $208), and agree to repurchase the CD from you in one month for $50,010. This means that you'll make $218 virtually risk-free, because you have the CD as collateral if for some reason I don't buy it back. I, on the other hand, am actually saving $32 over what it would have otherwise cost me to borrow $50,000 at 6% for 30-days. That's the basic form of a repo, but for Lehman Brothers, we're not talking $50,000--we're talking $50 Billion. In such huge numbers, a hundredth of a percentage point (aka a "basis point") is a huge difference in financing cost.

Central banks use repo's, commercial banks use repo's, investment banks use repo's-- everybody's using repo's. Repo's have become ever more common and integral in the system, especially since the boom in securitization and other "asset-backed" paper, because this collateral, particularly during the RMBS boom, was both something that banks wanted to hold on to (they didn't want to sell it for cash because the value was increasing), and because the paper behind the collateral was also higher yield-bearing securities. Now, let's compare the basic repo, which is therefore a financing device, to what the examiner discovered in Lehman's hamper--the repo-105.

To put it bluntly, Lehman's repo-105 is a specialized device with a specifically different purpose from the regular repo which, at least in Lehman's case, is used primarily for deceiving regulators, investors, and shareholders by allowing for a $50 Billion quarterly window-dressing charade. The regulators were "lazy" because if the examiner could figure this out, they could have too; additionally, please note that missing from this list is "auditors," because the auditors were actually informed of this action by a whistle-blower,
Matthew Lee, but they didn't want to hear it. Neither did Fuld and the other executives, as they fired Lee for questioning the practice.

You see, like a regular repo, a repo-105 has the repo-seller (Lehman) selling securities to a counterparty (repo-buyer) with the promise from Lehman to buy the same securities back at a set price and set date in the future. The "105" part, however, is the red light: "105" is referring to the fact that the counterparty (repo-buyer) demands not just 100% collateral (or "matching collateral") in return for agreeing to the deal and delivering the cash for the securities upfront, but the counterparty is actually demanding more collateral--ie, 105%--upfront before advancing the cash. Considering our above example of you and me as parties to the CD repo, this might smell a little fishy to you: if you would have demanded 105% collateral, I would have been better off getting the loan from the bank at 6%, right?

Right--so, if Lehman's repo-105 smells fishy to you, it should.

As you can probably see from the example, the only reason a bank would want to engage in a repo-105 is because:
A.) it had few other choices for getting cash, ie, other financing was too expensive; or
B.) it was trying to hide something.

The examiner's report reveals that both were true for Lehman:

1.) Banks were not willing to advance Lehman cash for the collateral it was offering because the collateral--largely backed by RMBS--was losing value by the minute. A 100% collateral match simply wasn't enough, as the counterparty was not only taking risk extending cash to Lehman, but was giving up an instrument--cash--that was actually bearing more yield than the collateral Lehman offered (which were disintegrating RMBS).

2.) Lehman was desperate to make the deals at whatever cost because they were not accounting for them as financing on the balance sheet, but as sales of toxic debt! The examiner's report reveals that the firm was financing up to $50 Billion of toxic debt in a single repo-105, while simultaneously shifting the bad debt "off" the balance sheet by listing it as a sale at quarter end--when it was actually financing that the bank had to cover days later. Lehman was using the repo-105's to hide its turn state of insolvency. If that also smells fishy, you're right again!

So, Lehman managed to "shift" billions off its balance sheet through the use of repo-105 accounting magic by simply writing the repo financing as an asset sale. If you did this--say, wrote off your monthly mortgage payment as a "sale" of the same amount to your checking account--well, then you'd be a multi-billion dollar investment bank, too! Of course, I don't suggest you try it, seeing as it is nonsensical and illegal, but if you'd like more details as to how Lehman did it, read Repo 101 on Repo-105's.

Lehman was using the repo-105 as a financing tool, meaning that they were pledging certain securities on the balance sheet as collateral for a cash advance from a counterparty, with the agreement that Lehman would re-purchase those same securities at a later day for a higher price. The counterparty advanced the cash, and in return made a profit off the repurchase from Lehman at that later date. Again, the reason Lehman had to front more than 100% collateral--105% or more--is because the "collateral" was comprised of increasingly compromised securities that the counterparty recognized as risky. The collateral was also illiquid, as evidenced by the fact that Lehman couldn't outright sell the securities for cash, and so the counterparty then appropriately demanded a risk premium. The next question you might be thinking is, "Okay, so even if the investors and shareholders didn't know that Lehman was engaging in repo-105, surely the counterparties who were demanding that 105% collateral knew--who were these counterparties, and what did they do with that information?"

Good question. Here's your answer: just seven non-US banks: Barclays, Mizuho, UBS, Mitsubishi, Deutsche Bank, KBC and ABN Amro. Why only non-US banks? Simple: Lehman could not get a single American law firm to sign off on the repo-105 "technique" it was utilizing, as they all recognized it as in violation of American reporting rules. Hell bent on using it, Lehman found
London-based law firm Linklaters, who approved the deal according to British law. The first name on that list--UK-based Barclay's--is the very bank that made a killing buying up Lehman Brothers assets in "the deal of the century" after its bankruptcy. And now we learn of Barclay's role in the repo-105, which clearly indicates that the bank knew of Lehman's balance sheet gymnastics and pending insolvency. (But this is fodder for another post all together.)

Other US banks, including
JP Morgan and Citigroup were engaged in regular repo's (not "repo-105's), but they also started demanding more collateral, according to the report. The examiner concludes that these increased collateral demands "had direct impact on Lehman’s liquidity," and that "Lehman’s available liquidity is central to the question of why Lehman failed," which is to be expected for an irresponsible and over-extended firm. Most essential in the report in regards to the repo's is that Valukas reveals Lehman had been using repo-105's for the purpose of window-dressing its balance sheet, and "removing" $50 Billion or more from its liabilities, for at least two quarters before the September 2008 collapse.

Most of the repo-105 business was through Barclays, Mizuho and UBS. Check
this article out. Below is a quote from the examiner's report that is in the article (broken up for easier reading):

"In the 2007 to 2008 period, Lehman’s Repo 105 counterparties were primarily restricted to Mizuho, Barclays, UBS, Mitsubishi, and KBC, though some of these also tapered off their Repo 105 trading in 2008...

"..E-mail from Chaz Gothard, Lehman, to Mark Gavin, Lehman, et al. (Sept. 4, 2007) [LBEX-DOCID 4553246] (“KBC are no longer able to finance our 105 agency trades. . . . This effectively means we only have 3 counterparts with which to transact this business – Mizuho, Barclays & UBS. Whilst they have taken all the paper we’ve thrown at them to date this situation should not be relied upon.”);

"...e-mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 28, 2008) [LBEX-DOCID 3207903] (reporting Repo 105 trades with “Barclays – $ 3 billion, UBS – $ 6 billion, Mizuho – $ 2 billion”);

"...e-mail from Mark Gavin, Lehman, to Daniel Malone, Lehman, et al. (May 20, 2008) [LBEX-DOCID 736184] (noting in e-mail with subject line “RE: Repo 105 CPS” that “Mizuho - $5bln,” “[n]o longer at the table: Barclays up to $15 bln,” “UBS up to $10 bln,” “Mitsubishi up to $1 bln,” and “KBC up to $2 bln”)..." "

There are many more examples of this kind of funny business in the examiner's 2,200 page report. The fact is, we only know about this surreptitious "financing" because Lehman went bankrupt. We will likely never know which other banks were up to the same deciet and perhaps fraud, because the Federal Reserve has opened up the flood-gates of liquidity and lent taxpayer money to save the skins of dozens of others banks which otherwise deserve to be, and should be, in Lehman's bankrupt place as well.

By the way, the Federal Reserve still refuses to release any information of how much was given to how many banks: we will only know when we get the bill.

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