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.
Showing posts with label repo-105. Show all posts
Showing posts with label repo-105. Show all posts
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.
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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