Lehman Brothers

Repo 105

Leverage Ratio

Source: https://knowledge.wharton.upenn.edu/article/lehmans-demise-and-repo-105-no-accounting-
for-deception/

The use of outside entities to remove risks from a company’s books is common and can be perfectly
legal. And, as Wharton finance professor Jeremy J. Siegel points out, “window dressing” to make the
books look better for a quarterly or annual report is a widespread practice that also can be perfectly
legal. Companies, for example, often rush to lay off workers or get rid of poor-performing units or
investments, so they won’t mar the next financial report.

Much of Lehman’s problem involved huge holdings of securities based on subprime mortgages and
other risky debt. As the market for these securities deteriorated in 2008, Lehman began to suffer huge
losses and a plunging stock price. Ratings firms downgraded many of its holdings, and other firms like
JPMorgan Chase and Citigroup demanded more collateral on loans, making it harder for Lehman to
borrow. The firm filed for bankruptcy on September 15, 2008.

A key step was to move $50 billion of assets off its books to conceal its heavy borrowing, or leverage.
The Repo 105 maneuver used to accomplish that was a twist on a standard financing method known as
a repurchase agreement. Lehman first used Repo 105 in 2001 and became dependent on it in the
months before the bankruptcy.

In a standard repo transaction, a firm like Lehman sells assets to another firm, agreeing to buy them
back at a slightly higher price after a short period, sometimes just overnight. Essentially, this is a short-
term loan using the assets as collateral. Because the term is so brief, there is little risk the collateral will
lose value. The lender – the firm purchasing the assets – therefore demands a very low interest rate.
With a sequence of repo transactions, a firm can borrow more cheaply than it could with one long-term
agreement that would put the lender at greater risk.

But Lehman found a way around the negotiations so it could count the transaction as a sale that
removed the assets from its books, often just before the end of the quarterly financial reporting period,
according to the Valukas report. The move temporarily made the firm’s debt levels appear lower than
they really were. About $39 billion was removed from the balance sheet at the end of the fourth quarter
of 2007, $49 billion at the end of the first quarter of 2008 and $50 billion at the end of the next quarter,
according to the report.

But the move was misleading, as Lehman also entered into a forward contract giving it the right to
buy the assets back, Bushee says. The forward contract would be on Lehman’s books, but at a value
near zero. “It’s very similar to what Enron did with their transactions. It’s called ’round-tripping.'”

Lehman’s use of Repo 105 was clearly intended to deceive, the Vakulas report concludes. One
executive email cited in the report described the program as just “window dressing.”
The Financial Accounting Standards Board moved last year to close the loophole that Lehman is accused
of using, Bushee says. A new rule, FAS 166, replaces the 98%-102% test with one designed to get at the
intent behind a repurchase agreement. The new rule, just taking effect now, looks at whether a
transaction truly involves a transfer of risk and reward. If it does not, the agreement is deemed a loan
and the assets stay on the borrower’s balance sheet.

The Valukas report also shows the need for better risk-management assessments by firm’s boards of
directors, Herring says. “Every time they reached a line, there should have been a risk-management
committee on the board that at least knew about it.” Lehman’s ability to get a favorable legal opinion
in England when it could not in the U.S. underscores the need for a “consistent set” of international
accounting rules, he adds.

The bank used the technique to make it look like it was less reliant on loans (leveraged) than it actually
was.

Source: https://www.npr.org/sections/money/2010/03/repo_105_lehmans_accounting_gi.html

But when Lehman Brothers wanted to make it look like it wasn't borrowing so much money, the
company used a special technique to get around this rule. It did repo deals where it took slightly less
cash than the asset was worth.

For example: If Lehman owned a bond that was worth $105, it would "sell" it on the repo market for
$100. (The "105" in Repo 105 refers to the fact that the assets were worth at least 105% of what
Lehman was getting for them.)

This gap allowed the company to record the transaction as if it had been a true sale of the bond --
despite the fact that, under the agreement, the company would repurchase the bond just a week or so
after it had sold it.

Lehman would take the money it got from selling the bond and pay off some of its debts. Then, after it
had issued its quarterly report, the company would borrow more money to repurchase the bond.

Lehman went big on this technique: In the second quarter of 2008 it used Repo 105 to move $50 billion
off of its balance sheet, according to the Examiner's report.

"Lehman did not disclose its use ... of Repo 105 to the Government, to the rating agencies, to its
investors, or to its own Board," the report said. One senior official inside the company warned that the
use of Repo 105 would present "reputational risk" to the company if the public found out.
Source: https://corporatefinanceinstitute.com/resources/knowledge/accounting/repo-105/

The bank used the technique to make it look like it was less reliant on loans (leveraged) than it actually
was.

According to a report by the court-appointed examiner, Anton R. Valukas, Lehman used Repo 105 three
times in its financial statements. The examiner disclosed that Lehman used Repo 105 and Repo 108 to
temporarily remove securities inventory from its financial statements for a period of seven to ten days.
The manipulation portrayed a misleading picture of the bank’s financial position to its investors, board
of directors, and the rating agencies.

Lehman increased the use of Repo 105 by two to three times before the end of an accounting period in
order to conceal financial distress. It would transfer the ownership of high-grade securities at either
105% or 108% of the amount received (hence the names Repo 105 and Repo 108). Lehman would then
use the proceeds from the sale of securities to reduce its liabilities and improve its leverage ratios.

Just after the start of a new quarter, the bank would borrow funds to repay the previous cash
borrowing plus interest, repurchase the securities, and restore these assets to its balance sheet.

The bank used Repo to lower its net leverage ratio and mislead rating agencies so that the agencies
would not give the company a poor rating that would portray a negative image to its stakeholders.
Between March and September 2008, the big three rating agencies took turns downgrading Lehman’s
credit outlook and rating.

Antony Valukas, chairman of Jenner and Block law firm, was appointed by a New York bankruptcy court
to examine the causes of the Lehman bankruptcy. The examiner found that there was sufficient
evidence to hold Lehman’s executives culpable of gross misconduct. The officers exposed Lehman to
potential liability by intentionally excluding specific transactions that were material to the bank’s
operations.

The examiner claimed that the management did not foresee the mortgage crisis. Instead, the bank
ignored the financial distress and expected to earn high revenues when the markets recovered.

The bank’s executives ventured into excessive risk-taking and high leverage. At the time of insolvency,
Lehman held $700 billion in assets and only $25 billion in equity. The bank held assets that had a
maturity of over a year while its liabilities were mostly short-term, maturing in less than one year.
That imbalance forced Lehman to borrow billions of dollars through the Repo market to pay its short-
term debt obligations.

Excessive short-term borrowing made lenders lose confidence in the bank’s ability to pay back loans.
The bank turned to financial statement manipulation to hide its financial distress from the rating
agencies and investors. In the opinion of the examiner, there was sufficient evidence to support legal
action and recovery of losses from the bank’s executives.
Questions:

1. Do you think that limiting its reliance on Repo 105, and looking for other ways to reduce their
balance sheet, could have saved the company from its downfall?
2. Would you agree that what Lehman did was illegal?
3. Did Repo 105 cause the downfall of the company?
4. What are the effects of excessive short term borrowing?
5. Aside from having an audit committee and hiring auditors, what controls do you think should
have been implemented within the company that would somehow mitigate over reliance on
Repo 105?
6. Do you think the Lehman and E&Y behaved illegally / unethically?
7. Had investors known of Lehman’s Repo 105 transactions, would they have declined to continue
to conduct business with Lehman?
8. If creditors knew of the poor financial health of Lehman, would they have still extended loans to
the firm?
9. Would you consider the actions and denial of knowledge executives negligent or fraudulent?
10. Why do you think the government let it file for bankruptcy instead of letting the company spiral
like Enron?
11. Do you think it is illegal to engage in non-traditional accounting methods by finding loopholes to
current policies?
12.