Group 5

“Lehman Brothers and Repo 105“

John Gil Maters in International Finance

Rohan Buddineni
Grecia Colmenares

Barcelona, 7. March 2018

Questions regarding the case

1. How did Lehman build up so much leverage?

2. What is a traditional repo and what is special on Repo 105?
3. What are the conditions for a Repo to be characterized as Repo 105?
4. Why did Lehman extensively employ Repo 105 around reporting days?
5. Was there any wrong doing of Lehman’s senior executives w.r.t. Repo 105?
6. Was there any wrong doing of Lehman’s auditor EY w.r.t. Repo 105?
7. What happened with the whistleblower Matthew Lee?
8. Why this cannot happen anymore?

2
Agenda
1 2 3 4 5 6 Agenda

1 The Rise and Fall of Lehman Brothers

2 Repo 105: Another drug we are on
3 Creative Accounting or Window dressing?
4 Auditing at Lehman
5 Dealing with a Whistleblower
6 Repo 105 after LB

3
The Beginning of the end of Lehman Brothers
1 2 3 4 5 6 Agenda- The rise and fall of
Lehman Brothers

2000’s changed their

Holdings in New York, strategy from low
Founded in 1850 in 2007: It was the fourth 26.189 London and Tokyo risk brokerage model
Montgomery by three largest investment employees in among others to a higher risk
German Brothers bank in USA 2008 banking model
.

4
The Beginning of the end of Lehman Brothers
1 2 3 4 5 6 Agenda- The rise and fall of
Lehman Brothers
Increase in assets over 300
billion but Equity just 6
billion Record profits of
4.2 billion USD Heavily relied on refinanced
short term loans

The Rise and Fall

of Lehman Brothers

S&P and Moody's

downgrade their
Liquidity Problems ratings
due to sub prime
Mortgages

Bankruptcy
with $600
million assets
5
 Repo 102 vs Repo 105
Agenda- Repo 105: Another
1 2 3 4 5 6
drug we are on

Repo 102 Repo 105

o Collateralization should between o Collateralization > 102%.

98% and 102%.
o Borrower preserves control over
the transferred assets and can
not move them off the balance
sheet.
o Low haircut around 2%.
o They classify a short-term loan
as a sale and subsequently use
the cash proceeds from said sale
to reduce its liabilities.
o Haircut of 5% or more to justify
the transaction as sale.

Facts:
• Repo market in US and Europe had gross amounts outstanding of roughly 11$ trillion. (2002)
• David Goldfarb is the one who have created the Repo 105 transactions inside Lehman.
• It was uncomplicated for them to use this with SFAS 140 on their side.
• Lehman never publicly disposed its use of Repo 105 transactions.
• Accounting justification to treat them as sales was ‘legalistic’ and ‘form-driven’.

6
Use of Repo 102 and Repo 105 at Lehman
1 2 3 4 5 6 7 Agenda – Repo 105: Another
drug we are on
Till 2007 (Balance Sheet effect of Repo 102)
-
Cash Assets Liabilities Leverage ratio
Lehman would then use the borrowed cash to pay down other debts causing their
leverage ratio to become neutral
- (Neutral)
Cash Assets Liabilities Leverage ratio

From 2007- 2008 ( Balance Sheet effect of Repo 105)

- (Neutral)
Cash Assets Liabilities Leverage ratio
Lehman would then use the borrowed cash to pay down other debts causing a decrease in
both cash and liabilities, which ultimately lowered their leverage ratio
-
Cash Assets Liabilities Leverage ratio

Source: Company Information

7
The effects of Repos on the balance sheet
Agenda- Repo 105: Another
1 2 3 4 5 6
drug we are on

November 30, 2007

Without Repo With Repo of 38.6 BOOST
billions % billions %
Total Assets 729.7 100% Total Assets 691.1 100%
Total Liabilities 707.2 96.917% Total Liabilities 668.6 96.744%
Total SHE 22.5 3.083% Total SHE 22.5 3.256% 5.59%
Feb 28, 2008
Without Repo With Repo of 49.1 BOOST
billions % billions %
Total Assets 835.1 100% Total Assets 786 100%
Total Liabilities 810.3 97.030% Total Liabilities 761.2 96.845%
Total SHE 24.8 2.970% Total SHE 24.8 3.155% 6.25%

May 31, 2008

Without Repo With Repo of 50.4 BOOST
billions % billions %
Total Assets 698.8 100% Total Assets 639.4 100%
Total Liabilities 663.5 94.948% Total Liabilities 613.1 95.887%
Total SHE 26.3 3.764% Total SHE 26.3 4.113% 9.29%

8
Repo 105: “Another drug we are on”
Agenda- Repo 105: Another
1 2 3 4 5 6
drug we are on

SFAS (Statement of Financial Accounting Standards) 140:

• The transferred assets have been isolated from the transferor.
• Each Transferee has the right to pledge or exchange the assets it received and no conditon both
constrains and transferee from taking advantage of its right to pledge more than a trivial benefit to
the transferor.
• The Transferor does not maintain effective control over the transferred assets through either: (1)
an agreement that both entitles and obligates the transferor to repurchase or redeem them
before maturity (2) the ability to unilaterally cause the holder to return specific assets, other than
through a cleanup call.

Paragraph 208:

“[P]articipants in the very large markets for repurchase agreements and securities lending transactions are, for the
most part, unaccustomed to treating those transactions as sales, and a change to sale treatment would have a
substantial impact on their reported financial position. ... Judgment is needed to interpret the term substantially all and
other aspects of the criterion that the terms of a repurchase agreement do not maintain effective control over the
transferred asset. However, arrangements to repurchase or lend readily obtainable securities, typically with as much
as 98 percent collateralization (for entities agreeing to repurchase) or as little as 102 percent overcollateralization (for
securities lenders), valued daily and adjusted up or down frequently for changes in the market price of the securities
transferred and with clear powers to use that collateral quickly in the event of default, typically fall clearly within that
guideline.”

9
Why did Lehman extensively employ Repo 105 around reporting
days?
Agenda- Repo 105: Another
1 2 3 4 5 6
drug we are on

Repo 105 Usage Quarter End

60

49.1 50.4
50

40 38.6
36.4

29.9 28.9
30
24.4 24.6 24.7

20 17.3

10

0
Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08

• Different Net leverage Ratio. • Ability to decrease the net leverage

ratio means good feedback for
• Investors pressure.
investors and better outlook for the
• Rating agencies. company, no matter how artificial
• Calm the markets with reassuring could that be.
news. • Lehman‘s apparent success.
10
Creative accounting or window dressing?
Agenda- Creative accounting or
1 2 3 4 5 6
window dressing?

• Assure they had taken leverage ratio down

• Firing employees and declaring losses while defending the company's position

• Taking higher haircuts to consider the transactions as sales

• Lehman regularly increased the repo 105 transactions in the days prior to reporting periods
which reduced the net leverage.

• Not disclosing its use of Repo 105 transactions and its accounting treatment for these. Lehman
accounted for these as derivatives and added them to the larger group of more 'traditional
derivatives' in a footnote.

• Failing to clarify in financial statements the obligation to repurchase securities worth tens of
billions of dollars on a short-term basis.

• David Goldfarb, who was previously a senior partner at E&Y from 1979 to 1993, was Lehman's
CFO from 2000 to 2004 and the alleged creator of Repo 105.

11
Auditing at Lehman’s
1 2 3 4 5 6 Agenda- Auditing at Lehman

• LB was E&Y 8th biggest American client
• Lehman‘s executives were E&Y Alumni
• E&Y was aware of the use of Repo 105
• E&Y knew the transgression of moving their US
based assets into the UK subsidiary and they didn´t
raise a flag
• Failed to follow concerns about “reputational risk“
• No hard or fast rule to determine materiality
• In 2001 Lehman stated to E&Y their wish to use Repo
105 transactions, E&Y approved the policy but did not
help Lehman to draft it and played no advisory role
regarding Repo 105 transactions.
• Initially, Repo 105 transactions were limited to $20-$30
billion, but by mid 2008 the transactions amounted $50
billion. E&Y was always aware of this.
• E&Y was informed of increased reliance from Lehman in
Repo 105 transactions, and Lehman's financial
controller appointed the accounting justification to treat
them as 'sales' were 'legalistic' and 'form-driven'. E&Y
never corrected this.

Linklaters

Lehman Brothers Lehman Brothers

(USA) International Europe
(UK)

12
MATTHEW LEE: After the incident
Agenda- Dealing with the
1 2 3 4 5 6
Whistleblower

Matthew Lee was fired two weeks after

the release of the letter.

According to his lawyer, after two years of unemployment

and living from his settlement payment, he was still
struggling to find a job.
Matthew Lee

"If you're a company and want to get rid of a

whistleblower, it's common to stick them in a round
of layoffs”.

"It looks like this person has all the attributes of a

major whistleblower retaliation case”.

-Stephen Kuhn, Director of National Whist Blowers Center

Stephen Kuhn
Repo after Lehman Brothers
Agenda- Creative accounting or
1 2 3 4 5 6
window dressing?

FASB needed to close the loophole

which Lehman wiggled through in
accounting for the Repo 105
transactions.
PLANNING

FASB removed the ability to

repurchase the assets after
the Repo was carried out.
APPLICATION

“I think it will certainly make it vastly harder for any reporting entity to do what Lehman did
in accounting for the Repo 105 transactions and claim they did it correctly under U.S.
GAAP,” said Bruce Pounder, an executive at SmartPros Ltd which provides education to
accounting professionals.
LEGAL OR ILLEGAL ??