Contents
1 Introduction to Lehman Brothers Holding Inc. and Their Collapse.....................................1
2 Repo 105
2.1 What is Repo 105 and How It Was Used by Lehman Brothers....................................2
2.2 How Repo 105 Changes Financial Ratios…………………………………………………5
2.3 Balance Sheet Recordings of Repo 105…………………………………………………..7
3 Lehman’s Repo 105 Policy and Types of Securities Used in Repo 105 Transactions
3.1 Lehman Brothers’ Repo 105 Policy………………………………………………………..9
3.2 Types of Securities Used in Repo 105 Transactions…………………………………..10
4 Conclusions………………………………………………………………………………………10
5 References………………………………………………………………………………………12
1 Introduction to Lehman Brothers Holding Inc. and Their Collapse
Lehman Brothers (LB), was founded in 1844 by Henry Lehman. In 1850, his brothers Emanuel and Mayer joined him and the company started to trade commodities such as cotton, therefore becoming a major trading company. In 1906 the company partnered with Golden Sachs and started performing invesment banking activities.
In the 1990s, Lehman Brothers expanded by conducting investment and also commercial banking practices. By 2007, Lehman Brothers was one of the biggest in the banking industry. Their success and profit mostly depended on and was a result of large investments in mortgage-backed securities (MBS). In fact, in 2007, Lehman was the largest holder of MBS in the industry. Coincidentally, MBSs played the main role in the company’s demise later on, due to the collapse of the housing market in the 2008 financial crisis.
On September 15, 2008, Lehman Brothers Holdings Inc. filed for a bankruptcy, which happened to be the largest bankruptcy proceeding ever filed.[1] One of the reasons for the collapse of LB was that on their balance sheets, the assets were long-term, while the liabilities were short-term.[2] To deal with this issue, LB consructed a stratagy that would consist of increasing leverage on its capital which seemed simple but under the circ*mstances the company was under at the time, this meant they had to take on greater risks. When the 2008 financial crisis hit, the firm started to lose the confidence of the market. The confidence LB lost depended on the ratings of the firm from rating agencies. To get higher ratings, LB had to improve their net leverage ratio and liquidity numbers, as the the leverage ratio measures the ratio of a business’ debt to earning. In other words LB had to decrease this ratio.
And they did lower their leverage ratio at the second quarter of 2008, and around June 30, the company was able to reduce the ratio to less than 12.5. All seemed to be working well for LB from the outside, at least as well as it can be for a collapsing company but the truth was that LB was hiding exactly how they managed to lower their net leverage ratio. To manage its balance sheet, LB used an accounting gimmick they called ‘Repo 105’. With Repo 105 transactions, Lehman’s reported net leverage was 12.1 at the end of the second quarter of 2008; but if Lehman had used ordinary repos, net leverage would have been reported at 13.9[3] In March 2008, Government Monitors from Securities and Exchange Commission (SEC) and the Federal Reserve Bank of New York (FRBNY) monitored LB’s financial condition, mainly focusing on liquidity. It was found that the firm had been reporting inaccurate liquidity numbers and manupilating their balance sheets with the usage of Repo 105.
2 Repo 105
2.1 What is Repo 105 and How It Was Used by Lehman Brothers
In an ordinary repurchase agreement (repo), a firm can use one of its securities or assets (like a bond) as collateral to borrow money. After a few days, the firm gets its asset back, and pays the loan back with interest. This is a way of short-term financing. A Repo 105 differs from an ordinary repo in that the Repo 105 transactions are recorded as‘sales’ on the income statement and this makes it seem like the firm removed the inventory they ‘sold’ from its balance sheet. By using this method, LB painted a reliable picture, as if they were getting rid of their risky assets by ‘selling’ them. In reality with the money they borrowed from the repo, they were trying to pay off their debts. LB decided to apply this method because the firm wanted to prevent their ratings from going down, they did not want to lose credibility. LB was one of the largest holders of mortgage-backed securities as mentioned above, and during the house market collapse in 2008, the firm was getting closer to bankruptcy.
In 2009, the chairman of the law firm Jenner & Block, Anton R. Valukas, was appointed by a NY bankruptcy court to investigate how Lehman Brothers Holdings Inc. collapsed. During this report, Valukas explains how the firm used Repo 105. Valukas writes in his report: ‘’Lehman employed off-balance sheet devices, known within Lehman as ‘Repo 105’ transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create materially misleading picture of the firm’s financial condition in late 2007 and 2008.’’ The method was named Repo 105, because the assets were worth at least 105% of what the firm was receiving in return.
To understand better how a Repo 105 transaction works, consider the sample balance sheet of a firm:
(Illustration 1, Anton Valukas’ report on Lehman Brothers)
If the firm uses $50 billion for an ordinary repo transaction, it would receive a $50 billion in cash borrowing, hence increasing the cash item on its asset side of the balance sheet. On the liability side, ‘collateralized financings’ item would incrase by the same amount since the securities are collateralized in a repo. The overall balance sheet would look like the one below:
(Illustration 2, Anton Valukas’ report on Lehman Brothers)
It can be seen that when the repo is accounted properlyi the leverage ratios increase.
By using a Repo 105 however, this is how the repo transaction would be accounted:
(Illustration 4, Anton Valukas’ report on Lehman Brothers)
Instead of accounting the borrowed 50 billion under collerteralized financings on the liability side, the amount is decrased from financial instrumens on the assets side, making it seem as if there has been a ‘sale’ of financial instruments and in a sense ‘hiding’ the fact that the firm has borrowed. ‘’ Unlike an ordinary repo transaction, Lehman did not record the borrowing of cash from a Repo 105 transaction even though Lehman was obliged to repay the borrowing.’’[4]
It lowers its financial instruments under assets, to make it seem as if they sold their bonds (350,000-50,000=300,000). If the repo was properly accounted the net leverage ratio would have been 19 but with a Repo 105, it is lower, 17. Then, the firm pays off its short-term debts and makes it seem like they let go of risky assets and payed off debts.
Here is an excerpt from an actual unaudited balance sheet of Lehman Brothers at Nov 30, 2007 and May 31, 2008:
As we can see, on the asset side there is the ‘financial instruments and other inventory positions owned’ account. By using a Repo 105, Lehman Brothers decreases this account instead of increasing the ‘collateralized financings’ account on the liability side:
2.2 How Repo 105 Changes Financial Ratios
Repo 105 does not only alter the leverage ratios, we can see it alterations on other ratios as well. For example the debt to equity ratio is calculated as Total Liabilities/Stockholder’s Equity. With the proper repo account, the debt to equity ratio would be 823,000/27,000= %3048.14. (Total Liabilities=850,000-27,000). With a Repo 105 recording however this ratio would become 773,000/27,000= %2862.96 which is less than the above amount. Therefore with the usage of a Repo 105, Lehman Brothers manupilated their balance sheets and painted a less risky picture of the firm.
The below chart shows the reduction in net leverage ratios of Lehman Brothers from the beginning of fourth quarter 2006 and to the end of second quarter 2008. The numbers are from the publicly reported recordings of the firm:[5]
Net Balance Sheet Ratios
fourth quarter 2006
second quarter 2008
$ in Millions
Nov 30, 2006
May 31, 2008
a) Total Assets
503,545
639,432
b)Net Assets
268,936
327,774
c)Tangible Equity Capital*
18,567
27,179
d)Repo 105 Usage
24,519
50,383
Net Leverage Ratios ((b+c)/c)
15.8
13.9
% Net Leverage Ratios
1,580.5
1,391.4
% Reduction in Net Leverage Ratio
-11.97
*Tangible Equity Capital is Total Stockholders’ Equity plus junior subordinated notes less identifiable intangible assets and goodwill.
As it can be seen from the chart, LB managed to reduce their net leverage ratios by %11.97 with the usage of repo 105 through the stated period of time.
2.3 Balance Sheet Recordings of Repo 105
The balance sheet recordings below show the trend of Repo 105 usage. The balance sheets are from the archived Lehman Brothers Global Consolidated Balance Sheets (GCBS documents). The yellow highlighted areas are the quarter-end dates.[6]
3 Lehman’s Repo 105 Policy and Types of Securities Used in Repo 105 Transactions
3.1 Lehman Brothers’ Repo 105 Policy
Before starting the application of Repo 105, the firm needed a legal groundwork since the method of Repo 105 is not entirely legal under US law. The Repo 105 policy of the LB depended on three main conditions of groundwork.
The first of these conditions is called ‘true sale opinion'. The true sale opinion is the letter a firm obtains from a law firm to confirm that the transaction is a’true sale’To be able to execute the repo transactions under the Repo 105 method, LB needed to be on the right side of law meaning that they had to find their way thorugh the US law so that they would not get into trouble. Under US law, repos cannot be treated as sales due to the lawyers being unable to provide a ‘true sale opinion.’. Since this couldn’t have been done under US law, LB executed this through UK law, through their subsidiary firm Lehman Brother International Eurooe (LBIE). This was the first condition for th e firm to be able to construct the Repo 105 method.
The second condition is called the ‘ability to pledge or exchange the transferred assets’. Because an ordinary repo requires a ‘’colleteralized’’ instrument during the transaction, it cannot be accounted as a sale. Because when a true sale transaction occurs, the transferred asset can be exchanged to whomever the transferee wishes to. Basically, after the sale the transferee is free to do with the purchase as they wish. Under a repo, the transferee does not have this right since the asset is colleteralized. Therefore, in order to make the Repo 105 transaction seem as a true sale, LB included the statement ‘’The transferee must have the ability to pledge or exchange the transferred assets free of any contractual conditions imposed by us and/or operational constraints. This ability to pledge or exchange must be a legal right and an operational capability’’ in their legal activities. The 'operational capability' term refers to the constraint that arises from re-transferring of assets that are not considered obtainable. When these types of assets are used, the transferee would be unable to practice their right to freely pledge or exchange the assets. So these types assets were not used in Repo 105 transactions.
The third and last condition that the firm constructed was called the ‘relunquish control of the transferred assets’. This means that in order to re-characterize a repo as a sale, control of the relunquished assets would have to be demonstrated. The ability to repurchase the asset even in the case of a default should be guarenteed to retain control over a transferred asset. This was guarenteed by obtaining collateral in cash. For this reason LB retained control of the transferred assets by margining a fixed income security at less than 105%.
3.2 Types of Securities Used in Repo 105 Transactions
Another aspect of the Repo 105 application that needed to be determined was the types of securities that were to be used in the transactions. The accounting policy of Lehman Brothers for the usage of Repo 105 method states that the types of assets used during the transaction should be obtainable, as mentioned above in the 'ability to pledge or exchange the transferred assets' policy. This means that liquid assets were preferred for the transactions. Another reason for the usage of liquid assets is the rating agencies' focus on liquidity when examining the reliability of the firm.
The true sale opinion letter LB received from the UK law firm mentions that the assets used in the Repo 105 transactions should be liquid securities, to allow the buyer dispose the securities easily, if they wishes to do so. For these policy reasons, LB mostly used liquid securities to execute their Repo 105 transactions but on three occasions comparatively more illiquid assets such as asset-backed securities were used. These types of securities were called non-governmental on the balance sheets of the firm, as non-governmental securities were considered more illiquid than governmental ones. These illiquid securities were used in Repo 105 transactions on November 30, 2007, February 29, 2008 and May 30, 2008.
Another characteristic of the types of securities used by LB in Repo 105 transactions was the credit ratinngs of the securities. LB used mostly A to AAA rated securities for the transactions.
4 Conclusions
The official collapse of Lehman Brothers happened on September 15, 2008 when the firm filed for bankruptcy due to the Federal Reserve refusing to guarentee their loans and therefore declining to rescue them. The firm’s bankruptcy filing exposed their accounting tricks because the bankpruptcy was the largest in US history and the balance sheets showed that their assets were actually far greater than other huge firms that also went bankrupt. Although Lehman Brothers was one of the largest investment banks in US at the time, it was not the largest, so how could the firm have greater assets than the firms that are bigger than it? Eventually, with the investigations going on, it was discovered that Lehman Brothers was using accounting tricks like Repo 105 to alter their accounting records.
The Repo 105 method is a quite simple trick, but then again the most unethical tricks are the simplest ones. It is simple in that it does not involve playing around or changing the numbers on the existing balance sheet, but it creates slight movements along the balance sheet. The total amount of money is not altered, it is only recorded under different titles. This is what makes Repo
105 so simple to execute and to understand. Perhaps the most ‘useful’ aspect of this method was that it allowed for the leverage ratios to be improved as well as manipulating liquidity levels. After all, the rating and inevitably the credibility of Lehman Brothers depended exactly on these ratios and levels. It seems Lehman Brothers invented a trick that suited their current needs at the time perfectly. But no trick, however smart, can last forever as seen with the inevitable collapse of Lehman Brothers.
By altering their balance sheets, Lehman Brothers misshaped their financial status. They executed unethical accounting methods and betrayed the trust of their clients as well as workers. The usage of accounting tricks, legal and illegal, are unfortunately not uncommon. From astrategic point of view, the Repo 105 method lacked a dynamic approach to Lehman Brothers' financial problems at the time not to mention its dishonest purpose. It goes without saying that an efficient solution to whichever problem a financial firm is facing should be an honest one but it should also be a consistent one throughout time. This consistency can only be achieved through solutions that go to the root of the problem instead of surface level easy ones and these types of efficient strategies can only be created by people that do not serve their self interests. The lack of responsibility that Lehman Brothers executives had in constructing Repo 105 can be seen in these e-mails between Michael J. de la Merced and Julia Werdigier :
“It’s basically window-dressing.’’
“I see … so it’s legally do-able but doesn’t look good when we actually do it? Does the rest of the street do it? Also is that why we have so muchbalance sheet to Rates Europe?”
“Yes, No and yes. :)”
Lehman Brothers thought they invented a clever trick that would take advantage of the loop holes in the accounting system and therefore save themselves. But what the firm's strategy lacked was the intuitive and efficient as well as ethical approach that would not only save their business but also hurt the economy less. In the end, Lehman Brothers disrupted the confidence and trust of their customers. The firm's Repo 105 method is an example of a false solution that at first seems like a genius idea, but a crucial mistake in the long run. The fact that such an enormous company can make such mistakes should serve as a great lesson for financial strategists and warn regulators to be stricter in their policies.
5 References
Valukas, Anton R. (2010). Report of Anton R. Valukas on Lehman Brothers, Volumes 1, 3 and 8. United States Bankruptcy Court Southern District of New York.
Jeffers, Agatha. (2011). How Lehman Brothers Used Repo 105 to Manipulate Their Financial Statements, Montclair State University.
Burke, John. Deconstructing the Use of Repo 105 and Repo 108 Transactions Under SFAs 140: The Case of Lehman Brothers Holding Inc. and the Liability of Ernst & Young, KIMEP University.
Tothova, Simona. Corporate Governance Failure in the Lehman Brothers Case.
Lehman Brothers Holdings Inc. , Form 10-Q For the Quarter Ended May 31, 2008.
[1] Anton R. Valukas’ Report, Volume 1, page 2.
[2] Anton R. Valukas’ Report, Volume 1, page 3.
[3] Anton R. Valukas’ Report, Volume 1, page 7.
[4] Anton R. Valukas’ Report Volume 3, page 781.
[5] Anton R. Valukas’ Report Volume 3, page 889.
[6] Anton R. Valukas’ Report, Volume 8, Appendix 17, pages 36,37.
