As The New York Times’s article on the court-appointed examiner’s report on Lehman Brothers makes clear, perhaps the most newsworthy element to pop out of the inquest’s 2,200 pages is an accounting trick known as “Repo 105.”
Named after a technical aspect of the gimmick, the accounting sleight of hand helped Lehman temporarily remove about $50 billion of assets from its balance sheet, helping to make it look better than it really was.
While Lehman executives began using the technique repeatedly in late 2007, the firm first devised the practice back in 2001 under unusual circ*mstances: it was blessed by the “magic circle” British law firm Linklaters and could only be carried out through the firm’s European arm.
First, a quick primer on how Repo 105 (and the similar, European-only Repo 108) worked, based on the report by Anton R. Valukas. Like all repos, short for “repurchase agreements,” it involved what amounts to a short-term loan, exchanging collateral for cash up front, and then unwinding the trade as soon as overnight.
Detailed illustration of a Repo 105 transaction.
Repo 105 involved Lehman using a variety of holdings as the collateral. (Alphaville has a breakdown of what the firm allowed for these transactions.) The counterparties were limited mostly to the following banks, according to the examiner’s report: Barclays of Britain, UBS of Switzerland, Mizuho Bank and Mitsubishi UFJ Financial Group of Japan, and KBC Bank of Belgium.
Unlike other repos, the value of the securities Lehman pledged in Repo 105 transactions were worth 105 percent of the cash it received. In other words, the firm was already taking a haircut on the transactions. And when Lehman eventually repaid the cash it received from its counterparties, it did so with interest, making this a rather expensive technique.
Yet the beauty of Repo 105 was that, according to Lehman adviser Linklaters, the firm could book the transactions as a “sale” rather than a “financing,” as most repos are regarded. That meant that for a few days — and by the fourth quarter of 2007 that meant end-of-quarter — Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was.
When Lehman first designed Repo 105 in 2001, however, there was one catch. The firm couldn’t get any American law firms to sign off on the aggressive accounting, namely that these transactions were true sales instead of what amounted to the parking of assets. From the firm’s own Repo 105 accounting policy document, according to the report:
Repos generally cannot be treated as sales in the United States because lawyers cannot provide a true sale opinion under U.S. law.
Enter Linklaters, which grounded its legal brief in English, rather than American, law. The firm explicitly said: “This opinion is limited to English law as applied by the English courts and is given on the basis that it will be governed by and construed in accordance with English law.”
Otherwise, Linklaters provided Lehman with exactly what it wanted to hear. The law firm decreed in its briefs, at least as outlined in the 2006 iteration obtained by Mr. Valukas, that intent matters. If two parties intend to exchange assets for cash, and then later the party receiving the assets decides to hand back “equivalent assets (such as securities of the same series and nominal value) rather than the very assets that were originally delivered,” that amounts to a sale.
Lehman and Linklaters refreshed their agreement multiple times, according to Mr. Valukas’s report. A 2006 version, signed by Linklaters partner Simon Firth, can be seen below.
Since the bankruptcy, Linklaters has also advised PricewaterhouseCoopers in its administration of Lehman’s international arm.
Sarah Peters, a spokeswoman for the law firm, told DealBook in a statement:
“The U.S. examiner’s report into the failure of Lehman Brothers includes references to English Law opinions which Linklaters gave in relation to a number of Lehman transactions. The examiner – who did not contact the firm during his investigations – does not criticise those opinions or say or suggest that they were wrong or improper. We have reviewed the opinions and are not aware of any facts or circ*mstances which would justify any criticism.
Mr. Firth did not respond immediately to requests for comment. He is, however, well known in the industry for his work in securitization and derivatives, and the author of the textbook “Derivatives: Law and Practice.”
There was one other technicality beyond needing to dub these repos sales rather than charges or financings. They had to be done through Lehman’s European arm, Lehman Brothers International (Europe), or L.B.I.E. for short. It didn’t seem to matter much whether the securities being pledged were European or American in origin; indeed, according to the examiner, these were the dollar amounts of United States-originated securities used in Repo 105 for the last three quarters of Lehman’s life:
- $8.3 billion for the fourth quarter of 2007
- $14.9 billion for the first quarter of 2008
- $13.6 biillion for the second quarter of 2008
And as the examiner’s report ultimately lays out, Lehman executives acknowledge a certain cosmetic quality to Repo 105, as the following e-mail exchange shows:
- “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 much BS [balance sheet] to Rates Europe?”
- “Yes, No and yes. :)”
— Michael J. de la Merced and Julia Werdigier
Linklaters Letter to Lehman Brothers re Repo 105
