Demystifying the Lehman Shell Game

Good article in the NYT:

A repo is simply a “sale” of a financial asset to someone else, with an agreement to repurchase it at a fixed price and date. That amounts to borrowing secured by the asset, often a Treasury bond, with the added security that the lender has the bond, and so can sell it quickly if need be.

Normally, such transactions are accounted for as loans, as they should be. They are often the cheapest way for a brokerage firm to borrow money.

I had taken for granted that repos were always accounted for as loans, but it turns out there was a loophole. The Financial Accounting Standards Board had accepted that under some conditions a repo could be treated as a sale. One condition: if the securities securing the transaction were worth significantly more than the loan, that could be a sale.

In the examples the board provided, it concluded that securing the loan with assets worth 102 percent of the amount borrowed did not produce a sale, but that 110 percent would push the deal over the line. In between was a gray area.

Lehman appears to have concluded that 105 percent was enough if the assets being borrowed against were bonds. If they were equities, it set the bar at 108 percent.

By doing such sales repos at the end of each quarter, and reversing them a few days later, the firm could seem to have less debt than it really did.

It started the practice in 2001 but really accelerated it in 2007 and early 2008, when investors belatedly discovered there were risks to high leverage ratios. At the end of 2007, the bankruptcy examiner concluded, Lehman’s real leverage ratio was 17.8 — meaning it had $17.80 in assets for every dollar of equity. It reported a ratio of 16.1.

By the end of June 2008 — Lehman’s last public balance sheet — it was hiding $50 billion of debt that way, enabling it to appear to be reducing its leverage far more than it was. When investors asked how it was doing that, Lehman officials chose not to explain what was actually happening.

Oddly enough, in the late 1990's I was working on a project for a large custodial bank implementing a new Securities Lending system. Specifically, I was focusing on Collateralization and Mark-to-Market functionality. I vividly recall having many meetings with the traders where they tried to explain this shell game to me, and I just walked away shaking my head in disbelief. At the time, I thought I was the one who wasn't getting how this could work.

Of course, what's odd about this article is that this practice was common across all the major houses on Wall street, not just Lehman. I guess it's easier to pick on a firm who's gone out of business...