The Valukas Report: 2,200 pages about Lehman and repos

Finally, repurchase agreements are getting some media attention.

That’s because examiner Anton Valukas in the Lehman Brothers bankruptcy has accused that company of using Repo 105 and Repo 108 accounting shams to hide debt. Valukas has a whole volume called “Repo 105.”

In a Repo 105 or 108 dodge, Lehman reported the transactions as sales, when they should have been reported as collateralized financings, a type of debt. Citigroup and Bank of America have admitted similar deck shuffling, all done in innocent error, they said.

The Valukas report issued March 11, 2010, is 2,200 pages of insight into how investment banks work. Repurchase agreements play a starring role throughout. They were Lehman’s lifeblood and its mortal blow. Valukas shows the run on the repurchase market in striking detail.

From the introduction:

Lehman’s business model was not unique; all of the major investment banks that existed at the time followed some variation of a high-risk, high-leverage model that required the confidence of counterparties to sustain. Lehman maintained approximately $700 billion of assets, and corresponding liabilities, on capital of approximately $25 billion. But the assets were predominantly long-term, while the liabilities were largely short-term. Lehman funded itself through the short-term repo markets and had to borrow tens or hundreds of billions of dollars in those markets each day from counterparties to be able to open for business. Confidence was critical. The moment that repo counterparties were to lose confidence in Lehman and decline to roll over its daily funding, Lehman would be unable to fund itself and continue to operate. So too with the other investment banks, had they continued business as usual. It is no coincidence that no major investment bank still exists with that model.

Repo 105s weren’t the only repo problems Valukas found at Lehman.

Valukas also reported that Lehman misrepresented repo transactions to make it falsely appear Lehman had $32.5 billion in securities it could quickly sell to repay lenders and investors in a crisis, and thus had plenty of liquidity. Actually it had only $2.4 billion.  Most of the difference was collateral it had privately pledged for trades, at least half of which were repo loans, Valukas reported.

Liquidity is absolutely critical to the broker-dealer and investment bank holding company  business model due to the fact that these financial entities are dependent on short‐term secured financing to fund their daily operations. The near collapse of Bear Stearns, and ultimately, the collapse of Lehman, is testimony to the fact that investment banks “live and die by liquidity.”

Valukas tells in detail the struggle over repo collateral between Lehman and J.P. Morgan, which was Lehman’s clearing bank on the tri-party repurchase market. Lehman went to its death blaming J.P. Morgan for striking the mortal blow, with its insatiable demands for more collateral in the climactic days of the crisis.

From the report, about Repo 105:

Lehman employed off-balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008.

Repo 105 transactions were nearly identical to standard repurchase and resale (“repo”) transactions that Lehman (and other investment banks) used to secure short-term financing, with a critical difference: Lehman accounted for Repo 105 transactions as “sales” as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction.

By recharacterizing the Repo 105 transaction as a “sale,” Lehman removed the inventory from its balance sheet.

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet. Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt. Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios. Thus, Lehman’s Repo 105 practice consisted of a two-step process: (1) undertaking Repo 105 transactions followed by (2) the use of Repo 105 cash borrowings to pay down liabilities, thereby reducing leverage. A few days after the new quarter began, Lehman would borrow the necessary funds to repay the cash borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet.
Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio. …

In addition to its material omissions, Lehman affirmatively misrepresented in its financial
statements that the firm treated all repo transactions as financing transactions – i.e., not
sales – for financial reporting purposes.

Is there any reasonable way to believe that other bankers weren’t using similar dodges? We may never know, because there’s no bankruptcy receiver, no Anton Valukas, to dissect them. That’s because taxpayers bailed them out.


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