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Accountants spar over Repo 105

CPA Tom Selling at Accounting Onion does not think much of the Financial Accounting Standards Board’s proposal to solve the Repo 105 sleight of hand.

Lehman Brothers made Repo 105 famous when the bankruptcy receiver discovered Lehman was using a so-called “105” accounting standard to pretend that when it borrowed money on the repo market it wasn’t getting a loan, it was selling the collateral. In other words, it reported a sale of an asset instead of a collateralized financing.

To report the transaction as a sale, accounting standards required that Lehman give up “effective control.” FASB’s new proposal would tweak the criteria for determining “effective control.”

From Selling’s January 17, 2011, column:

Please allow me to translate and remove the varnish:

“We were burned by Lehman Brothers, who on multiple occasions dressed up its balance sheet by exploiting a loophole in our repo accounting rules. We allowed Lehman to presume that, because they received ‘only’ 5 percent less cash collateral than the value of the assets they transferred to an accommodating counterparty, it would be able to account for certain repo contracts as ‘sales.’

“Our rationale for including in Generally Accepted Account Principles ( GAAP) a size-of-collateral loophole was that even if the counterparty defaults on its obligation to return the securities, the transferor (e.g., Lehman) would be holding sufficient cash collateral so that the transferor could buy replacement securities in the market. We now realize that our rationale completely ignored the basic fact that cash collateral is fully fungible with other sources of cash. The Lehmans of the world would have all sorts of cash hanging around for purchasing equivalent assets in the market, if that’s what they wanted to do. So, let’s be frank: we totally screwed up.

“This proposed Accounting Standards Update (ASU) is really our admission that collateral considerations had no basis in logic or reality. However, we really, really now believe that the remaining loopholes are sufficient for determining which party to a repo agreement has ‘effective control’—whatever that means—over the transferred assets. “

Will this work? Here’s Selling’s view:

Under the remaining loopholes, a transferor would have retained ‘effective control’ of the non-cash assets (and have to account for the repo as a collateralized borrowing instead of a sale) unless it can wriggle through at least one:

-The financial assets to be repurchased are the same, or substantially the same, as the ones transferred; 
-The repurchase is for a fixed price;
-The repo agreement is entered into at the same time, or in contemplation of, the transfer.

Selling has a different idea for fixing Repo 105. See his January 17 column.

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