BusinessCorporate FinanceDo repos have a future?

Do repos have a future?

After Lehmans, repos became a byword for corporate mismanagement but they are still a legitimate form of financing

Lehman Brothers’ former offices in Canary Wharf

For a long time, “repos” was corporate slang for short-term financing, but
since the financial crisis the term has come to represent all that is wrong with
banking culture. As banks emerge from the financial crisis, repos will remain
legitimate tools of the trade, but the stain left by corporate failings may
never truly rub off the long-standing finance tool.

Some estimate the repo market to be worth in excess of $5 trillion (£3.2
trillion) and it remains a primary source of investment bank financing.

But, by the spring of 2010, “repo” had become a dirty word. Anton Valukas,
the court-appointed examiner for New York’s southern district bankruptcy court,
wrote the report into America’s biggest corporate collapse, Lehman Brothers.

His sharpest criticism lay in chapter three of the voluminous report, which
detailed Lehman’s use of repurchase transactions known internally as “Repo 105s”
or “Repo 108s”.
Repos involve an agreement to sell and then buy back an asset after a set period
of time. Valukas alleged the transactions were used to displace items worth tens
of billions of dollars from Lehman’s balance sheet during sensitive reporting
periods and effectively distort the company’s true financial position.

Who uses repos?

Two weeks after the report’s release the US Securities & Exchange
Commission sent out a “Dear CFO” letter to 19 banks and financial institutions
in the US asking how they accounted for repos. Following a freedom of
information request from Accountancy Age, the US financial regulator revealed
the names of the 19 companies.

Officials were searching for banks which, like Lehman, treated repos as sales
in their accounts. Using sales account­ing for repos can have the consequence of
allowing these assets to drop off their balance sheets. A smaller balance sheet
influences key metrics like net leverage, which analysts rely on.

Valukas’ report found Lehman removed $50bn (£32bn) of assets off its balance
sheet via repos in the 2008 financial year. If the bank had recorded the
transactions as borrowings, and not sales, it would have significantly increased
Lehman’s debt.

When the SEC looked at what other banks were doing it found the picture
wasn’t quite as straightforward. Most com­panies claimed they did not account
for standard repos as sales, but there were a few notable exceptions.

Banking giant Citigroup said its UK subsidiary accounted for an average $5.4
billion (£3.5bn) in repos as sales each quarter between 2007 and 2009, reaching
as high as $9.2bn (£6bn) in a single quarter.

Citigroup pointed out the transactions only ever came to less than half a
percent of its total assets and “did not have a material impact to the balance
sheet during any period”. The bank said all its repurchase transactions by UK
staff would be reaccounted for as financings in the first quarter 2010.

“Since it is apparent that the restricted margining practice may not have
been applied during the last three years to certain of those UK-based trades,
sale accounting treatment may not have been appropriate for those trades during
that time,” the bank said in its filing.

US insurance giant AIG, which was rescued by the US government in 2008, also
admitted to the practice. In its statement it said it classified some repos as
sales, to the tune of about $5.2bn (£3.4bn) during 2009, but believes it had
little choice. In the darkest days of the credit crunch, when the insurer’s
liquidity crisis reached its nadir, the firm’s counterparties “demanded”
significantly higher levels of collateral to complete a repo. As the price of
engaging in repos climbed so too did the number qualifying as sales.

“AIG did not structure the transactions to obtain sales treatment,” the
company said. “During the 2008 fourth quarter and throughout 2009 certain
repurchase agreement transactions did not meet the… criterion required by
[accounting rule] ASC 860. Accordingly, AIG was required to account for such
transactions as sales of securities with derivatives to repurchase the
securities – forward purchase commitments – rather than as collateralised

AIG argued it had little choice but to classify repurchase agreements as
sales. With its repo-partners dem­and­ing a higher margin it had, according to
US accounting rules, lost control of the asset and had to remove it from its
balance sheet.

Losing control

Under US accounting require­ments a company has to prove it has lost
“effective control” of an asset before it can classify it as a sale. AIG’s
rationale was that in situations where counterparties are asking for increased
margins, to insure against real or perceived risk factors, companies may find
themselves being forced into accounting for repos as sales, and fall into the
Lehman trap of inadvertently distorting their financial position.

Chris Rowland, PriceWaterhouseCooper partner specialising in banking and
capital markets, believes rapid evaporation of repo credit took many by surprise
in the crisis, and significantly affected the terms of repo arrangements.

“We had never been in a situation where it dried up. Every body became more
cautious. It was harder to transact longer-term repos, it was harder to transact
repos with less, good collateral,” he said.

Repos are unlikely to disappear though. “They have been around for a long
ling time, they are a legitimate well understood instrument that are widely
used,” Rowland said. “The crisis was a wake-up call to everybody who perhaps has
not been as diligent in monitoring their collateral obligations.”


On or off balance sheet?

The repo dilemma comes during a much wider debate about the quality of US
accounting rules. US regulators are debating whether to take on international
accounting rules, which at present use a different repo recognition method.
Under international rules repo assets can only escape a company’s balance sheet
if the asset’s accompanying risks and rewards escape with it. Under this
treatment, repos would remain firmly on balance sheet and Lehman would not have
been able to intentionally, or unintentionally, hide the assets. This
international principles-based approach and its impact on repos is likely to be
a key argument used by those pushing for US adoption of international accounting

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