Repo 105: Now You See It, Now You Don't

The debacle that Lehman Brothers found themselves in because of the subprime mortgage crisis led to a period of substantial losses that pushed the firm into the brink. A $2.8billion loss was announced on 9^th June in the 2^nd quarter report of 2008 which was the first reported loss during Fuld’s tenure as chairman.

The figures quoted on Lehman’s balance sheet were supposed assets of $700billion maintained with only a reported $25billion of equity. If these values were ever true, Lehman Bros had an extremely high leverage ratio of around 30-1, when commercial banks were restricted to a ratio of 15-1. In this position Lehman had to borrow billions of dollars each day to continue its operations. Whilst interest rates are low, a higher leverage ratio like that of Lehman’s can be profitable and manageable. When the decisions to undertake leverage were first made, the market reflected this and general conditions were favourable with a strong housing market and low interest rate, Zingales (2008). However, the financial markets changed, as we all know, and an unstable market with uncertain outcomes introduces instability in highly leveraged models. Risk managers within the company recognised that this leverage could become an insurmountable problem as the USA’s economy took a nosedive.

As a direct result of the 9^th June announcement, a process began to try to reduce the leverage ratio used by the firm. Some assets on the balance sheet are written down and whilst some others were reduced through fire-sales to improve overall liquidity. The publication of the financial figures consequently led to a reduced revenue stream and losses on hedge funds. All-in-all it seemed that assets fell by $60billion so Lehman reported their leverage ratio was now somewhere in the region of 12.5-1. However, the balance sheet was hiding a few details that actually shed a little light on how much trouble the firm was actually in.

The report from Valukas (2010) indicated that Lehman’s accounting department had been implementing a practice codenamed “Repo 105” within the firm. There is a slight difference between this and the standard repo operation of corporate firms. When an ordinary repo is performed, assets are sold to raise quick, liquid cash but it also comes with a concurrent obligation to repurchase the same assets within a very short period of time since the original transfer of funds. Repo 105 is performed in the same way but the assets are repurchased at 105% of the value that was paid for them originally. However, the main difference between these is how they are classified when publishing the quarterly returns. The assets transferred in a normal repo procedure remain on the firm’s balance sheet and are explained as “financings”. Repo 105 assets can be included on the balance sheet in the same way but it is no compulsory to do so. Accounting regulations allow for these particular assets to be treated as sales and, consequently, removed from the balance sheet. This procedure is an accounting manipulation that reduces net leverage on paper but not in reality.

Accounting trickery had taken place over a period of years. But it was during the final 3 quarterly reports that Lehman produced before bankruptcy that this procedure became of prime importance. At this stage as much as $50billion in the form of assets were being temporarily removed from the balance sheet to make their leverage appear lower than it actually was. It is evident that the only purpose of Repo 105 was to buy Lehman time with misleading information to continue operating in the hope that the situation could be rescued. The managers were fully aware that the firm was in trouble. Leverage and liquidity were recognised as the key factors. Continually, Lehman announced that they had enough liquid cash reserves to allow them to weather the financial storm and cover their liabilities, which was a lie because the majority of their reserves were illiquid. They wanted to the rating agencies to maintain their confidence in the firm, which in return will continue to be classified with the top security rating. In turn, this would encourage more buyers as Lehman would still be an attractive option.

Lehman didn’t disclose the use of Repo 105 to any other financial institutions, let alone the public. In fact, it was unclear who inside Lehman even knew of the “numbers massaging”. Richard Fuld himself overtly claimed that he wasn’t aware of the codename Repo 105, not to mention what the term referred to. Evidence found during Valukas’ investigation suggests otherwise. The Wall Street Journal, issued on March 11^th 2010, made clear that the executives at the top of Lehman had hidden the truth from their own board of directors, who would surely have objected to it.

In the aftermath it has become clear that the auditors of Lehman at the time, Ernst & Young, were fully aware of the implementation of Repo 105. They took no action upon discovering this. Ernst & Young were judged not to have met the professional standards expected of them. The Financial Times confirmed in December 2010 that Ernst & Young would face a lawsuit for their negligence and fraud. With 47 other complaints officially lodged against the accountancy firm at the time and several court cases already lost, this showed that they had previous form.

Accounting gimmicks, Repo 105 included, posed a serious risk to Lehman’s public image and overall professional reputation. Plain and simple, this was lazy banking. If anything, Repo 105 only exacerbated their problems in the long-term, plunging Lehman further into debt. When considering that the other option was to actually sell assets, reduce debt and meet leverage targets, Repo 105 was the easy way out on the short term loan market.

Subprime Mortgages: The Road To Ruin

As discussed in the previous post, Richard S. Fuld, Jr controlled Lehman Bros, instilling his own ambitions upon those working for him. Institutional Investor Magazine reported that at a company party on 7^th February 2005, Fuld showed his true colours in an address to his managing directors. Lehman shares debuted on the stock market in 1994 at a price of $8.00 (adjusted value) each. The end of day figure 11 years on was $92.70. The interim time period saw unprecedented growth. A conscious decision was made to pursue an aggressive market strategy some time in 2006 into a more capital intense banking model. All energies were focused on becoming the biggest player in Wall Street. To do so, the aim was in reaching a share price of $150 by 2007, but as he remarked:

“We have a problem. The problem is that now I can see 150. We’re getting close, and we need to raise the bar. So I want you all to think about how we get to 200.”

In a way this strategy was no different to any other investment bank. Lehman’s own model was not wholly unique, it was just a variation of how their competitors were generally organised. During the early-to-mid-2000s period, the mortgage market became a key element of Wall Street banking. Bankers found themselves dealing with securitised mortgages, summarised succinctly by the video at the bottom of the post. Lehman also got involved in this. It was viewed as a safer bet and profitable investment because of the strict approval process that was required for buyers to complete before they were allowed loans. This process required personal information about the buyer, including employment details and their income levels. A deposit of at least 25% the value of the house was also a prerequisite in some cases. These measures were needed to ensure that only a minority of mortgages were defaulted on. In any case that a default did occur, the recently purchased house would be used as leverage and would become property of the bank. This would help maintain the overall assets on their balance sheet, although their own cash reserves would become more illiquid. Thanks to the housing market this was proving to be successful. However, greed took over and the luck that the investors were experiencing desserted them.

A study conducted by Luigi Zingales (2008) highlighted that in the build-up to the subprime mortgage crisis, interest rates in the USA were set at a relatively low rate, and this had continued for a very long time. In turn, this lead to rising house prices for 9 consecutive years until 2006. The relative values of living over a 100 year period are indicated in Figure 1, taken from Robert Shiller (2005). This is interesting on the whole but our attention is drawn to the most recent era. Whilst interest rates and the cost of building remained fairly constant, the USA’s population grew steadily and house prices grew at an exponential pace.

It was also found that the loan delinquency rate dropped over the same time frame, which is the amount of loads that were defaulted on in comparison to the total amount of loans that were approved. Within the general population, confidence in the banking system was high and many more prosperous years were expected, as expressed in a survey by Case & Shiller (2005).

This proved to be a very profitable branch of their operations and investment banks saw an opportunity to make more money. The majority of those who qualified for a mortgage had already been approved and purchased their property. These earned large returns in interest due the sheer number of policies agreed. As a result, the mortgage brokers became more eager to lend because all of the risk involved was transferred to the purchasing bank. However, as the pool of possible customers dried up, so did the available profits. Therefore, they began to be more creative with the deals they offered to attract a larger portion of the public. A book by Schwartz (2009) claims this is when the lower quality adjustable-rate and subprime mortgages began to infect the market and pushed the boundaries of safe banking to the limits. This was a direct result of market regulations being relaxed.

Subprime mortgages are of particular significance. This is an alternative for borrowers with a lower credit rating. Effectively, these are riskier because the recipients of these loans are judged to be more likely to default on repayments. To reflect the higher level of risk involved, subprime mortgages are undertaken with a higher interest rate.

The idea of deflecting risk associated with mortgages was known as securitization. This was the practice of collating several mortgages together in a pool to be sold all together. Largely, there was very little monitoring of these deals, therefore, many types of mortgage were often grouped together whether they good or bad, prime, subprime or otherwise. There was further over-confidence with securitizations when the investment banks that agreed to buy them failed to perform their own quality checks. These blatantly obvious oversights meant that, more often than not, investment banks were in the possession of worthless and extremely risky securities, which were of considerably less value than they were credited as having.

Yuliya Demyanyk (2009) explains that the growth of the housing market was unsustainable and the quality of the mortgage loans had decreased year on year for nearly a decade. The risks that this brought were hidden by the excessive values given to properties at the time. This spelled trouble for banks when the level of defaults reached an all-time high and, consequently, the housing market bubble crashed in mid-2008. Now, investment banks, including Lehman, found themselves holding illiquid cash in the form of devalued housing. This deprives banks of the regular stream of money brought in by these investments, bringing on cash flow issues with their own loans to pay back and dividends to be issued to shareholders.

The examiner’s report into the Lehman Brothers Bankruptcy, conducted by Anton R. Valukas (2010), indicated that the management at the top of the firm were slow to recognize the crisis that lay ahead. The situation was grossly underestimated by Fuld and other executives, who didn’t think that it could infect other sectors within the market and it was too far gone by the time they finally took action. As they were aware that buyers would not be forthcoming, the decision was taken to “double down” with the mortgages the firm held. Akin to the blackjack strategy of the same name, it is a calculated gamble to hold on to mortgages already purchased in the hope that market conditions will improve again and will prove profitable. In a sense, Lehman was trying to weather the storm.

Essentially, the housing bubble bursting compounded the losses that Lehman had been accruing over last reported quarters. Their venture into housing assets had been funded by taking on loans with the interest offered by the held mortgages high enough to still turn a significant profit.

The video above, created by CrisisOfCredit.com, is a simplified version of events, which I think helps to explain how the subprime mortgage crisis came about and brought on the collapse of financial institutions including Lehman.

Who Was Behind The Lehman Brothers Collapse?

The demise of a firm can be attributed to poor leadership. The majority of the blame will fall at the door of the most powerful individual within the organisation. Naturally, they have most control over the company’s operating strategy and direction. At the time of their collapse, Lehman Brothers had a very experienced management team headed by the longest serving CEO on Wall Street. Bloomberg’s BusinessWeek magazine identified Richard S. Fuld Jr as holding the position of CEO since November 1993 until the end of 2008, after the bank’s collapse. Many of Fuld’s employees viewed him as a tyrant and noted that all decisions were undertaken by Fuld’s management team, his confidants, as noted by Ward’s book "The Devil's Casino" (2010). In the aftermath, he was cited as the single biggest factor in their demise.

Before the Lehman Bros bankruptcy, Fuld had been considered by his peers and the public as a successful and commanding figure. As unlikely as it may sound, Barron's Magazine, published in New York, featured an article praising Fuld as late as 11^th February 2008. In it, Steven M. Sears, claims that in a bear market such as the USA was at that point in time, those firms that are properly run are easier to identify. He claimed that it would be unlikely that Lehman Bros would be forced to devalue themselves, let alone become insolvent!

Fuld could claim many triumphs under his leadership. One particular instance was weathering the problems of the Mexican Peso Crisis at the very beginning of his reign. Another was shielding the bank against pension fund depreciation during the 1997-1998 Asian Crisis when many Asian currencies dramatically lost value, thoroughly discussed by Dess, Lumpkin & Eisner (2010). Forbes Magazine (2006) had identified him as the uniting force behind the Lehman Bros. Barron’s Magazine, based in New York, publishes an annual list of the 30 most influential CEOs currently on Wall Street. The list is in no way based on scientific formula or statistics; rather it is centred on the public reputation of each CEO and the opinions of their peers and analysts. Barron’s cite their criteria for inclusion as the “bold vision and strikingly effective management style” shown by each CEO. The editors believe this is as an indicator of how much of a driving force they are behind their company and how much success is due to their input alone. Fuld had been included on the three lists since its first inception in 2005 until the 2007 version.

Once it became apparent that Lehman was in trouble, public opinion turned against Fuld and his team of managers as this was viewed as their fault. Below are images indicative of the time post-bankruptcy. The media portrayed Fuld as a caricature and a hate figure.

Each of the 14 years under Fuld’s stewardship had resulted in consecutive year end profit. Publicly traded stocks even reached an all-time high of $86 during this period. 2007 proved to be the last year to produce a profitable financial report. This was the fourth consecutive year of record revenue and income to the institution, Reuters (Sept. 12, 2008). Revenues were reported to be over $60billion and profits in excess of $4billion, details provided in research carried out by Kwabena Boamah (2011) for the Swiss Management Centre University.

In March 2008 Lehman Bros stock price fell by up to 48% upon the news of Bear Stearns fire-sale. Even that this stage, only 6 months before collapse, the bank appeared to be the next casualty, Fineman & Onaran (2008) reported for Bloomberg. The third quarter report on 10^th September announced a loss of $3.9billion, the largest in Lehman Bros history. When no buyer was willing to match the valuation attributed to the corporation by Fuld's team and as the Federal Reserve had already stated that they would not be forth-coming with help, Lehman Bros filed for bankruptcy with listed assets of $639billion.

Below is an extract of Fuld’s written statement that he issued on the 1^st September 2010 for use by the Financial Crisis Inquiry Panel – he declined to appear in person. Fuld took full responsibility for the bank’s collapse, possibly due to media pressure. But even at this juncture, he believed that Lehman Bros could have been saved with a Treasury bail-out:

“Lehman’s demise was caused by uncontrollable market forces and the incorrect perception and accompanying rumours that Lehman did not have sufficient capital to support its investments. All of this resulted in a loss of confidence, which then undermined the firm’s strength and soundness.”

Introduction: The World Circa 2008

On 15^th September 2008, Lehman Brothers became the largest firm on record to file for bankruptcy. This came against the back-drop of the global recession, which was preceded by the “Subprime Mortgage Crisis” in the USA. The consequences of the market meltdown were all encompassing, with many firms, banks and individuals suffering losses of wealth.

As it were, Lehman Bros were only one of a large number of public companies to collapse, whilst an even larger number flirted with extinction. There were other high profile investment banks that received a lot of media attention due to their particular problems. Bear Stearns, were bought by and incorporated into the JP Morgan group in March of that year and Merrill Lynch, were sold for a nominal fee to the Bank of America. This raises questions as to why the Lehman Bros were allowed to collapse.

Why could the Federal Reserve Bank not have intervened to save Lehman Bros with a “cash injection” as it did the following day for the insurance company American International Group (AIG)? Nationalisation also occurred less than a week later on the 21^st September in Newcastle-Upon-Tyne, England, when the Northern Rock bank was also rescued with a government bailout when it came under severe pressure. A.J. Joines (2010) research explores the notion of institutions being classified, based on perceptions rather than governed by strict rules, as “too big to fail”.