How Repo 105 accounting worked for Lehman Brothers

¶ … Lehmann Brothers

Repo 105 was a method of accounting that allows Lehmann Brothers to conceal billions of dollars in unprofitable assets from the public eye. The financial institution arranged to sell packages of Treasury bonds, Eurobonds, mortgages, and other bad investments at the end of an accounting quarter with the understanding that they would reacquire them a few weeks later. By this means the company was able to hide in the region of $38.6 billion in the fourth quarter of 2007, $49.1 billion in the first quarter of 2008, and $50.3 billion in the second quarter of 2008. This enabled Lehmann Brothers to publish reports that enhanced the company's appearance of solvency.

Lehmann Brothers was able to accomplish this by entering into repurchase agreements with banks in the Cayman Islands. Alan Sharp (2010, March 10) explained the ruse worked this way, imagine you want to buy a car and need a loan. Unfortunately you've maxed out several credit cards. On the day before a loan examiner checks your credit you hide all your credit card liability under a fictitious person's name, hence the examiner believes your credit is good and approves the loan. Once the loan is secured you reassume all your debts.

Companies legitimately move transactions off their balance sheet all the time. If a company moves a transaction off their balance sheet accounting regulations must be followed to explain where the entry was moved and the reason it was moved to investors. But Lehmann Brothers appears to have had dishonest motives for moving transactions off-balance-sheet, to prevent others for scrutinizing their problems.

Banks employ this business practice on a regular basis, and record these off-balance-sheet transactions as loans in their books. At Lehmann Brothers these transactions were entered as sales. The result was, at least on the books, the company presented with more cash assets and less liability. The primary reason for doing this was to make the company's balance sheet look better to investors and more importantly rating agencies. If word of their true financial position became public, and the company was downgraded, any chance of securing new investors or loans would be seriously damaged.

According to Frank Ahrens (2010, April 20) not only did Lehmann Brothers hide this practice from the investing public, rating agencies, and government regulators, they even deceived their own board of directors. "In this way Lehmann reversed engineered the firm's leverage ratio for public consumption."

In 2008 analysts frequently asked about the means by which the company was able to achieve reduction in risk. Lehmann Brothers' company official reported reducing its leverage through the sale of less liquid asset categories claimed and simultaneously claimed they were trying to give the group a great amount of transparency on the balance sheet. (Ahrens, 2010, April 10)

Lehmann Brothers executives are currently under criminal investigation. Subpoenas in grand jury probes were issued as early as October, 2008. Andrew Clark (2010, March 12) reports the problem is that it isn't easy to prove fraud in many of these cases. A top law or accounting firm will have at least constructed an argument of legality before they will sign off on anything. To achieve a successful prosecution and conviction conscious wrongdoing would need to be proved. That is to say that those allegedly responsible actually knew what they were doing was fraudulent behavior.

Resources

Ahrens, F. (2010, April 20). Lehmann brothers, the evil repo 105s and the danger of off-balance-sheet deals. washingtonpost.com, Retrieved on May 13,2010, from C:UsersOwnerDesktop