Saturday, March 20, 2010

Repo 105’s antecedents: Ken Lewis

I agree with Felix Salmon that the former Lehman staffers who defend Repo 105 are psychopaths – certifiably insane.  They state (as if this justifies it) that …

The only people who would worry about using an old trick to reduce leverage from 13.9 to 12.1, are “yappers who don’t know anything.”

For those that don’t know Repo 105 was a sale and repurchase agreement by which Lehman parked about 50 billion in assets (presumably assets they did not want to discuss) overnight via a repo transaction so they would not appear on the balance sheet. 

By now anyone who does not realize that sort of accounting legerdemain is unacceptable is (a) entirely out of touch with reality and (b) self aggrandizing on a magnificent scale.  Both are signs of mental illness.

But unfortunately the Lehman executives do have one point.  Repo 105 type balance sheet faking was “an old trick” and well known to anyone who cared to read balance sheets (very) carefully.*

Let me take you back to 2006 and Bank of America.  Pages 94 and 95 of the 2006 Annual Report show (amongst other things) the average total assets by quarter from the fourth quarter of 2005 to the fourth quarter of 2006 inclusive.  Here are the numbers:

(US dollars - millions) Q4 2006 Q3 2006 Q2 2006 Q1 2006 Q4 2005
Average total assets 1,495,150 1,497,987 1,456,004 1,416,373 1,305,057

Now lets extend this table by including period end assets.  You can find the data here (see page 4 for both fourth quarters and third quarter, and page 4 here for the first and second quarters). 

(US dollars - millions) Q4 2006 Q3 2006 Q2 2006 Q1 2006 Q4 2005
Average total assets 1,495,150 1,497,987 1,456,004 1,416,373 1,305,057
End period total assets 1,459,737 1,449,211 1,445,193 1,375,080 1,291,803
end period less average assets -35,413 -48,776 -10,811 -41,293 -13,254


You will notice that the end period assets were always lower than the average assets.  Moreover it was not obvious unless you really looked because the quarterly earnings releases did not include average assets (but you could work it out because they stated return on average assets). 

It was not just 2006 either – this had been happening for a while.  Bank of America was parking its assets off balance sheet at the end of every quarter for some time and had been obscuring the fact


If Bank of America wanted to shove the assets off balance sheet someone (credit worthy) needed to be found to house the assets overnight.  There are not that many parties credit worthy for $50 billion or more of overnight repos. 

Well – being an obsessive reader of bank accounts I found the counterparty.  It was MUFJ.  If you wish to you can show – the same way that MUFJ had end period assets higher than average assets and that the differences and timing roughly match.  Someone had to assist BofA in its financial legerdemain and we know the counterparty.

Once – through an interpreter – I asked senior MUFJ executives about this.  Any nuance in the answer was lost in translation. 

So back to Repo 105

Repo 105 is fraud.  Its a lie to investors and rating and regulatory agencies.  It was also fraud when BofA did it.  But both Lehman and Ken Lewis compartmentalized it as OK.  And it was not the fraud that undid them – it was the overweening arrogance that thought this was alright.  The same overweening arrogance that made Ken Lewis think it was alright to pay a big premium to close for Merrill Lynch (and later force mass dilution of BofA common shareholders). 

But the chief executive (or other executive) who thought this was alright was probably certifiable.  Just as certifiable as the Lehman execs who Felix rightly chastises. 

Do we want to prosecute?

There is a big debate in the blogosphere as to whether anything in the Valukas Report rises to the level of prosecution.

I suspect in a vacuum it does.  But this was a collective insanity every bit as mad as the poisoning craze written about Charles Mackay.  Mass insanity does lower moral culpability and it takes an extraordinary person to stand up to it. 

Besides – if we are going to slap Erin Callan’s wrists in handcuffs then we are going to have to do the same to Ken Lewis and probably have to extradite the top-end of the Japanese establishment who were the counterparties. 

I do not want to go there – and I do not think it would be constructive.




Disclosure:  Long a lot of Bank of America – surprising given this post I guess. 

*It is my burden to read balance sheets like this and to remember details four years later. 


Cool said...

I still remember your old post when you wrote that people like Chris Whalen and Grantham are "spectacularly Wrong".But I'm really happy and respect you that you accept what is there in b/s of BofA.

Anonymous said...

I've read through the section on Repo 105 in the report. Interesting stuff.

I agree that there is definitely misrepresentation and they were definitely using those repo 105s to hide stuff.

However, what benefit is there in changing the leverage ratio by 1 or 2 pts? They were already heavily leveraged, I don't see if they are 14 times leveraged or 12 times leveraged it would have made anyone bat an eye.

Would anyone have really changed their opinion on Lehman from a buy to a sell? I doubt it, not given the climate at the time.

John Hempton said...

Bank of America did it for some time - and presumably they did it because it made their metrics look better.

Lehman did it for the same reason.


Anonymous said...

The statement in many stories is that Lehman were fiddling their leverage ratio to maintain credit ratings.

Although it doesn't make sense. You would have thought after Enron etc. any credit analyst would have been asking management "do you have any material off balance sheet commitments?" Repo 105 should have come up somewhere.

Anonymous said...

Very nice spot. And plenty, plenty more balance sheet cockroaches to come, no doubt.

That's an intriguing sign-off line, though. Is there literally nothing that can/should be done to deter this sort of behaviour, when it's going on at this scale? That almost seems to be your implication, but I suspect I am misreading what you are saying.

MattJ said...

Suffice it to say that those of us who saw very little benefit from the finance boom of the last decade, and are now expected to cover the ensuing losses, do want to go 'there'.

Anonymous said...

One point and one item of speculation:

In standing as counterparty to the repos at issue, I don't see how the Japanese bank has done anything criminal under US law. They aren't accused of prettying their balance sheet and are not responsible for BoA/Lehman etc. financial reporting.

Of course, getting the testimony of a bunch of Japan-resident individuals will be a pain, especially as no criminal charges will be filed, so no extradition.

I wonder whether that was one of the reasons underlying the decision to engage in swaps with this particular bank?

Of course, as you pointed out, the number of counterparties is limited and Masters of the Universe are practically immune to investigation, much less imdictment or conviction.

We don't need any commies in the fbi! Sid

Anonymous said...

wasn't repo 105 only used to park treasuries? seems the line about "parking assets not wanting to discuss" is fallacious...

Anonymous said...

Agreed with anonymous above.
Most of the assets that were parked off balance sheet using repo 105 were treasuries and agencies. Very few corporates, and only a few percent of more complex securities.

FT Alphaville has a pretty detailed breakdown:

A lot of banks use special vehicles and constructions to get holdings off balance sheet. The main criticism in this case is that
1) It may have been illegal under US law
2) It was not properly disclosed.

Gobanian said...

It doesn't follow that bank of America was using Repo 105 or anything like it. All big banks squeeze their balance sheets at the end of the quarter. But there's a difference between doing that by reducing positions as you move to quarter end and the purely cosmetic operation of Repo 105.
What Lehman did sounds dreadful. But suppose they had just sold the position at 105, along with selling a put at the same price and buying a call at 105 as well.
Nobody suggests that options need to be in the balance sheet, yet the risk would have been the same as in what Lehman did.
You just need to remember that there are lies, damned lies, statistics and audited accounts. And the biggest untruth of all is in the audited accounts.

Anonymous said...

John Maynard Keynes is quoted as having said, way back in 1931, that
"a sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.”

Jeez, Keynes was a sharp guy.

Doug Shaw said...

questionning the state of mind of those with whom you disagree kinda closes down any room for honest debate.

But What do I Know? said...

>>>Besides – if we are going to slap Erin Callan’s wrists in handcuffs then we are going to have to do the same to Ken Lewis and probably have to extradite the top-end of the Japanese establishment who were the counterparties. <<<

Only if "we" were going to be fair--and I suspect "we" are not going to be. Bernie Ebbers is in jail when a lot of his peers are not--someone will be made an example of in this case as well.

najdorf said...

Anon 1: There's an enormous advantage in changing the leverage ratio by 1 or 2 points. Do you think Lehman traders did $50 billion of overpriced international repos with cumbersome rules because it was fun? Out here in the real world numbers matter, because we're not just looking at companies and saying "Eh, double-digit leverage - all the same". Superficially small differences in risk-taking are the difference between Lehman at 0 and Goldman at 170. In the particular case, the ratings agencies cared a great deal about leverage ratios and would have downgraded Lehman more aggressively had they known true leverage. These downgrades would have caused a much more rapid failure as counterparties pulled back from Lehman or demanded more collateral (see Bear Stearns, AIG). Lower leverage/better balance sheet makes it much easier to roll funding and attract new equity. Lehman had an undeserved chance to raise capital during the spring/summer of 2008, which management completely wasted. The fact that the outcome was the same as it would have been had they disclosed the truth shouldn't blind you to the fact that they went to great lengths to hide the truth from investors while continuing to pay themselves fat salaries and make big promises to the public. The eventual failure of the company was made vastly more chaotic and destructive by years of increasing leverage and obfuscation.

"Cassandra" said...


I remember the scathing denunications coming the USA in regards to the arguably laughable and ludicrous zaitech shenanigans in Japan. So pure and transparent were the US by comparison, people argued. But :"what's normal" in the USA has travelled a long long way, as a mere inventory reveals continuously across the time-line:
- Tainted & conflicted analysts passing off as "research",
- largest mutual fund companies complicitous in mutual-fund timing,
- rampant, options back-dating, balance sheet and income statement fabrication across a wide universe of securities;
- altering of pension-fund return assumptions;
- ludicrous, unbenchmarked and grossed-up executive comp schemes,
- abuse of SPVs and tax-havens for balance sheet distortion and tax avoidance
- bid-rigging by brokers across the entire reinsurance industry
- "finite-insurance" to directly smooth earnings
- wholesale capture of the ratings agencies at the very center of financial money markets

This is before one even talks about the abuse of securitisation-run-amok, and the shadow banking system. And I am sure I have left a few out. All these things were/are criminal in the spirit of the law, and most to the letter. It has got to the point where one has to look hard for the honest company with real values. Ahhh, yes, one points to Warren Buffett and that pillar of sobriety, Berkshire Hathway. Errr ummm, except that even the revered WB was front-and-center to the finite reinsurance game of providing earnings-smoothing "insurance" and earnings management to those in need. Anything to make a buck.

At least the Japanese bowed their heads in shame, and eventually fessed-up and took the medicine. Mr Buffett, by contrast disavowed himself of all knowledge of these activities, for crimes which his loyal underling now is rotting in jail. With Repo-105, only the number of zeros have gotten larger, with the pattern of behavoiur of what is normal, completely out of bounds to what prevailed, and what is required in modernity to enforce the rules of fairness and what remains of trust, else the entire system unravels towards lawless chaos, or an authoritarian nightmare arbitrarily awarding the spoils to the cadre of cronies .

Paul said...

Thank you Cassandra! Three great paragraphs that summarize the situation with gusto and perspicacity.

And let's not forget the great accounting scandal of 'The Smartest Guys in the Room' -

Where are we headed with all of this?

Anonymous said...

so I don't feel so bad now, since I did not get caught, that I padded my sales and commissions by selling big lots of 'aged' disk drives to make my year end number and subsequently took a 'customer convienience' return from my largest customer the next period. In fact I helped my company on the ROII and aged writedown too, good thing I could hold up the trailer so no shipping cost was incurred.

Anonymous said...


Mary said...

Lehman's is nothing compared to Goldman Sach. One dollar at GS is leveraged at 33,xxx.00. Gosh, what a scam, where are the cops????

Common Sense said...

Disclosure of Repo 150s was done in accordance with the law. Don't play into Government Sachs' hand and go shilling for them. Taking down BofA will make only Goldman Sachs' CEO richer. Don't be a pawn.

Anonymous said...

Come on, it's the secret agreements that are belied by the tactics. Of course it's only top rated collateral -- there was no contract for the conterparty to fall back on, so they needed to hedge in the event of a loss. It's always the secret agreements with these guys, yet everyone wants to parse what is publically known to the nth degree. But hey, maybe they are all smart as Paulson, who doesn't keep notes or use email because he has a fantastic memory. Can anyone say Capo de Tutti Capo?

Mary said...

Lehman's is small fry compared to Goldman. GS cooks every $ to 32 thousand something; of course this is now, not that unregulated 2008

Timothy Mak said...

Mr Hempton has already answered this question, I want to elaborate that by saying many decisions are made by people who only read summaries, and the few percentage points in credit metrics made all the difference on a powerpoint slide. Mr Hempton's observation re MUFJ/Bank of America is a piece of artwork - almost moving me to tears. The closest comparison to that is Mr Ted Butler suggesting Bear Stearns had a huge short position in silver, which was assumed by JP Morgan when JPM bought Bear.

"However, what benefit is there in changing the leverage ratio by 1 or 2 pts? They were already heavily leveraged, I don't see if they are 14 times leveraged or 12 times leveraged it would have made anyone bat an eye.

Would anyone have really changed their opinion on Lehman from a buy to a sell? I doubt it, not given the climate at the time."

Andrew (London) said...

*sigh* see Anglo Irish Bank for my homelands primary example of such practices. These dubious accounting systems feel all to obvious.

Quis custodiet ipsos custodes?

Andrew (London) said...

Also, this is presumable completely unrelated...

Schmuckler... hmmmm

Anonymous said...

John Blunt's characterization (Mar 22) of the problem is spot-on:
"...there are lies, damned lies, statistics and audited accounts. And the biggest untruth of all is in the audited accounts."
It is surely not a Lehman or a Bank of America thing. They are just responding to the carrot (or stick) that is dangled in front of them. We all know too well about the limitations of - and dangers of extrapolating from - a point-in-time accounting representation of a company's finances. Yet we continue to evaluate a company's financial health by calculating sophisticated performance metrics and even determining regulatory compliance based on these end-of-period accounts. If we are serious about wanting to change corporate behavior let's start with revamping our evaluation systems.

Lucy L. Honeychurch said...

Well said Cassandra. Don't forget mark-to-'book' v. mark-to-market, which is still grossly inflating financials.

... and yes, that's legal too.

Because, apparently buying-off American politicians has become a more fundamental component of these firms' business model, than actual BUSINESS.

Every time I hear someone like Blankfein pontificate about the Banks' social value in reallocating scarce capital to drive entrepreneurship - I get a great belly laugh.

They're reallocating capital in a very 'entrepreneurial' and 'innovative' way alright!

Anonymous said...

Actually i think the examiner's report indicated that many of the lehman assets involved in repo 105 were of higher quality than much of what was causing trouble. I guess this was necessary to induce the counterparties to participate.

Walt French said...

Whatever one wants to say about using repos, they are indeed old news. I heard of banks using them years ago, so whatever else, one knows that the regulators were not fooled in any way. Nor, as you show how easy it is to back out averages, would any serious investor be fooled.

The only difference, AFAICT, is that we no longer have independent brokerages that close their books in Feb/May/Aug/Nov, so the banks' quarter-end repos need to go somewhere else: foreign banks seem as good a place as any. Might cost another basis point due to the lesser competition, so the window-dressing is less justifiable than before. Only one of dozens of "putting one's best foot forward."

Unsympathetic said...

"what benefit is there in changing the leverage ratio"

Financial industry twits -- if leverage doesn't matter so much, then why shouldn't we put Bill Black back in charge of all federal and state regulators and state clearly that 10:1 is the maximum allowed, with no games permitted?

Surely if there's no problem then you wouldn't mind being on the receiving end of a 20-yr felony prison term for one-one thousandth of a point of error, would you?

Of course leverage matters.. bank profits are higher if they can lever more, but taxpayer losses are also higher when those incompetent morons make yet another mistake.

Ted K said...

If I remember correctly your politics is to the right (Republican we say here in America, not sure "over yonder" those parts what they call it). I'm on the left, but I want to say I really admire you for digging into these numbers. Don't quit digging in those balance sheets and income statements even when those eyes feel tired. And don't lose that cursed long-term memory. A lot of people out here appreciate what you do that lost art.

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