Repo to Oblivion: Five Questions for Law Professor Steve Thel

MF Global is the second financial company since Lehman Brothers to fail at least partly because of its reliance on transactions known as Repo 105. An SEC lawyer-turned-Fordham prof explains why.

repo-pic-large.jpg

How is it that the “Repo 105” transaction, which now-bankrupt Lehman Brothers and MF Global used to dress up their balance sheets, is still a factor in financial accounting?

In early 2010, Lehman bankruptcy examiner Anton Valukas issued a nine-volume report on the collapse of the highly leveraged bank. He singled out the use of Repo 105 transactions, repurchase agreements in which Lehman lent out mortgage securities for a short period of time in exchange for cash minus 5 percent of their value plus interest, as a key to the bank’s failure. According to the report, the bank used these deals at the end of several quarters in 2007 and 2008 to make it appear that its balance sheet was stronger than it actually was. It lent subprime debt at the end of the period, only to “repurchase” it as soon as the next period began. By accounting for these transactions as asset sales, instead of as debt on its balance sheet, Lehman reduced its reported level of leverage. Valukas, an attorney, found that “that the only purpose or motive for the transactions was reduction in balance sheet” and that “there was no substance to the transactions.” While not necessarily illegal — the bank had to go to the U.K. to find lawyers willing to sign off on the accounting — Valukas noted that former Lehman chief financial officers Erin Callan and Ian Lowitt warned that the use of Repo 105s posed a reputational risk.

The use of Repo 105s was highlighted again on October 31, when trading firm MF Global filed for bankruptcy protection. Company documents showed that it, too, relied on Repo 105s, in this case lending European sovereign debt and repurchasing it an an ongoing cycle known as repo to maturity. As the price of the sovereign debt in its portfolio swung wildly in value--as much as 5 percent or 10 percent in a single day--MF Global had to post more margin to industry regulator FINRA as well as to counterpaties to its repo transactions. Those margin calls, coming on top of a $90 million August settlement in an investor lawsuit going back to 2008, proved too much for the firm.

How is it that the use of Repo 105s remains unchecked, even after the collapse of Lehman? And in the wake of the MF Global collapse, what are the odds that other financial institutions are using Repo 105s to take debt off the balance sheet? Institutional Investor contributing writer Steve Rosenbush discussed the issue with Steve Thel, a former SEC attorney who now teaches at Fordham Law. Here are edited highlights of their conversation.

1. Does the persistence of Repo 105s in the financial system reflect a failure of regulatory reform?

It is disturbing to see that the very thing that the Lehman examiner found so troubling — the only thing that he said Lehman actually did wrong — is still occurring. Now, oddly, I am not sure that Lehman’s use of Repo 105s was illegal. But the examiner said it was a problem. Now, It has been said MF Global used a lot of Repo 105 transactions — just as Lehman did. Of course that is troubling.

Sponsored

2. At what point does the use of Repo 105s skirt the limits of legality?

The question of legality boils down to whether their legal advisers told them the transactions were loans or asset sales. If the lawyers told them the repos were sales, then they had to account for them as sales. They had no choice.

The main problem is that lawyers in the U.S. and the U.K. look at Repo 105s differently. In the U.S., lawyers tend to treat them as loans. In the U.K., lawyers are more willing to treat them as sales. That is why Lehman is said to have conducted its repos in London. That ability to choose a venue is one reason why it is difficult to regulate Repo 105s.

Another reason is that regulators have been over burdened with work since the financial crisis.

3. Should Repo 105s be banned outright? Many financial institutions use them to raise cash against receivables and, unlike Lehman or MF Global, are transparent about the process.

There are legitimate reasons for using Repo 105s. They can become a problem if banks use them at the end of the quarter just to make their balance sheets look cleaner. The question is whether the level of repos at a bank rises at the end of one quarter and falls at the beginning of the next quarter. In the case of Lehman, the examiner said the bank was using repos to deceive investors and that their use was misleading.

You can look in the quarterly financial statements of any of the large banks and tell what their repo exposure is at the end of a quarter. But is it different at the beginning of the quarter?

Lehman ran into trouble because of its high leverage level and its use of subprime debt in Repo 105. That wasn’t the case with MF Global’s, where the Repo 105s involved sovereign debt.

4. How did it get into trouble?

Most repos are made with high-quality debt and they are conducted over a short period of time. The person who buys $100 of debt for $102 should feel confident that it won’t lose more than 2 percent of its value in two days. The problem is that we have found out that some supposedly high quality sovereign debt can lose more than 2 percent of its value in two days. In that case, the buyer can demand more collateral or refuse to provide more loans, which is what happened in the MF Global case.

5. How is that the Repo 105 continues to haunt the markets even after the passage of Dodd-Frank? If that law didn’t fix the problems with Repo 105s, what would?

The regulatory changes actually have to occur in the area of accounting rules — are they accounted for as loans or as sales?

And I think the problems with Repo 105s suggest that banks ought to have more capital.

Related