Let Me Tell You A Funny Story: Lehman’s Repo 105 AccountingBy Francine • Jan 9th, 2011 • Category: Food for Thought, Writing for Others
This article was originally posted at Going Concern.com on March 24, 2010.
The formal definition of “professional skepticism” does not include the phrase, “pass the smell test.” Nor does it include the phrase, “If it walks like a duck, and quacks like a duck, it’s probably a duck.”
Like most AICPA prose it’s pretty vanilla.
Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. The auditor should conduct the engagement with a mindset that recognizes the possibility that a material misstatement due to fraud could be present, regardless of any past experience with the entity and regardless of the auditor’s belief about management’s honesty and integrity.
When a new batch of Ernst & Young auditors arrived at Lehman Brothers each year, Repo 105 transactions must have caused debate. After all, a transaction that’s called a “Repo,” short for “repurchase”, but that’s actually recorded on the books as a sale, is a little odd.
It may have even quacked.
The Repo 105 transaction began with an exchange of $105 of collateral for a $100 loan. Because the Repo was structured that way, Lehman said it was a “sale” and, therefore, did not record the loan. That is, forget the CR “loan payable.” CR Assets to take the securities off the books, DR cash. Then CR Cash and DR Liab when the cash received is used to pay off other liabilities.
The transaction reduced assets – Lehman used highly liquid, marketable securities for the trades. Lehman realized a benefit by using the cash received to pay down other liabilities for a temporary improvement in the leverage ratio. Lehman “bought” back the security 10 days after the quarter end, paying an additional above-market amount in “interest” for the faux-loan, and took back the full collateral on its books.
There’s been a lot of talk about the excess collateral, securities worth 105% of loan value versus typical 102%, as the cornerstone of Lehman’s position, supported by EY, that ‘control” of the assets passed from Lehman to the counterparties. The excess collateral was a necessary condition for treating the transaction as a ‘sale” but not a sufficient condition for any US law firm to bless it.
However, what really doesn’t smell right to me is Lehman continued collecting the coupon payments for these securities while they were temporarily not “owned” by Lehman.
Lehman “sells” the highly liquid government bonds and removes them from their system. The counterparty, UBS for example, “buys” these securities, and puts them on their investment accounting subsystem. But the coupon payment on the bonds is still recorded Lehman. How does Lehman account for this income? There’s no asset to record it against, no CUSIP to match it with. How does the counterparty, UBS, account for the fact they will not be receiving any coupon payment for a highly liquid government bond they own?
Professor Roger Collins of Thompson Rivers University commented, “If I were teaching an Introductory Financial Accounting class I’d have a very hard time explaining to my students that a Repo 105 transaction represented a sale, especially given the coupon collected.”
Maybe Lehman never takes the bonds off their system. They are, after all, “Repo” transactions. There’s an intention and a contractual obligation to “repurchase” them. How, then, to run financial statements and leave these assets out of the numbers at quarter-end?
Who are we kidding?
Either way, sounds to me like a lot of string and sticky tape to make these transactions work each quarter on both ends. But UBS, one of Lehman’s counterparties for Repo 105s is also an Ernst & Young audit client and a pretty conflicted one at that. Maybe they all talked it over amongst themselves and worked it out.
Nothing would surprise me.