Saturday, 13 March 2010

What Does Repo 105 Tell Us About This Crisis?

Now that a couple of news cycles have washed over us since the revelation of the Lehman Brothers accounting scheme known as "Repo 105" (cute street drug name that suggests quick-hit crack for financiers), I thought it was worth trying to distill the takeaways from this news.

First, if you need to get up to speed: Lehman was very heavily massaging its books so as to hide its high leverage from shareholders and other outsiders (such as the credit-rating agencies). It was using "repo" transactions to shift large sums off the balance sheet temporarily at quarter's end. The program was known as "Repo 105" because Lehman would get $1 for each $1.05 of securities that it temporarily parked with any of seven counterparties (Mizuho, Barclays, UBS, Deutsche, etc.).

If you want more on Repo 105:
The original (gasp!) 2,200+ page report by examiner Anton Valukas
Here's Zero Hedge as one of the first to weigh in
Karl Denninger waxes indignant (and justifiably so)
My favorite Repo 105 blog headline

Okay, so what does the unfolding Repo 105 scandal tell us about this financial crisis?

1. That shadow banking is a big issue that must be addressed.

Most Americans know of the word "repo" only as it pertains to some guy who shows up to take your car after you miss half a dozen payments. But a different "repo" lies at the heart of the shadow banking system. It's short for a "repurchase agreement," originally designed for rock-solid government securities "sold" to investors, usually overnight to be bought back the next day, in this way generating short-term financing for the seller. The repo market gradually broadened out to other seemingly rock-solid products rated triple AAA, such as what turned out to be dodgy securitizations. The repo market is opaque and unstable ... and HUGE ... and needs to be much better regulated on these grounds alone. But now we find out that it can be used for playing accounting games too.

2. That regulators were really, really asleep at the switch. Catatonic perhaps.

It just keeps getting worse and worse. I thought the serial bungling at the SEC on the Madoff case was mind-boggling, but Denninger quotes a section of the Valukas report that will make your jaw drop and hit the kitchen table with an audible thud. Get this: the SEC and Federal Reserve Bank of New York began onsite daily monitoring of Lehman in March 2008. Worried whether the firm could survive a bank run, the New York Fed devised two stress tests. And Lehman failed both. Then the New York Fed came up with a third test. And Lehman failed that too. So you'd expect the Fed to lower the boom, right? Demand Lehman raise capital or at least ... do something for chrissakes. No, instead Lehman is allowed to create its own test that the firm ... passes. Is there any planet on which this makes any sense at all? Head of NY Fed at the time: one Timothy Geithner. And oh yeah, so much for confidence in those "stress tests" the banks underwent last year.

3. That, faced with a banking culture of gold-medalist loophole divers, we must adopt much more principle-based accounting.

How can you "sell" securities with an agreement to "buy" them back a week later, solely to skirt a true accounting of your assets and liabilities, and this isn't considered fraud? The answer: because you found a nifty loophole (Lehman's had to go to England to get it) that ratifies the highly dubious transaction as a "true sale" and it sounds like this:
If two parties intend to exchange assets for cash, and then later the party receiving the assets decides to hand back “equivalent assets (such as securities of the same series and nominal value) rather than the very assets that were originally delivered,” that amounts to a sale.
4. That effective financial regulation demands global cooperation.

Lehman couldn't get a U.S. law firm to sign off on Repo 105, so it looked overseas and got the approval and justification from London-based Linklaters. Also Lehman shuffled the Repo 105 sales through its European arm, Lehman Brothers International (Europe). So in an age of easy global money transfers, and of financial companies adept at arbitraging regulatory regimes, we need to find ways to make sure bad behavior doesn't simply hop over a body of water and wreck our financial system from afar.

5. That our biggest failing in the U.S. may be that we have not seen fit to prosecute a single top executive from a major financial institution for their role in helping precipitate the crisis, a year and a half after it erupted, a failure that has badly corroded faith in our government.

Why can't we summon the courage to do the right thing? Sure, many executives just made bad bets -- greedy and stupid though they were. But others, as we clearly see in Lehman's case, purposefully misled the world. Why is this any less serious than Enron? The government's gross failure only gives ammunition to the critics that say that the Wall Street titans have a choke chain on our leaders in Washington.