The Lehman Report, “Repo 105,” and “tobashi”

The Valukas report

A court-appointed examiner, Anton Valukas, released his nine-volume, 2200 page report on the bankruptcy of Lehman Brothers last Thursday, after more than a year of investigation.

I haven’t read the report and I don’t intend to, since I’m pretty sure it won’t be chock full of useful investment information.  There’s one aspect of the newspaper accounts of Valukas’s work that jumps out to me, though–the now-becoming-infamous “repo 105″ transactions.  It isn’t just that Lehman actively distorted its financial statements so that Wall Street would not understand the true extent of its borrowings.  It’s that all the distortions emanated from London.

Why do US transactions in London?

From the beginning of the financial crisis it has struck me as odd that very many of the “toxic” asset transactions done by the big commercial and investment banks were executed in London–even though they involved US assets, US-based sellers and US-based buyers!

nothing by accident

It’s my experience that nothing big companies do happens by accident.  There’s always a reason, even if you can’t immediately see what it is.  In the toxic asset case, I thought the two logical possibilities were that:

–there was an economic reason–a tax advantage, perhaps, or lower execution costs–to doing the transactions in the UK, or

–there was legal one–firms were trying to protect themselves from civil or criminal action.  In other words, they were doing things that London’s “regulation lite” philosophy might lead it to turn a blind eye to, but which would be clearly illegal in the US.

The Lehman Report seems to tip the balance in favor of the second explanation.

What “Repo 105” was

The name has already caught reporters’ fancy.  In its simplest form, toward the end of each quarterly reporting period Lehman would agree with commercial banks:

(1) to exchange large baskets of the company’s assets for cash, and

(2) to repurchase the assets at a higher price a few days later, after the end of the quarter.

Lehman would use the proceeds of these “repurchase agreements” to reduce the debt outstanding on its balance sheet at quarter’s end.  Repos are very common, plain-vanilla transactions in finance.  A money market fund, for example, might buy a short-term note from, say, IBM for 99 that both sides agree will be cashed in a month from now for 100.  So the fact of repos or even that they made debt “vanish” for a few days is not where the problem lies.

But Lehman also decided that in its SEC filings and other official reporting to shareholders, it would suppress the information about its repurchase obligations.  By only showing one side of the trade, it made itself seem to have less debt than it actually had.  In its last year of existence, Lehman was hiding close to $50 billion in borrowings.

Illegal in the US, ok in the UK

Lehman maintained that if it was fancy enough in structuring the transactions, it would get away with not disclosing the repurchase obligations.  Ernst & Young, Lehman’s auditors, had no quarrel with this.  But Lehman couldn’t find a single US law firm willing to say that doing so was legal.  Put another way, every law firm it approached told Lehman what it was proposing to do was against the law.

How did Lehman respond?

It found a British law firm willing to say that not revealing the repurchases would be legal in the UK–and then did all the transactions in London!

As Lehman got into deeper and deeper trouble, the amounts repoed got larger.  During 2008 the repos approached $50 billion, enough to “lower” Lehman’s financial leverage (its borrowings divided by net worth) by over 10%.  That’s an enormous difference.

Madoff redux

Even though the amounts were mammoth and that reducing leverage was one of his key aims, Lehman’s chairman, Richard Fuld, reportedly denies any knowledge of the scheme.  And in a reprise of the Bernie Madoff scandal, a very persistent whistleblower was apparently ignored by regulators, and Lehman’s top management and board of directors alike.

It will be interesting to see if the Valukas report is an effective counter to the intensive, and so far successful, lobbying efforts of the banks to maintain the status quo, avoid prosecution of their managements, and stymie regulatory reform.

We’ve seen this once before–“tobashi”

During the second half of the Eighties, when the Japanese stock market was booming, investment bankers persuaded many domestic companies to raise capital by issuing bonds with warrants attached.

The companies didn’t really need the money, but the bankers’ sales pitch was persuasive:  give the money to us, they said, to invest for you in the Japanese stock market.  As the Nikkei rises, we’ll make lots of money for you.  And you’ll pay the bonds back with the funds you’ll get when the warrant holders exercise their rights to buy new shares of your stock at much higher prices than today’s.  You win two ways.

Events didn’t work out as planned, though.  For one thing, most of the warrants expired worthless, leaving the issuing companies stuck with repaying bondholders.

Just as bad, the Japanese investment banks lived up to their reputations as notoriously bad investors by losing in the stock market virtually all the money entrusted to them in the corporate stock accounts.  That’s when they came up with the idea of “tobashi,” or “hot potato,” as a way of disguising from company shareholders the fact of their horrible investment performance.

Let’s say the original amount invested, and the carrying value of the portfolio, was 100, but the money left was only 10.  (Hard as it is to imagine, I think this would have been a typical situation.)  The investment banks would find a third party willing to “buy” the portfolio at a price of 100 just before balance sheet date and sell it back to the original holder for the same amount a couple of days later.  Thereby, the losses would never be discovered.  This activity was a very closely guarded secret.

What eventually happened?  One reporting period, a company decided that selling a portfolio worth 10 for 100 was a great deal.  So it refused to accept back the “hot potato” it had tossed to the other firm.  The whole fraudulent scheme quickly became public.

Maybe this is where Lehman got the idea.  After all, it was around in Japan at the time.

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