In observance of the 5th anniversary of the Lehman bankruptcy filing, we are putting together a series of posts with the top securities financing lessons learned from the events leading up, during, and afterwards. These lessons were crowd sourced from friends in the industry, distilled by us, and presented to you. Comments are absolutely encouraged. They are in no particular order of importance.
The first issue we will address is Lehman 105. This was the scheme designed to reduce balance sheet by characterizing repo transactions as true sales. Analysts looking at Lehman’s financials thought they understood what they were seeing. But Repo 105 made figuring out Lehman’s balance sheet, leverage, and ultimately risk, virtually impossible. Only no one knew they were looking through smoke and mirrors until after the fact. Lehman’s auditors and outside counsel, it has been reported, blessed the arrangement.
Repo 105 was an unfortunate reminder that accounting rules seem to be more about spinning them in one’s favor than actually abiding by the spirit of the rule. No one is denying that accounting rules can be vague and open to interpretation, but Repo 105 seemed a bridge too far. The press continues to beat the drum on this, wondering why five years later we haven’t seen prosecutions. Was it cooking the books or a legitimate loophole? It may not have been what cratered Lehman, but the risk that was obscured meant that Lehman was a tinderbox. And if they were so vulnerable, who else was in the same boat?
The primary lesson from Repo 105 is while creativity is fine, obfuscation is not. Repo 105 can be seen as a cautionary tale in the debate on why uncomplicated and concise rules are so powerful. Using simplified leverage ratios instead of every-man-for-themselves RWA based rules is so appealing precisely because (the hope is) it will prevent another Repo 105-type debacle. Will every bank apply the rules exactly the same way all the time? Probably not. And how can they — every business is different. But trusting that comparing one set of financials to another isn’t apples to orangutans is crucial. The irony is that simple leverage ratios could, as they are envisioned, make repo much less and less attractive as a business as more capital is required and spreads need to widen to maintain profitability.
A combination of the Financial Stability Board’s Trade Repositories and netting rules for Basel III’s Leverage Ratio will probably reduce the fog of repo. But the lesson of Repo 105 is that accounting rules can hide a host of sins at a financial services firm. As Basel III and Dodd-Frank go to pains to get right, the point here is transparency.