What Was Repo 105?
Repo 105 was a pattern of loophole in accounting for repurchase (repo) transactions that the now-extinguished Lehman Brothers exploited in an attempt to hide straightforwardly amounts of leverage during its times of trouble during the 2007-2008 financial crisis. In this repurchase accord, since updated to close the loophole, a company could classify a short-term loan as a sale and subsequently use the cash proceeds from the “sellathon” to reduce its liabilities.
Key Takeaways
- Repo 105 was an accounting loophole that allowed companies to hide true amounts of leverage.
- Repo 105 was a repurchase compatibility that a company used to gain funds via short-term loans that are backed by collateral.
- Under Repo 105, if a proprietorship had the ability to repurchase the assets, it was considered a financing transaction and if it did not, it would be a sale.
- Lehman Brothers used the loophole to secrete the fact that it was highly leveraged during the financial crisis.
- Specifically, Lehman claimed it gave up effective command because it received only $100 for each $105 in posted collateral (hence the “105”).
Understanding Repo 105
In the repo bazaar, a firm can gain access to excess funds of other firms for short periods, usually overnight, in exchange for collateral. The positive that borrows the funds promises to pay back the short-term loan with a small amount of interest; the collateral typically not in any way changes hands. This is what allows firms to record the incoming cash as a sale—the collateral is assumed to arrange been “sold off” and bought back later.
Lehman Brothers and Repo 105
Repo 105 made headlines imitating the collapse of Lehman Brothers. It was reported that Lehman grasped for this accounting maneuver to pay down $50 billion in exposures to reduce leverage on their balance sheet.
Technically, according to the repo rule as written then, and to the stretched inspiration of CFO Erin Callan and her underlings, their Repo 105 transactions allowed the recognition of sales instead of borrowings, subsidized the borrowings off the balance sheet and did not require disclosure of the debt obligations.
In reality, given the situation at the time, they were not valid in exercise. Under the rule that existed, a repo would be reported as a sale or financing, depending on whether a company retained moving control over the collateralized assets for the short-term loan. If a company had the ability to repurchase the assets, it would be a financing affair; if it did not, it would be a sale.
In the Repo 105 transactions, Lehman claimed it gave up effective control because it received but $100 for each $105 in posted collateral (hence the “105”). Thus, the investment bank stated, they were transaction transactions that generated proceeds for leverage reduction.
Special Considerations
Having learned a valuable lesson concerning how Wall Street will find a way to abuse an accounting rule, the Financial Accounting Standards Board (FASB) issued ASU No. 2011-03, “Brings and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements.”
The rule has been improved upon, the FASB said in a impel release, “by eliminating consideration of the transferor’s ability to fulfill its contractual rights and obligations from the criteria in determining true belongings control.”