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Lehman autopsy spotlights the fascinating 'Repo 105'

Published:Thursday | April 1, 2010 | 12:00 AM
Barclays Capital logos are seen on the former Lehman Brothers building, Tuesday, September 23, 2008, in New York. Lehman's filed for Chapter 11 bankruptcy in September 2008.
Wilberne Persaud, Financial Gleaner Columnist

The Valukas report - post-mortem really - of the Lehman Brothers meltdown is the hottest attraction for Wall Street watchers and analysts interested in the shape of an effective regulatory regime for the post-September 2008 landscape.

As expected, the feature attraction of the March 11, 2010 report has been the 'Repo 105', a repurchase agreement with a stinging twist in the tail.

It was used several times in 2007 and at least twice in 2008 prior to Lehman's fateful mid-September, midnight collapse.

The normal repo sees a firm going to market with collateral in exchange for upfront cash.

An undertaking is made to repurchase the collateral as quickly as overnight or, at most, in a few days.

The Repo 105 was different: US$49 billion collateral pledged would be repurchased at 105 per cent of the original deal. In addition to the 5.0 per cent top-up, accrued interest was also paid.

Counter parties in Repo 105 transactions included Britain's Barclays, which Lehman courted as a buyer in mid-September 2008, UBS of Switzerland, KBC Bank of Belgium and Mitsubishi UFJ Financial Group of Japan.

This was very lucrative business for all, but smelling like barely if at all legal, Ponzi dealing. Lehman was taking a sharp haircut for this facility. Typically it allowed seven to 10 days to elapse before repurchase.

The big benefit was that instead of showing a loan of US$49 billion, its balance sheet could boast cash or reduced liabilities of US$49 billion and a healthier picture of leverage.

The practice was begun in 2001 when Linklaters, one of London's Magic Circle law firms - top four or five - opined that Lehman could treat such a transaction as a sale even though it could not do the transaction in the United States, but had to do it through its European office, Lehman Brothers International.

Sounds like 'torture memos'

Fact is, Lehman could not find a US law firm that would give such an opinion. Linklaters, however, specified that its opinion held only under English law.

This sounds so much like the now infamous 'torture memos' that US Justice Department staff created regarding Guantanamo Bay detainees: seek a justifying opinion; if it doesn't exist, reverse engineer it.

Securities slated for Repo 105 had, therefore, to be transferred to the broker-dealer in Europe to effect the transaction.

The 'technical' and distinguishing difference appears to be that more than the original contract value swap was being repurchased - the law does have that uncanny ability to promote and host, a normally illicit romantic waltz, a dance on pinheads.

We might recall that in the mid-1990s, our own Jamaica Mutual Life Assurance Society wished to hold National Commercial Bank stock on its books at (historic) purchase price rather than marked-to-market, and our insurance companies purchased high cost short-term commercial paper to maintain bleeding long-term liabilities.

It's not exactly the same but representative of comparable issues.

Boiled down to its essence, like good Jamaican pimento with its combination taste of cloves, juniper berries, cinnamon and pepper, the substance of this matter is also fourfold: truth and transparency in reporting; absence of effective regulatory framework and oversight; capital adequacy; and although some may find it laughable, ethics in business — call it corporate governance if you prefer.

Lehman could have purchased repos considerably cheaper than it did. It incurred punitive additional costs in order to affect, materially, the position of its leverage ratios seen by the public.

Emails unearthed by bankruptcy examiner Aton R. Valukas show Lehman executives fully aware of, indeed deploying these transactions precisely for the impact they had on leverage.

One staffer, emailing a spade as a spade, described the process to a querying colleague as "basically window dressing".

Upon reviewing these materials, the examiner "concluded that colorable claims of breach of fiduciary duty exist against Richard Fuld, Chris O'Meara, Erin Callan and Ian Lowitt (respectively the boss and high level Lehman operatives) and that a colorable claim of professional malpractice exists against Ernst & Young". Serious charges indeed.

Give or take a few days, the investigation took a year and six months. But the comprehensive 2,000-odd-page report justifies the wait and the US system allows immediate publication. Question now is what response?

Politically, it appears the Obama administration has support for comprehensive reform from vast numbers of ordinary people among both Republicans and Democrats. But that is never enough.

John Boehner, House minority leader, in a talk to Wall Street bankers about efforts at regulatory change, urged them not to "let those little punk staffers take advantage of you, and stand up for yourselves".

Financial reform bills

He was referring to Washington's Capitol Hill staff, crafting financial reform bills.

This is amazing. Having benefited from, in reality, trillions of dollars of taxpayer support, Wall Street is urged to consider as 'little punks', the technical people who facilitated the legislative process enabling that support to pass Congress.

It is debatable whether this current Republican position can hold, or even if they themselves will continue to maintain it. But the fact that it has been 18 months since the bailout and that huge bonuses have been paid out based purely on taxpayer support - government capital injection - with no change whatsoever, provides neither encouragement nor comfort.

The public is right to speak of 'banksters' committing robbery without a gun, without even a threatening note.

The four issues will have to be tackled. Unlike in 1929, today we know how to do it.

This is as clear a case, as any, of the power of money in politics. Reliance on ethics is sadly, a non-starter, current regulators all seem to await the day when they can join the pack they are supposed to regulate and capital adequacy appears almost a matter of individual choice after the Glass-Steagall repeal of 1999.

This model embodies, as if through its DNA, a malignant and ever-present cancer. If governments will bail out 'too big to fail' gambling financial institutions, if the upside continues, dedicated to private harvest, while downside losses and drought, generated by behaviours that provide 'colorable' causes of action, fall on taxpayers, then for capitalism to survive someone must confiscate the punch bowl.

It was Adam Smith, who gave us that "invisible hand" providing the greatest good. But he also very quickly let us know that the first thing businessmen will do behind closed doors is collude to defraud the consumer.

Findings of the Lehman autopsy suggest he was absolutely correct.