Repo Tricks

Brokers dealers and investment banks get a substantial amount of their funding from the repo market. In a typical repo, party #1 (the borrower) gets funds from selling securities to party #2 (the lender); when the repo matures the transaction is reversed: party #1 repurchases the securities by paying party #2 the initial funds plus interest (the repo rate).

To protect the lender, the funds initially received by the borrower are less than the market value of the securities used as collateral. The difference, reflecting the credit risk of the repo borrower and the volatility in the prices of the securities, is commonly referred to as the haircut. To make matters straight, a repo contains bilateral credit risk for both the lender or the borrower might default.

U.S. accounting standards determine that repos be treated as secured financing (FAS 140, §218) in the case of arrangements to repurchase or lend securities typically with as much as 98 per cent collateralization (for entities agreeing to repurchase) or as little as 102 per cent overcollateralization (for securities lenders). In secured financing the loan is reported by the borrower as a liability, while the funds received go to the asset side of the borrower’s balance sheet. More important, in secured loans, the securities remain in the books of the borrower. The idea is that the borrower maintains control of the collateral because it has received sufficient funds to repurchase the securities even if the lender defaults.

The problem is that setting an interval [98-102] opens the opportunity for dubious accounting. Suppose that a borrower agreed to a $1M repo with a haircut higher than 2 per cent for liquid fixed income securities, say 4 percent. Then, it would be judged as not having received sufficient funds to repurchase the securities. The repo transaction would then be reported as a sale of securities plus a forward contract to repurchase for $1M securities valued at $1.04M. The sale of securities would be recorded as a credit entry for $1M in cash, but no associated loan. The repo does not increase the liabilities. Furthermore, the cash can be used to pay off additional loans.

This is how an increase of $1M in liabilities can show up in the books as a reduction of $1M in liabilities. According to the Valukas report (2010) this is how Lehman systematically deceived the markets.[1]


[1] See “Hidden debt: From Enron’s Commodity Prepays to Lehmon’s Repos 105s”, Donald. J. Smith, The Financial Analysts Journal, October 2011.

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