Repurchase agreements, or repos, have existed since 1917 and play an important role in the short-term liquidity markets. Although the purpose of a typical repo is to provide a short-term loan between two parties, accounting standards have permitted the transaction to be recorded as a sale under certain circumstances. Repos became headline news in 2008 when Lehman Brothers went bankrupt, shedding a light on their particular accounting methods for these transactions. Three years later, the use of repos-to-maturity was blamed for the collapse of MF Global. This article describes how Lehman Brothers and MF Global manipulated and exploited the sale accounting method for repo agreements and the subsequent revisions to accounting standards.
Repos are arrangements wherein one party transfers securities to another for a specified price, along with an agreement to repurchase the securities at a fixed date and amount with interest. The arrangements are short-term, and many are settled within a day. Because the terms are so brief, there is little risk involved, which results in lower interest rates than other types of loans. The Exhibit depicts a standard repo arrangement.
For most repos, the economic substance of the transaction is similar to a secured loan. The cash received for the securities is less than the fair value of the asset and represents the principal of the loan. The difference between the fair value of the asset transferred and the cash received is referred to as the “haircut” in repo transactions. The securities transferred are the collateral, and the amount paid to repurchase the securities represents payment of the principal plus interest at the agreed-upon rate. If the transferor defaults and does not repur-chase the securities, the transferee can sell them to satisfy the obligation.
There are, however, several important differences between repos and traditional secured loans. First, the transferee actually acquires title to the securities on the trade date and has the authority to sell or pledge the assets to another party during the term of the agreement. In addition, if the fair value of the asset declines, the agreement may give the transferee the right to demand more collateral. Finally, the assets returned to the transferor at the settlement date do not have to be the same assets that were originally transferred.
Although the business purpose of most repo transactions is for companies to borrow and lend money, Statement of Financial Accounting Standards (SFAS) 125, issued in 1996, permitted the transactions to be recorded as sales or as loans depending on whether the transferor maintained control of the asset. There were many implementation problems with the standard, and the effective date was delayed until 1998. FASB subsequently revised and replaced the standard in 2000 with SFAS 140, although most of the provisions in SFAS 125 were carried forward without reconsideration. SFAS 140 was in effect when Lehman Brothers developed its sale accounting method.
Sales versus Loans
In order for a repo transaction to be considered a sale, the transferor must have relinquished control. According to SFAS 140, paragraph 9, the transferor would not have control if all of the following conditions were met:
- The transferred assets were isolated from the transferor.
- The transferee had the right to pledge or sell the asset.
- There was no agreement that required the transferor to repurchase the assets before their maturity or permitted the transferee to require the transferor to return specific assets.
Although the business purpose of most repo transactions is for companies to borrow and lend money, Statement of Financial Accounting Standards (SFAS) 125 permitted the transactions to be recorded as sales or as loans.
SFAS 140, paragraph 47, defined an agreement as one that met all of the following conditions:
- The assets to be repurchased were substantially the same as those that were transferred.
- The transferor was able to repurchase them on substantially the agreed terms.
- The agreement was at a fixed or determinable price.
- The agreement was entered into concurrently with the transfer.
If any of the conditions in paragraph 9 were not met, effective control would not be considered surrendered by the transferor, and the transaction would be recorded as a secured loan on the initiation date of the agreement. The following journal entries provide such an example:
Note: Assumes that securities with a fair value of $100 were transferred to the lender. The transferor receives cash for 98% of the fair value, representing a haircut of 2%. The assets would continue to be reported by the transferor although classified separately from other assets. The liability would be repaid at the settlement date, along with interest at the agreed-upon rate.
If all of the conditions in paragraph 9 were met, the transaction would be recorded as a sale with a forward repurchase/resale agreement between the two parties. The assets would be derecognized by the transferor and recorded at fair value by the transferee, as shown in the following journal entries:
|Forward Repurchase Commitment||2|
|Gain on Sale of Securities||5|
|Forward Resale Commitment||2|
Note: Assumes that securities with a book value of $95 and fair value of $100 were sold to the transferee. The gain is the difference between the book value of the assets and the fair value (sales price). The transferor receives cash for 98% of the fair value, representing a haircut of 2%. The difference between the fair value of the asset and the cash received/paid represents the repurchase/resale agreement. Because the underlying purpose of most repurchase agreements is to borrow or lend money, recording the transaction as a sale historically allowed for off-balance sheet financing by the transferee.
Lehman Brothers and Repos
Lehman Brothers had been involved in repos for many years and had always accounted for them as secured borrowing arrangements. In 2001, however, to reduce its leverage ratio and improve its balance sheet, it designed a new approach to recording repos as sales, allowing it to temporarily obtain cash without recording a liability. Under the conditions of SFAS 140, paragraph 9, the transaction had to be structured so that the assets were isolated, the transferee had the right to pledge or sell the assets, and there was no agreement to purchase the assets.
Lehman used this brief, but very specific, guidance to create agreements that would fall outside of FASB’s bright-line guidance for “substantially all” and therefore could be accounted for as sales.
Although the accounting standards did not specifically require a legal opinion that a repo agreement was a sale in legal terms, companies usually obtained one to satisfy auditors that the assets were isolated from the transferor and its creditors in the event of bankruptcy. No American law firm would provide Lehman with such a statement; instead, it had to employ Linklaters LLP in London, which stated that the transaction represented a true sale only under English law. Therefore, the transactions had to be executed by Lehman Brothers International in Europe, with European banks as transfer-ees. The consolidated financial statements of Lehman Brothers Holdings Inc. that included these transactions were, however, filed in the United States.
Demonstrating that there was no agreement to repurchase the assets was another complication, Lehman focused on the provision requiring the transferor to be able to do so on “substantially the agreed terms.” This required the transferor to have obtained cash or other collateral sufficient to fund substantially all of the cost of purchasing other assets. FASB had not provided a detailed explanation for the phrase “substantially all.” The implementation guidance in SFAS 140, paragraph 218, however, stated in part:
Judgment is needed to interpret the term substantially all and other aspects of the criterion that the terms of a repurchase agreement do not maintain effective control over the transferred asset. However, arrangements to repur-chase or lend readily obtainable securities, typically with as much as 98 percent collateralization (for entities agreeing to repurchase) or as little as 102 percent overcollateralization (for securities lenders), valued daily and adjusted up or down frequently for changes in the market price of the security transferred and with clear powers to use that collateral quickly in the event of default, typically fall clearly within that guideline. The Board believes that other collateral arrangements typically fall well outside that guideline.
Lehman used this brief, but very specific, guidance to create agreements that would fall outside of FASB’s bright-line guidance for “substantially all” and therefore could be accounted for as sales, designing them so that the value of the assets transferred was 105% of the cash received for fixed income securities and 108% for equity securities. These became known within the company as Repo 105 and Repo 108.
During the housing boom, Lehman had acquired several mortgage lenders. When the housing market began to collapse in 2007, Lehman and other similar firms recorded huge losses in write-downs of subprime mortgages. At the same time, investment banks, including Lehman, were advised to reduce their leverage to avoid ratings downgrades. Instead of selling assets and using the money to pay down its debt—which the growing financial crisis made both difficult and costly—Lehman increased its use of Repo 105 and 108 transactions. It would enter into transactions near the end of each quarter and make repayment—using borrowed money—at the beginning of the next period, usually within seven to ten days. The assets would be removed from the books and the cash used to pay down other short-term debt, reducing its leverage ratio on quarterly and annual reports. Upon repayment, the assets and liabilities would be put back onto the books, and the leverage ratio would increase to the pre-transaction levels. The trades ranged from $39 billion to over $50 billion from the end of 2007 through the second quarter of 2008.
These transactions were material and should have been disclosed in the notes to the financial statements. Instead, Lehman not only failed to disclose the transactions; it reported that all repurchase agreements were accounted for as secured borrowing arrangements. It also failed to disclose any off–balance sheet arrangements in its management’s discussion and analysis, as required on all quarterly and annual reports.
The housing market continued to decline, and in the second quarter of 2008 Lehman reported its first loss since going public in 1994. Banks refused to extend lines of credit, and, without cash, Lehman was unable to continue operating and filed for bankruptcy on September 15, 2008. The Repo 105 and 108 transactions were not the sole cause of the bankruptcy; however, they helped disguise the actual financial position of the company for over a year. Anton Valukas, the court-appointed bankruptcy examiner, stated in his 2010 report that it was clear that the executives engaged in these transactions for the sole purpose of improving the balance sheet and leverage ratios. Lehman’s own executives referred to these transactions as a “gimmick” and a “lazy way of managing the balance sheet.” Lehman may not have violated the letter of the accounting standards, but it definitely violated their intent by materially misleading financial statement users.
Revisions to Accounting Standards after Lehman’s Bankruptcy
In June 2009, FASB issued SFAS 166, Accounting for Transfers of Financial Assets, which was codified as Accounting Standards Codification (ASC) Topic 860, “Transfers and Servicing.” The new standard modified some of the language in paragraph 9 of SFAS 140 to include all entities in the transferor’s financial statements as part of the analysis of effective control of the assets. It also eliminated the concept of a qualifying special-purpose entity and modified the financial-components approach of SFAS 140. The revisions did not, however, specifically address paragraphs 47 and 49 (subsequently ASC 860-10-40-24b). It also did not eliminate paragraph 218 (subsequently ASC 860-10-55-37); in fact, the codification provided a link to it, stating in part, “See paragraph 860-10-55-37 for implementation guidance related to the term substantially all.” The focus of the new standard was the criteria that had permitted companies to keep entire entities off the balance sheet rather than the type of repo transactions created by Lehman. It did add significant disclosure requirements lacking in SFAS 140.
In April 2011, FASB issued ASU 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements, to deal with the Repo 105/108 issue. It eliminated the criterion of whether the transferor can repurchase the assets on the agreed-upon terms from the assessment of effective control. This also eliminated the related guidance concerning having enough cash to redeem substantially all of the securities in the initial agreement, as well as the “substantially all” bright-line definition used by Lehman. The remaining criteria were left unchanged.
These revisions dealt with agreements that settled before the maturity of the securities. The changes made it more difficult for companies to construct transactions as sales when effective control had not really been transferred to the other party, but did not apply to repurchase agreements that settled at maturity, leaving an opening for further abuse.
MF Global and Repos-to-Maturity
When Jon Corzine became CEO of MF Global in 2010—after losing his reelection bid for New Jersey governor—the company had not shown a profit in over four years and had a credit rating only two steps above junk status. Rating agencies told Corzine that the company needed to increase revenues by at least $200 million or face further downgrades. MF Global had generated much of its revenue from interest income, and when the Federal Reserve dramatically cut interest rates in 2008, that revenue dropped sharply. Since interest rates were not expected to increase in the near future, Corzine began to initiate trades on sovereign debt issued by European countries experiencing financial difficulties, believing that the market overestimated the countries’ risk of default and the securities were therefore undervalued. Because revenue needed to be generated quickly, the trades were structured as repo-to-maturity (RTM) agreements.
It does not appear that MF Global misused or manipulated accounting standards when record ing RTM transactions.
In an RTM, the timing of the settlement matches the maturity of the security, allowing the transferee to either return the security to the transferor or redeem it from the issuer. Most RTMs are settled by a net cash payment on the maturity date. Because the transferor does not reacquire the asset, accounting standards deem control to be surrendered, and therefore a sale is recorded on the date the trade is initiated. Profit is recorded on the date of the sale, and the security is removed from the transferor’s accounting records, eliminating subsequent income statement effects related to changes in market values. Because the securities MF Global bought were issued by countries experiencing financial distress, there was a higher risk of future declines in market value when compared to other types of securities, and derecognizing the securities eliminated the risk of recording any future losses.
MF Global purchased the securities at a discounted price through its U.K. subsidiary, MFGUK, then repoed them back to MFGUK, which then initiated another repo transaction with the London Clearing House (LCH). This latter transaction was also treated as an RTM, although the actual term was for two days shorter than the maturity date of the bonds, as LCH did not want the risk of default on the maturity date. Accounting standards did not define “before maturity,” but stated that an agreement would not be considered a redemption before maturity if the time period was so short as to prohibit the transferor from selling the financial asset again (ASC 860-10-55-51). In addition, there was no requirement in the accounting standards to record an allowance for potential default. Therefore, MF Global recorded a gain on the date of the latter RTM as the difference between the original discounted purchase price by MF Global and the RTM sale price to LCH.
By early October 2011, these RTMs had produced $124 million in upfront gains. MF Global was still responsible, however, for covering the margins for any declines in the market value of the securities. As fears of default increased, the required margins also increased, and MF Global had to find additional sources of cash to meet them. This need for cash ultimately resulted in the misappropriation of millions of dollars from customer accounts, and the company filed for bankruptcy on October 31, 2011.
Revisions to Accounting Standards after MF Global’s Bankruptcy
It does not appear that MF Global misused or manipulated accounting standards when recording these transactions. Instead, by allowing profits to be recorded upfront, the standards provided the incentive for MF Global to engage in risky RTMs. In March 2012, FASB therefore announced plans to revise the repo agreement standards. It found that users did not consider standard repos-before-maturity and RTMs to be substantively different instruments. Users also indicated a need for additional disclosures related to the liquidity risk profile of the transferor. ASU 2014-11, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures, was issued in June 2014. A detailed discussion of the new guidance appears in “Changes to Accounting for Repurchase Agreements” on page 50 of this issue.
The updated standards responding to the Lehman Brothers and MF Global bankruptcies are now in effect for all companies. While their long-term effects have yet to be seen, certainly FASB hopes that they will prevent such massive failures in the future. History shows, though, that if a loophole exists, eventually someone will find and exploit it. Only time will tell whether replacing the exploited brightlines with more principles-based guidance will solve the underlying problems or merely open the door to new ones.