What Was Repo 105?
Repo 105 was a type of loophole in accounting for repurchase (repo) transactions that the now-extinguished Lehman Brothers exploited in an attempt to hide true amounts of leverage during its times of trouble during the 2007-2008 financial crisis. In this repurchase agreement, 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 "sale" to reduce its liabilities.
- Repo 105 was an accounting loophole that allowed companies to hide true amounts of leverage.
- Repo 105 was a repurchase agreement that a company used to gain funds via short-term loans that are backed by collateral.
- Under Repo 105, if a company 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 hide the fact that it was highly leveraged during the financial crisis.
- Specifically, Lehman claimed it gave up effective control because it received only $100 for each $105 in posted collateral (hence the "105").
Understanding Repo 105
In the repo market, a firm can gain access to excess funds of other firms for short periods, usually overnight, in exchange for collateral. The firm that borrows the funds promises to pay back the short-term loan with a small amount of interest; the collateral typically never changes hands. This is what allows firms to record the incoming cash as a sale—the collateral is assumed to have been "sold off" and bought back later.
Lehman Brothers and Repo 105
Repo 105 made headlines following the collapse of Lehman Brothers. It was reported that Lehman grasped for this accounting maneuver to pay down $50 billion in liabilities to reduce leverage on their balance sheet.
Technically, according to the repo rule as written then, and to the stretched imagination of CFO Erin Callan and her underlings, their Repo 105 transactions allowed the recognition of sales instead of borrowings, kept 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 practice. Under the rule that existed, a repo would be reported as a sale or financing, depending on whether a company retained effective 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 transaction; if it did not, it would be a sale.
In the Repo 105 transactions, Lehman claimed it gave up effective control because it received only $100 for each $105 in posted collateral (hence the "105"). Thus, the investment bank stated, they were sale transactions that generated proceeds for leverage reduction.
Having learned a valuable lesson about how Wall Street will find a way to abuse an accounting rule, the Financial Accounting Standards Board (FASB) issued ASU No. 2011-03, "Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements."
The rule has been improved upon, the FASB said in a press release, "by eliminating consideration of the transferor's ability to fulfill its contractual rights and obligations from the criteria in determining effective control."