Good Math, Bad Math

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I’m glad to report that electricity has been restored to the Chu-Carroll
household. So now I’m trying to catch up.

During the outage, I got a bunch of questions about the latest news coming
out of the big financial disasters. A major report came out about the failure
of Lehman Brothers, and one thing that’s been mentioned frequently is
something called repo105.

The whole repo105 thing is interesting to me, not so much because of what
it actually means, but because of how it’s been reported. The term has been
mentioned everywhere – but trying to find any information about just what the
hell it means seems to be next to impossible. It’s absolutely amazing how many
places have reported on it without bothering to explain it.

Let’s start with the basics: what’s a repo? Before getting questions about
this from you folks, I had no idea. The only way I’ve ever seen the term
before was reposession – as in repo-men – the nasty people who come to take
stuff away from you if you miss payments. In financial circles, a repo is a
repurchase agreement.

A repurchase agreement is, effectively, a kind of short-term loan. Suppose
that you’re a bank. Today, you’ve got $1000 worth of investments, and $500
worth of cash on hand. You’ve previously made a loan of $1000 to someone which
is due to be repaid tomorrow – so tommorow, you’ll have $1500 worth of cash.
But you’ve got a contract that requires you to pay $750 to someone else today.
You don’t have the cash to make the payment. And you don’t want to sell your
investments just to cover you for 24 hours. So what you do is take $250 worth
of your investments, and sell them to someone under a contract that specifies
that you’ll buy them back tomorrow for $260. The “buyer” doesn’t really own
the stuff you sold them; they’re not allowed to sell it to anyone else. It’s
really just collateral on a loan: you’re really borrowing $250 from them, with
a promise of $10 worth of interest for the loan. The property is just
collateral. That kind of a loan is called a repo.

So far, there’s nothing remotely questionable about this. It’s a perfectly
reasonable thing to do. Large financial companies have huge numbers of
contracts with different timings; getting everything timed properly is
frequently impossible without the use of short-term loans to cover gaps. And
in fact, there are variants of this that get used by individuals all the time.
For example, when my wife and I bought our current house, we were also selling
our old house. The contract on the new house specified a close date
before the closing on our old house. Since we were using some of the
money from selling the old house to make the downpayment on the new one, we
had a problem. So we took a loan against the equity we had in our old house,
and used it to cover the downpayment in that gap. In financial terms, what we
did was effectively the same thing as setting up a repo on our home
equity.

Where things start getting tricky is when you look at the interaction
between repos and financial statements. Large institutions have to
periodically file statements describing where their money is. They need to
account for all of their property and what it’s worth. If some piece of
property lost value, then they need to report that.

So, what happens if you’ve got a repo? Theoretically, you’ve sold the
property in exchange for cash. But you’ve also got a contract to re-buy it. So
if it’s worth less than you’ve claimed in the repo, then you’re still on the
hook for the difference. On the other hand, there are all sorts of incredibly
complicated contracts that involve buying and selling different things at
different times. So the laws on reporting set up a standard for
differentiating a repo from a simple sale that’s part of a more complicated
contract.

It turns out that the legal distinction is based on how much money you get
for the property. After all, if it’s collateral, you’re putting up $100 worth
of collateral to secure $100 worth of loans: why would you put up more
collateral than you needed to? So if you set up a repo with $105 dollars worth
of collateral for a $100 loan, then legally, you can treat it as a
sale (at a loss) of the property you’re using as collateral.

So, a repo105 is a repurchase agreement where you borrow $100, using $105
worth of property as collateral. Then you can, in your financial statements,
put that down as a sale with a roughly $5 loss. But why would you want to do
that?

Finally, we get to the sleaze. Suppose that you’ve got $100 worth of CDOs
- that is, those href="http://scienceblogs.com/goodmath/2007/12/the_total_stupidity_of_crowds.php">stupid
compounded mortgage bonds that we talked about last year. Those bonds are
close to worthless. They’re garbage. If you own them, then you need to mention
them in your financial statements, and you need to estimate just how much you
lost on them. That can make you look really bad. No one wants to look
bad – especially not when looking bad could make the difference between having
your company go into bankruptcy today before you get your bonus, versus next
year, after you get your multi-million dollar bonus.

So, here’s what you do. You wait until just before you’re
required to issue your financial statement. Then, you set up a repo of the
things that you don’t want to show in your books. They’re garbage – so you
can’t really sell them. But if you do a repo105, then you can claim
to have sold them. And instead of losing 80 or 90 percent of their value, you
lost a measly four percent. No biggie there. So you do the repo, and you do it
for a term of 7 days.

Now, since you “sold” them, you don’t need to mention them in your
financial statements. You don’t need to talk about how much money you’re on
the hook for with those. After all, you sold them for close to 96% of their
face value! They’re off your picks. Any liability you have from owning them,
you’ve just erased. Poof! They’re gone.

So that’s the scam. Yes, it’s a bit complicated. Or actually, it’s very
complicated. But the basic concept is really simple: you temporarily get rid
of something that would appear as a debt, by pretending to sell it at
a loss. And yet, if you look at most of the articles about this, you’ll see
lots of mentions of the term “repo105″, and some mumble about how
they were using repo105 to shift some losses off the books, but
the overwhelming majority never actually explain just what the hell the 105
was really about.

Comments

  1. #1 Adam
    March 19, 2010

    Nice explanation here as well.

    http://marketplace.publicradio.org/display/web/2010/03/12/whiteboard-repo-105/

    Gotta love Patty Hirsch.

  2. #2 Jake Wildstrom
    March 19, 2010

    Your explanation is excellent, but I have a couple of (probably dumb) questions about it:

    (1) is there a penalty besides seizing the collateral for failing to go through with the repurchase? I thought that was why this sort of arrangement was usually collateralized with something equal in actual value to the loan, specifically to keep the original seller from just taking the money and running. And doing so in this case would allow the institution selling them to _actually_ realize a mere 4% loss by simply reneging, leaving the buyer with the useless CDOs.

    (2) why would any buyer agree to hold these things, even for a short while? Yes, they presumably make a modest profit on the loan, but between implication in the seller’s own asset-laundering, the risk of being left holding the bag (see point 1, above), and having to put them on their own financial statements, is it actually worth the risk to them?

  3. #3 Joe Shelby
    March 19, 2010

    Why would the buyer take them? Because maybe he doesn’t have to report his numbers at the same time. The whole point of this is temporarily hiding the dog crap. I hold on to your paper full of crap for a week, and you pay me for it, then you take the paper crap back, I walk away with a little interest, and you can do something else with the paper crap rather than be caught with it the week you really shouldn’t.

    The thing is, this stuff is still worth something on paper until you actually try to sell it for real, or it gets listed in the end-of-whatever reviews (as described above), THEN it gets actually looked at in a detailed audit and the level of its worthlessness becomes clear.

    This is much like the mortgage-backed securities MCC discussed last year – they are worth what you feel like you claim they are worth until someone else becomes responsible enough to decide otherwise.

    Many of these today are likely in the commercial real estate sector, where the collapse on a scale trouncing the home loans has, behind the scenes, already happened (it killed Greenpoint Mortgage for example), but everybody else is playing the games with the numbers to keep the system from noticing for as long as possible until enough money gets back into the system to prop their value back up.

    So on the one hand, it is utterly corrupt. On the other hand, if we can keep lying about the value of these things long enough (through this kind of obscurity), something else of real value will come in to support them to the point where it is no longer a market-shaking loss to have them actually audited…that is, unless that something else bubbles and needs its own mess cleaned up.

    How are the tulips this season, anyways?

    I can’t answer the first question, what are the other penalties, though I surmise it is a level of trust that the system just has to have or it doesn’t work at all, possibly in the scratch-my-back sense.

  4. #4 Crankenstein
    March 19, 2010

    @jake#2: I would imagine that the agreement to repurchase does not allow the seller to just take the money and leave. Normally the asset would be collateral in the event that the seller can’t afford to buy it back. In this case I think that they are likely to use some other means to ensure that the seller can afford to repurchase the asset. Maybe they’ll mix in some assets that the seller can’t afford to loose.

  5. #5 Mark C. Chu-Carroll
    March 19, 2010

    @2:

    (1) Yes, there’s a penalty for not repurchasing. Remember that despite all appearances, this is a loan. Large financial firms absolutely rely on their ability to borrow money when they need it. If they were cut off from access to short term loans, they’d be out of business and bankrupt overnight.

    So they can’t back out on the contracts – because doing that is defaulting on a loan, and once they default on one of the loans, they’ll never get another one. That’s effectively a death sentence for the company.

    (2) The “buyer” has no reason to be concerned. As I said in answer #1, they know that the borrower isn’t going to stick them with bad assets. They’re going to make a tidy profit for doing absolutely nothing. And they don’t need to worry about the bad stuff on their books – different companies issue their reports at different times. These things only last a couple of days, so as long as they’re not publishing their reports on the exact same days, it’s easy enough to arrange that the bad stuff never shows up on anyone’s reports.

  6. #6 Omega Centauri
    March 19, 2010

    (5) It sounds to me like juggling hot potatoes. You can avoid being burned by keeping them in the air, but if you are ever forced to step its gonna burn.
    So for your number (2) in comment 5, is the buyer really proteced? What if the seller (in this case Lehman) implodes during the breif time your holding the worthless product? Can you get stuck with the loss? When Lehman did implode, I thought the larger issue was the effect on counterparties (i.e. people who had dealings with Lehman, that were now in danger of not being honouered).

  7. #7 Gerard Hurley
    March 19, 2010

    Dear Mr Chu-Carroll

    I don’t think it’s correct to say that “you borrow $100, using $105 worth of property as collateral. Then you can, in your financial statements, put that down as a sale with a roughly $5 loss.” In fact Lehmans weren’t booking a loss on ANY of these Repo 105 deals. They were exchanging a security worth 105 for cash of 100, but they had the right to buy back the security for 100. If somebody is going to sell me an asset worth 105 for 100, then I can sell it and make an immediate gain of 5, so I’ve got an asset (a derivative) worth 5. So the way Lehmans accounted for it, they were exchanging a security worth 105 for cash of 100 and a derivative asset of 5. No gain, no loss.

    They also weren’t selling CDOs, or any rubbish like that. They were using high-quality securities – government bonds and the like. The reason why “Repo 105″ was still an expensive thing to do is that they could have done an ORDINARY repo with the same securities: exchanged 100 bonds for 100 cash, due in 5 days, and been charged market rates (say 3%). If they’re offering 105 of bonds for 100 cash, the counterparty knows that there’s something funny going on (whether or not it understands exactly what), and charges them well above market rates.

    The question then is how on earth does this transaction get to be a sale rather than a loan? The video linked to points out that there’s some numerology in US accounting standards whereby if you overcollateralise this sort of deal by 102 or more, then it MIGHT be a sale. (I think I understand the accounting issue, but won’t try to explain). But it also needs to be a “true sale” in a legal sense, which depends on the laws of a particular jurisdiction, and how they interact with specific contractual terms. It seems that, under Lehman’s standard terms and conditions, this kind of repo WASN’T a true sale if it was done anywhere in the US, but it was if they did it in London. Which is odd, because the legal systems aren’t all that different.

    If I get to the bottom of this, I’ll give you an update.

    Kind regards

    Gerard Hurley

  8. #8 jules
    March 20, 2010

    A longer term version of a repo is what a short seller does, right?

  9. #9 Matt
    March 20, 2010

    I think you may be getting some of the details a little wrong.

    From what I understand, the 105 part implies that the collateral you use to guarantee the loan is worth more than 105% of the value of the loan. When the repo opens, you get cash and the other side holds your collateral. When it closes, you return the cash plus interest and the other side releases your collateral.

    I am not sure what collateral that Lehman was using, it wouldn’t make sense for them to use high quality debt like Treasuries as they could easily sell those for the value that they were on the books. I am guessing that they used less liquid investments like junk bonds or mortgage backed securities that could not be sold without taking a large loss on them.

    Even still, the transaction was not done to hide the possible drop of value in these assets but rather to make it look like Lehman did not own so much debt. Thanks to fuzzy accounting and the nature of the market, Lehman could have continued to list these assets on whatever price they thought was reasonable and thus show no loss. It is hard to get a good price on these assets, even today. You can rely of models (which is what was happening several years ago) but if you made a mistake in your model the price would be wrong. Or you could rely on 3rd party sources but the values you get from these sources can be widely different – one source could tell you 20 and another would tell you 50.

    At the end of the day, the only price that matters is the one that someone is willing to pay you to buy the asset and that was the problem. As long as people were buying, you could hope to sell the asset. But as soon as the financial crisis started, people stopped buying these assets and the only way to get rid of them to sell them to someone who would give you pennies on the dollar.

    These investment were worth more than pennies (but still less than the price they were marked at) yet Lehman needed to to raise cash to make it seem like they had not borrowed so much money. Hence this repo which allowed them to move these assets off their books for a short time. This was, without a doubt, a stupid thing to do.

    The best explanation of the repo 105 thing I have seen is here –

    http://www.npr.org/blogs/money/2010/03/repo_105_lehmans_accounting_gi.html

  10. #10 GMHurley
    March 20, 2010

    Matt -

    The collateral that Lehman were using was all investment grade stuff traded on liquid markets, and had to be for at least three reasons: (1) the counterparty wants liquid collateral that can be realised immediately if the seller fails to repurchase (2) only high grade stuff could be used at 105% (junk bonds or RMBS, if anyone would take them at all, would have to be overcollateralised way more than that – 150% or more) (3) the accounting treatment depended on the instruments in the repo being highly liquid so that they were fungible, and you wouldn’t necessarily be repurchasing exactly what you sold (after all, if you purport to sell an asset and then a few days later get back the EXACT SAME asset, then it looks very much as though all you’ve done is rent it out, not lose control of it, whereas if you sell 100 worth of US gov’t bonds, what you buy back is bonds WORTH 100 – they may have different maturities and coupons – and the counterparty is taking market risk, because it may take a loss on the bonds it bought from you before it has to deliver equivalent value back to you).

    Further to my previous comment, about getting a “true sale” in London, the report doesn’t give any detail about this that I’ve found, but the Examiner is clear that he’s not addressing whether the legal opinion or the accounting were CORRECT or not. His argument is that Lehman’s failure to disclose/explain what they were doing was in itself misleading to investors. (In fact, the accounting treatment depends on the assets in a repo being “isolated”, which seems to mean that, if the seller goes bust before repurchasing, the liquidator can’t recover the asset from the purchaser by unwinding the trade. There must be all sorts of differences between US and English law about what transactions a liquidator can potentially nullify.)

    Kind regards

    Gerard Hurley

  11. #11 Matt
    March 21, 2010

    Gerard,

    I finally got around to reading the actual report and you are correct, the securities involved in the 105 repos were investment grade securities.

    The purpose of the transactions was to improve the balance sheet, and if you refer to illustrations 1-5 (pg 752,753,754,758,760) in the report ( http://lehmanreport.jenner.com/VOLUME%203.pdf ) you can get a good feel for exactly what these transactions did.

    On a related note, if you look at page 740, you will see the answer to your questions about why these transactions were done in London. Simply put, Lehman couldn’t find a US based law firm that would sign off on the treatment but found one in London what would.

  12. #12 Jérôme ^
    March 23, 2010

    So a “simple” fix to end this scam would be to require that all companies publish their reports at the same date. It needs to be done globally, of course, else the bad assets will migrate seasonally just like birds do. This is why it is not so simple: a country that « cheats » on this by allowing reports at a different date would have its banks able to make profit by buying repo105s. But a weapon to use against such countries/banks would be (as in #2 above) to (threaten to) defect on the repurchase itself, and adapt local law to make litigation harder when coming from a « cheating » bank.

    (I’m not sure of the extent of the phenomenon, so at this point I may be casting « Summon Sledgehammer III » to crush a tiny bug…)

  13. #13 Hephaestus
    March 23, 2010

    Mark, you wouldn’t happen to have any of the fun, good math promised in your subtitle, would you? It’s a little depressing to think about all of the ways that we’re surrounded by crooks and cranks.

    Practical uses for eigenvectors, new search algorithms, and simulated annealing are all areas about which I’d love to read some of your insights. Of course, if there is some crank who’s used simulated annealing to steal millions, I’d be open to entertaining other topics, instead.

  14. #14 Richard G Brown
    March 24, 2010

    A good explanation but it sort of misses the key point.

    Lehman were not really doing this to hide the writedowns on the dodgy assets. Rather, they were trying to reduce their leverage ratio.

    That is: they did $50bn of Repo 105s and used that to *pay off* $50bn of loans.

    Suddenly the ratio of debt to capital dropped by about 2 points… which was very important to them at the time.

  15. #15 Crankenstein
    March 25, 2010

    Glenfarclas 105, aged 40 years, “there are only
    893 bottles in total”.

  16. #16 PSC
    March 27, 2010

    The simple fix is to change the accounting standards to say:

    “Any transaction with the financial character of a loan mus be recorded on the balance sheet, irrespective of any other rule. And the directors have to sign off on the books. And they’re personally liable for ensuring the company obeys the rules.”

  17. #17 Angry
    April 9, 2010

    Dear Mr Chu,
    I read your latest post and the comment section is closed, but I would still like to respond. You sir, are a coward. You have no substance. I know this post won’t be published but at least I get to say that you are a disgrace and an embarrasment to all good, decent, hardworking white people out there. You are a racist – you don’t get to bring our race down because you feel guilty. In fact, I fire you from the white race. You are now a non-race – you are now free to pick your new hood. You are also fired from Google – a company built by white technology and white brains. Shocking that you think you can unleash your putrid thoughts and then get like-minded libtards to beat their breast in horror at being a member of the white race. You need to get a life. There are more important things to be sorry and guilty for than being sorry and guilty for being white. You are fired!

  18. #18 tawaen
    April 9, 2010

    @17

    No, a coward is someone who refuses to accept the objective reality that they do not deserve the innate benefits they recieve through no effort of their own.

    In other words, someone like you who says, “good, decent, hardworking white people” as if those qualities have anything to do with skin color is the real coward.

    When you want to grow up and join reality, please let us know. Until then, your concern (and bile) is noted.

  19. #19 Angry
    April 10, 2010

    You, sir, are still a coward. You can use all the fancy english phrases you want to try and dazzle people into thinking you’re an intelligent person, but deep down you are a coward. No matter what you say, you have no self worth. You need to belittle people to feel good. You are a bully and a weakling. Just by saying that you are white and guity is enough to tell me you are a bigger racist than most red-necks out there. You are a progressive bullshitter who thinks you know better. You and your fellow libtards need to stick together and talk yourselves up cause no one else thinks much of you. And by the way, I am in reality, unlike you, sitting in your ivory tower, flogging youself in guilt.

  20. #20 Gray Falcon
    April 10, 2010

    So far, Angry, neither you, nor anyone else, have actually bothered to address the issues presented in that thread, just slung out talk about “guilt”. When MarkCC locked the thread, it wasn’t an act of cowardice, he was basically telling you that your hatred isn’t welcome here.

    MarkCC, please block this guy.

  21. #21 Angry
    April 10, 2010

    Yes, please block me – he can’t stand to listen to a person having an opinion. Why do you assume I’m a male? I’m a female – see, not only are you racist, you’re sexist too! Point proven.

  22. #22 Mark C. Chu-Carroll
    April 10, 2010

    @21:

    I’ve listened plenty – in case you didn’t notice, I let the discussion on post go on until the stormfronters started showing up.

    On the other hand, you’re such an ass that you can’t even respect that I closed the comments after two days – and you need to hijack other posts in order to put in your two cents repeating the same old insults that you and your pals have been flinging non-stop.

    You’ve managed to have your say in a completely inappropriate forum. Now fuck off. Go away. You are *not* welcome to post off-topic comments on random posts on my blog.
    You’ve gotten three off-topic comments – that’s all you’ll get. Anything further will simply be deleted.

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