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
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
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
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
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.