This sounds like the name of a low-budget Hollywood blood & guts / smash-up movie.  Would that it were true. Repo 105 is a reference to an arcane accounting rule that permits banks to misrepresent the state of their health (balance sheet). This subject is beginning to catch some press because we recently learned that this is one of the tactics Lehman Brothers was using before it cratered and helped push the global banking system to the edge of a cliff.  It turns out most of the large US banks have been doing the same thing. Here is how it works:
  • Let’s say I’m a Bank CEO. I know there’s a pile of assets on my company balance sheet that we paid $50B for, but are probably only worth $5-10B (mortgage-backed bonds). If I actually accounted for the fact that the assets were only worth $5B, my bank would be insolvent and be liquidated by the FDIC. No more $10M annual bonuses for me.  
  • As CEO of a publicly traded company, I know that 4 times per year I have to provide a snapshot of what my company looks like to the SEC and so the owners of my company -the shareholders- can understand how their investment is doing.
  • Since I don’t want the gravy train to end (who wouldn’t?), I need to make sure the SEC and my company owners don’t know about the accurate state of the company balance sheet. So I make use of an accounting rule known as repo 105.
  • Repo 105 allows me to swap out the $50B pile of manure on my balance sheet to someone else and exchange it for something desirable — like cash  – and to do this just before the company snapshot is taken so that my bank looks far healthier than it really is. Then a few days/weeks after the snapshot is taken, I give the cash back to its rightful owner and get my pile of pooh back. I thank the good folks that leant the cash to my bank and tell them I’ll see them again in a few months time so we can do it again.
  • Yes this is absolutely legal. Of course it is a complete abomination to fairness and accuracy, but apparently not all accounting rules are designed for fairness.
The above situation is close to what Lehman Brother’s (under CEO Dick Fuld) did – with this modification: Lehman did not want the cash to show up as a loan. They wanted the balance sheet to look even better so they categorized the cash from the swap as proceeds from a sale. This makes the balance sheet look even better! 
 
Lehman knew they were pressing the outer limits of the envelope with this move, so they went shopping for an accounting firm to bless the concept. But they could not find an accountant in the US, so they extended their search and found a suitably classy firm in the UK. Well done !  But they knew that this move would be perceived as aggressive, so they left out the details of the transaction on the quarterly SEC filing. That’s called fraud. And last time I checked that was still illegal in the US. Inconvenient yes, but still illegal.  
 
Since Dick Fuld (CEO) claims he knew nothing of any of these transactions, I’ll be charitable and say that a very senior person at Lehman Brothers arranged all this to happen – but that the CEO –Dick Fuld — was not aware. So over $50B worth of assets were repeatedly being swapped, but the CEO did not know of it. So he was unbelievably incompetent. That’s better. (My thanks to the Wall St Journal for the facts behind this short story.) But keep in mind that a Sr VP at Lehman raised this shoddy practice as an issue back in 2008 and was then fired within days. So apparently somewhere between the Sr VP level and the CEO lies a villain able to make repeated multi-billion dollar transactions and bury them so no one else knew.
 
This story offers that rare combination of humor and outrage. Now back to the top of the story where we learn that 18 of the 19 largest US banks were doing repo 105 transactions to different degrees and still are. I don’t believe any took it to the new and creative levels that Lehman Brothers did. Gives you confidence in our banks, doesn’t it?