Banks Trim Debt or “How To Dress For The End Of The Quarter Dance”

ByStander

Banks Trim Debt or “How To Dress For The End Of The Quarter Dance”

How Repo 105 helped Lehman Brothers maintain a veneer of health, and how the biggest banks are using quarterly window dressing to trim debts and obscure risks?

I know many times these stories are difficult to grasp, however I have outlined in the best way that I know how Lehman Brothers and some banks still are obscuring the risks associated with their businesses. We begin with how repurchase agreements work. An ordinary sales and repurchase agreement ‐‐ or repo ‐‐ involves the transfer of assets to another party in exchange for cash, while agreeing to repay the money and take back the assets at a later date.

Repo 105 is based around a repurchase agreement. This is a standard tool that investment banks use all the time to get the money that they need to operate. Investment banks tend not to have large amounts of money sitting around so they need to get the money that they need to do business (i.e. salaries) from somewhere else. One of the ways they get this money is through repurchase agreements. Nothing wrong with repurchases agreements.

There are a couple of counterparties involved. Let’s use the example that I need to borrow $100 for 24 hours, so I go to Lance who has $100 to lend. Lance will say to me, “OK, I will lend you $100 bucks but I need $100 in collateral.” So he will essentially buy $100 worth of stuff from me. I put up my Ipod as collateral, which I believe is worth $100.
In terms of the contract, Lance BUYS my Ipod, which is worth $100, for $100 on the provision that I am going to come back in 24 hours to Lance and buy back my Ipod for $100. So the $100 will be back into Lance’s pocket, plus a small fee for loaning me the money. – With me so far?

In the case of the Investment banks, such as Lehman Brothers, we are talking about large amounts of money, not IPods. We are talking about securities. So Lehman would put up bonds, mbs’s, and even treasuries as collateral instead of an Ipod. In a Repo transaction it appears more as a loan. So Lance reports the transaction as a loan, because he knows that I am going to come back and pay back the $100 and receive my Ipod (or collateral) back again. And I am reporting it as a loan, because I am going back to repurchase my IPod. Although this looks like a sale, it is still reported as a loan.

Lehman Brothers very cleverly looked into the accounting standards and saw the rules only required you to book these repurchase transactions as coming back if the securities are worth between 98 cents and 102 cents on the dollar. So, instead of supplying $100M in securities as collateral, Lehman supplied $105M in securities. In other words, they over collateralized the deal. So The Bank of Mike says, “I’ve lent you $100M and you’re giving me $105M in collateral. That’s OK with me. If all goes wrong, I get $105M. And I am still booking this as a loan because you are going to come back and buy back these securities. “

Now in our eyes we look at this and see this as a loan. But because of the accounting standards rules, Lehman Brothers was able to book this as a sale, not a loan. So if they book this transaction as a sale then it would seem that the securities they used as collateral would not be repurchased or coming back. So as a snap shot of the balance sheet, the net result shrank both sides of the balance sheet. That led to a sharp reduction in the reported leverage which was crucial for maintaining the group’s credit rating as rating agencies and investors began to focus more on leverage and demanding lower risk. So if you load this Repo 105 transaction up with assets, those assets have disappeared and been replaced with cash even though the repurchase agreement still exists, and even though Lehman will still be going back to The Bank of Lance to repurchase their securities.

This is how Lehman was able to disguise or dissolve billions of dollars in assets and get those assets off its balance sheets. Therefore, it improved its profile to anyone that was looking at it. So why would they want to do this? Well Lehman wanted its counterparties (people like The Bank of Lance) to continue doing business with them because it had a leverage problem. People were also worried about the quality of the assets it was holding. Of course, if you are worried about a counterparty you are not going to want to lend money to a guy who may not be able to pay it back are you? Lehman was worried about the perception people had of it, so it wanted to make it appear that its balance sheet was in as good of shape as possible.

So that is the reason it found this Repo 105 rule as a way of shifting this stuff off its balance sheet, and make itself look good. Of course in the end, everyone realized what a state Lehman Brothers was in and there was a liquidity crisis, and others refused to do business with the bank. Suddenly it had no money to operate and that led to the demise of Lehman.

Why is this relevant today Luke? “That was in late 2007, and the crisis is over.” Allow me to explain...
Three big banks—Bank of America Corp., Deutsche Bank AG and Citigroup Inc., are among the most active at temporarily shedding debt just before reporting their finances to the public, similar to what Lehman Brothers did to obscure its level of risk. In recent filings with regulators, the two big banks disclosed that over the past three years, they at times erroneously classified some short‐term repurchase agreements, or "repos," as sales when they should have been classified as borrowings.

In addition, another practice, known as end‐of‐quarter "window dressing", suggests that the banks are carrying more risk most of the time than their investors or customers can easily see. This activity has accelerated since 2008, when the financial crisis and the demise of Lehman Brothers brought actions like these under greater scrutiny. The Journal reported last month that “18 large banks, as a group, had routinely reduced their short‐term borrowings in this way.”
Specifically, over the past 10 quarters, the three banks have lowered their net borrowings in the "repurchase," or repo, market by an average of 41% at the ends of the quarters, compared with their average net repo borrowings for the entire quarter, according to an analysis of Federal Reserve data. Once a new quarter begins, they boost those levels. This is illustrated in the charts below for all three banks.

The banks' overall "leverage"—that is, their use of borrowed funds to boost returns—frequently declines at the end of quarterly period. Thus the balance sheet indicates less leverage and as a result, less risk. In this environment, it is very important for banks to appear healthy, and the data suggests "conscious balance‐sheet management."
As I mentioned in the case of Lehman, repos let financial firms borrow cash short term by putting up securities as collateral, enabling them to make bigger trading bets with borrowed money. Investing borrowed money magnifies profits in good times, but aggravates losses in bad times.

In a statement, Bank of America said: "From time to time, the size of our balance sheet will fluctuate due to market liquidity, client financing needs, the company's risk appetite and balance‐sheet‐management functions." Oh really? It is just coincidence that the analysis shows that leverage is decreased prior to quarterly earnings report releases, and then is increased immediately following earnings releases.

By the way, intentionally masking debt to deceive investors violates Securities and Exchange Commission guidelines. Leading up to the crisis, this went unnoticed by the SEC. Although a bankruptcy examiner found later the financial picture created by Lehman was "materially misleading". Other banks have denied using the same kind of transactions,which Lehman dubbed "Repo 105s." The SEC is now considering stricter disclosure and a clearer rationale from firms about quarter‐end borrowing activities. The agency may extend these rules to all companies, not just banks.

The agency's disclosure was made by SEC Chairwoman Mary Schapiro at a congressional hearing last month. A Wall Street Journal story reported last month that 18 large banks—known as "primary dealers" because they trade directly with the Federal Reserve—had reduced short‐term borrowings as a group by an average of 42% at the ends of the past five quarterly periods, compared with quarterly peaks. Coincidence?

At the congressional hearing, a representative asked Ms. Schapiro about those findings. Ms. Schapiro said the commission is gathering detailed information from large banks "so that we don't just have them dress up the balance sheet for quarter‐end and then have dramatic increases during the course of the quarter."


Bank of America, Deutsche Bank and Citigroup account for about one‐quarter of all repo borrowings by the 18‐firm group of primary dealers. The three stand out among banks examined in the new analysis because they showed the most consistent, repeated pattern of quarter‐end declines in repo debt from average levels for the same quarters.For this recent examination, the Journal looked at eight of the 18 primary dealers, the only ones in that group which file average quarterly numbers with U.S. regulators. The eight firms represent two‐thirds of all repo borrowings by the 18‐firm group. Bank of America's average net repo borrowings have exceeded the bank's reported period‐end debt by 32% on average over the past 10 quarters, according to the analysis. It exceeded the totals at the end of the previous periods as well. The differences were particularly pronounced since 2009, after the bank bought Merrill Lynch. During 2009's fourth quarter, Bank of America had average net repo debt of $109.1 billion. That fell 52%, to $52.5 billion, at the end of the same quarter. During the first quarter of 2010, Bank of America's average net repo debt rose to an average $130.1 billion, and then dropped 61%, to $50.6 billion, at the end of the same quarter. Bank of America's overall leverage declined in each of the 10 quarters as well, although by more modest amounts. That's because the repo debt was just a relatively small slice of the bank's overall balance sheet.

Over the same period at Deutsche Bank, the quarterly average net repo debt at Taunus Corp., a holding company for the German bank's U.S. units, has been an average 39% higher than the total at quarter‐end. It was also nine times higher than the ends of the previous periods.

At Citigroup, average net repo borrowings have exceeded the bank's reported period‐end debt by an average of 52% over the past 10 quarters, according to the analysis. However, in each of the past two quarters, Citigroup appears not to have borrowed in the repo market in this way. In both quarters it was a net lender rather than a net borrower, both on an average basis across the entire quarter, and at quarter's end.

Bank wide leverage also declined from average to period‐end in most of the quarters at both Citigroup and Deutsche Bank, according to the analysis.

So why does this matter? Well, these shenanigans are the kind of misleading activities that get our financial system into trouble. As investors we make decisions to buy or sell these securities based on good faith that these companies are providing accurate and full disclosure when reporting their financial condition.

You may not hold Citigroup or Bank of America as individual stock holdings, but do your mutual funds? How will this affect our financial system if these banks are caught in another liquidity crisis and are highly leveraged? Will this be the equivalent of the last man standing when the music stops in musical chairs?

Luke Patterson

blackrock

看起来BoA的情况不太妙