The recent report by a bankruptcy examiner reviewing the implosion of Lehman Brothers spent more than 300 pages detailing a practice known within the investment bank as “Repo 105”, a practice the company used to minimize its reported debt. A “repo” is essentially a collateralized loan, in which the borrower agrees to a short-term sale of securities (the collateral) while promising to buy them back later at a higher price. The transaction is booked as a loan, but Lehman’s “Repo 105” booked the transaction as a sale, thereby eliminating the securities (which were some of the worst that the company owned) from its balance sheet.

Now, the Wall Street Journal is reporting that 18 other banks, including Goldman Sachs (GS), Morgan Stanley (MS), JP Morgan Chase (JPM), Bank of America (BAC), and Citigroup (C) also used repurchase agreements to lower reported debt levels by an average of 42% in each of the past five quarters. The repurchase deals are perfectly legal, but the effect is to understate the risk the banks are taking over a full quarter. Because a 10-Q quarterly report is essentially a snapshot of a company’s financial position on the final day of a quarter, repurchase deals that lower a bank’s reported leverage do not accurately reflect how much risk the bank normally holds.

The information about the repurchase deals is contained in reports that the banks file with the Federal Reserve Bank of New York. Several of the banks refused to comment on the Journal’s story, but Bank of America said that its “efforts to manage the size of our balance sheet are appropriate.”

The catch to that line of reasoning is that the bank is not managing its balance sheet because it is only temporarily moving the assets off its books. The assets really aren’t going anywhere except into the closet while the bank reports on its assets and liabilities. The end-of-quarter repos lowered the banks’ liabilities by an average of 42% from the peak borrowings during the quarter. Legal yes, but certainly misleading.

Lehman used its “Repo 105” transactions to hide $50 billion in debt before the bank collapsed. The US Securities and Exchange Commission, in a ‘better late than never’ move, is now looking at the accounting practices at other big banks that could serve to hide a bank’s risk level.

None of the banks named in the Journal story admits to characterizing the repurchase deals as sales instead of loans, but if the effect of the loan is identical to the effect of a sale, what should the SEC call the transactions?

One possible fix to this shifting of assets would be to make the banks report a quarterly average debt level rather than a fixed-date snapshot. Perhaps the SEC could also prohibit transactions within the quarter that are above a certain size. That is, if a repurchase deal is more than some percentage of total assets, then the transaction cannot be completed until the following quarter.

The main issue remains transparency. Quarterly and annual reports are shareholders’ main source of information about a company. When those reports can be legally jiggered to paint a rosier picture than actually exists, shareholders and investors are being bilked. It’s really pretty simple.

Tell us what you think here.

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