Lehman’s Balance Sheet Games: REPO 105 and its $3 Billion Mini-Me

by REIT Wrecks on March 15, 2010

“Our enemies are innovative and resourceful, and so are we. They never stop thinking about new ways to harm our country and our people, and neither do we.”

Number 42, August 5, 2004

What a mess. Before the most recent giant sucking sounds you all heard, the two largest bankruptcies in the U.S. were Enron and Worldcom, and they were largely the result of corporate accounting scandals.

ThoseĀ  numbers games gave rise to some considerable prison time, what is now known as Sarbanes-Oxley, as well as a whole host of new GAAP accounting literature designed to prevent a repeat of that deception.

Given the considerable efforts of Mssrs. Sarbanes and Oxley to drum creative types completely out of the accounting profession, you may wonder how Lehman managed to make nearly $50 billion of debt disappear from its balance sheet quarter after quarter. Surprisingly, the answer is that they were able to combine a little bit of good old fashioned jurisdiction shopping with some pretty stale, nearly 20 year old accounting guidelines to create a technical asset sale, even though the substance of the transaction amounted to no more than a five day loan. Of course, Lehman would have gladly sold all of this stuff permanently if it could have, but no reasonable investor would touch it.

During Lehman’s final months, the independent examiner (the reports are linked here) confirms that there was an almost constant scramble for liquidity, and that despite this, some senior managers – including Dick Fuld – suffered from considerable delusion over the value and marketability of the firm’s massive real estate portolio.

Nevertheless, as Lehman’s balance sheet froze up and the hunt for liquidity grew more desperate, the firm began selling chunks of its illiquid loan book to anyone it could, including long-time clients and even its own employees:

Expected Return Slides

While REPO 105 was simply the result of a conflict between U.S. and U.K. accounting guidelines, the deal outlined above was the result of a more fundamental conflict between large Wall Street firms and their own clients (and in this case, large Wall Street firms and their own employees). If you ever had doubts about that, all you need to do is take a quick peak at the disclaimer on the target return analysis for the above $3 billion loan “opportunity” fund:

“This model makes a significant number of assumptions, including the general assumption that investing conditions will not deteriorate.”


If your job is to throw assets assets over the side like so many seat cushions on the Titanic, I suppose you’d need a fair bit of optimism just to make it through the day. But under the circumstances, peddling a 21% gross IRR on an illiquid, 2006 vintage senior secured loan book seems just a tad exuberant. Nevertheless, this loan opportunity fund closed nearly fully subscribed, even though “investing conditions” were deteriorating by the minute. Sold to you my friend!

commercial real estate

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