Foreign Banks Such as Deutsche Using Variant of Lehman “Repo 105” Balance-Sheet Tarting Up Strategy

For readers who did not follow the run-up to the crisis closely, one of the heated debates was over “how sick is Lehman?” We were of the “very sick” persuasion because Lehman was making large mis-marks on assets that outside parties could see, such as greatly exaggerating the worth of garbage barge commercial real estate investments in exurban California (SunCal and Archstone). A general rule is if you need to cook your books, do it in such as way as to be difficult to detect. Lehman had so many position that would not be readily observed by third parties that it could fudge that it clearly had to be desperate if it also needed to tart up valuations that could be checked.

After the crisis, a very large “pretty it up” technique of Lehman’s was exposed, the so-called Repo 105. As we wrote in 2010:

Quite a few observers, including this blogger, have been stunned and frustrated at the refusal to investigate what was almost certain accounting fraud at Lehman….. Indeed, it was such common knowledge in the Lehman flailing about period that Lehman’s accounts were sus that Hank Paulson’s recent book mentions repeatedly that Lehman’s valuations were phony as if it were no big deal.

Well, it is folks, as a newly-released examiner’s report by Anton Valukas in connection with the Lehman bankruptcy makes clear. The unraveling isn’t merely implicating Fuld and his recent succession of CFOs, or its accounting firm, Ernst & Young, as might be expected. It also emerges that the NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations….

The key revelation is that Lehman as of late 2007 was routinely using repo transactions at the end of the quarter to mask how levered it truly was:

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.2850 Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851 Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.

Yves here. The stunning bit is these “repos” were actually a conventional type of repo, despite the name, but Lehman was engaging in blatant misreporting, treating these “repos” (in which a bank still shows them on its balance sheet as sold with the obligation to repurchase) as sales. Note that at the time (as the report notes) analysts and others kept probing at the seeming miracle of Lehman’s deleveraging in a difficult market.

Fast forward to the new revelations via the Financial Times:

Foreign banks operating in the US short-term debt markets are “window-dressing” their accounts, routinely cutting about $170bn of balances at the end of each quarter to appear safer and more profitable, says a new study.

The study from the Washington, DC-based Office of Financial Research describes a pattern of behaviour that has prevailed since July 2008, and suggests that the banks are carrying more risk than their investors or customers can easily see.

The study examines the vast market for repurchase agreements, or “repos,” where banks lend out assets in return for short-term financing. It finds that dealers sell heavily to customers in the last days of the quarter, and immediately buy assets back once the new quarter starts…

Analysts said the behaviour outlined in the study has shades of the notorious “Repo 105” trades that Lehman Brothers used to bring down its reported leverage in the quarters leading up to its collapse. In that programme, the broker accepted a relatively high 5 per cent fee in order to count its repo transactions as true sales, even though it remained under a contractual obligation to buy the assets back.

Joshua Ronen, a professor of accounting at New York University’s Stern School of Business said the OFR’s study — which did not cite individual banks by name — showed that lenders with the lowest capital ratios were making the biggest quarter-end reductions.

Sports fans, that list is sure to include Deutsche Bank, which is the worst capitalized of the major banks, and separately, as the Financial Times pointed out, is also a major dealer in repo. The article points out that banks are required to provide more transparent repo reporting by 2018 but some counterparties may still be surprised. Gee, does that mean that the officialdom anticipates that the abusers of repo won’t be able to get their balance sheet houses in order by then?

Even worse is that balance sheet reporting problems are almost always symptoms of bigger issues. For instance, as law professor and derivatives expert Frank Partnoy warned in 2010:

The Repo 105 section of the Lehman report shows that Lehman’s balance sheet was fiction. That was bad. The Valuation section shows that Lehman’s approach to valuing assets and liabilities was seriously flawed. That is worse. For a levered trading firm, to not understand your economic position is to sign your own death warrant.

We’ve seen with Deutsche Bank that not only are they the most seriously leveraged major dealer bank, but their risk control metrics have been sorely wanting. For instance, Deutsche’s failure to model the cost of a gap option on the biggest trade in its derivatives book led it to overstate its Tier One more than €8 billion during the crisis. Marking it properly would have also put the bank’s capital below the 8% minimum required by German regulators. And as a result of the understating of the risks of this trade, the Canadian commercial paper market needed to be bailed out (no, I am not making this up, I’m merely giving you the short version. Of this so-called “leveraged super senior” or “LSS” trade:

The LSS trade, if properly modeled and accounted for, would never have been done in the volume that it was and Canadian investors would have been spared at least some of the disruption and losses that they suffered. But the traders and their managers were able to pull out more in bonuses by booking the trade in a way that exaggerated its profits. This is looting, pure and simple. Tough accounting and controls won’t catch all bad or sloppy behavior, but it would have stopped this trade, and you can be sure it would have prevented others.

There is good reason to be concerned about Deutsche’s accounting. Consider the warnings issued by the New York Fed. From the Financial Times in March:

The German bank’s attempts to improve its regulatory reporting structure suffered a blow after a private letter from the New York Federal Reserve leaked last year accusing the bank of having “low quality, inaccurate and unreliable” reporting.

The Fed said it “identified numerous and significant deficiencies across Deutsche Bank Trust Corporation’s risk-identification, measurement, and aggregation processes; approaches to loss and revenue projection; and internal controls”.

The US central bank examined only a small part of Deutsche’s US operations — Deutsche Bank Trust Corp — which has a $62bn balance sheet and houses its wealth management and transaction banking operations.

The German bank’s much bigger broker-dealer operations are housed in Deutsche Bank Securities Inc, which is due to be included in the Fed stress tests from 2018.

What is disconcerting is that the problems at Deutsche may well extend to the critically important trading operations. A colleague who worked from them more than a decade ago in a financial control function has said privately how poor their systems were. He was recently approached about working for them again and was told, “You know how it works here. Nothing has changed.” Given Deutsche’s political and financial standing in Germany, the odds do not favor tough enough questions being asked about the state of the giant bank’s books and risk management.

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  1. timotheus

    Would there be a parallel with the overly cozy Volkswagen relationship with policymakers due to its “political and financial standing” in Germany? If so, should we anticipate that everything will be papered over until the bombshell revelations and ensuing debacle?

  2. Deep Thought

    Lehman was engaging in blatant misreporting, treating these “repos” (in which a bank still shows them on its balance sheet as sold with the obligation to repurchase) as sales

    Thank you for writing this bit. All the explanations I’ve read of Repo 105 seemed to be missing the step where liabilities were actually reduced – because what’s the difference between an asset and an obligation/contract to buy said asset in X hours time?

    So I’m glad a more financially astute mind than mind wrote down what I’d suspected, that real liabilities weren’t actually reduced by Repo 105 and it’s just window dressing to fool the regulators. I’d hazard that it actually makes the situation worse, because it’s pretty expensive window dressing and that’s real cash that has to head out the door once a quarter.

    1. tawal

      Turning all the brokerages into bank holding companies, where now they all have a calendar year end and can’t temporarily hide their trash on each other’s books, but can all hide it on the Fed’s unaudited balance sheet.

      Why isn’t Deutsche Bank doing this too, and are UBS, Barclays and HSBC the next to fail?

  3. fresno dan

    “It also emerges that the NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations….”

    Upon finding this out, tire squeal, sirens wail, lights flash, and grim faced men rush to take into custody little Timmy Geithner and serve warrants a the New York FED….

    LOL – of course not. Most government officials, of BOTH parties, would say Timmy Geithner and his ilk performed fantastically….
    After all, he worked hard to prop it up…. If you remove the corruption, the double and self dealing, price fixing, fraud, ad infinitum, and how could the system continue as constituted? And the people at the top of the system thinks it works very well indeed.

  4. Gordon Cook

    I wonder what the title Chief Data Officer actually means? JP Rangaswami assumed this title at Deutsche Bank on November 10, 2014 according to Google. I first met JP at a Supernova in I believe 2005. He was CIO at Dresner Kleinwort at the time. knew him fairly well when in late 2006 he joined British Telecom where on my private mail list he was an exceptionally intelligent and valued contributor. We thought that with the Dutchman blanking on the man’s name as CEO of British Telecom JP was bringing in a team that had a chance to really transform this giant telco into what Internet people would like to see telcos become. but alas the CEO left and about a year later JP left and went to Salesforce. At Salesforce, to be quite honest, I personally found that the quality of JP’s comments on the mail list became much more like advertisements for his employer than had ever been the case before. I wonder if there is any chance that this man would have any hope of being able to help clean up the banks act? dream on? In the past three or four years I have become much more radical and outspoken and anti-capitalist. JP could certainly see that from my remarks on list and elsewhere I confess I found myself wondering if that’s why he left.

    I used to read his blog all the time which is a compliment because I do not spend much time reading blogs.

  5. Chauncey Gardiner

    This issue is unsurprising to me. Many signs over the past couple years of deeply troubling matters at this TBTF: CEO resignations, NY Fed criticisms of systems and financial reporting (as Yves pointed out), participation in market manipulations, billions in writedowns, suicide death of bank’s regulatory lawyer, massive derivatives exposures, central bank calls for increased capital, etc.

    Although I hope the bank’s newly appointed CEO is able to implement measures to rectify these problems, if DB “goes Lehman”, I suspect it will occur much as Lehman did: quite suddenly.

    Recalling Ernest Hemingway in “The Sun Also Rises”:
    “How did you go bankrupt?” Bill asked.
”Two ways,” Mike said. “Gradually and then suddenly.”

  6. JustAnObserver

    Deutche Bank = Germany’s RBS (Royal Bank of Scotland) ?

    All the Eurozone’s nightmares since 2010 have been down to a desperate attempt to postpone DB’s “Minsky Moment” ?

    I did see a report that DB is withdrawing from a number of countries but Wall Street wasn’t on that list. Interestingly the list includes all the Scandinavian countries as well as the usual suspects – Mexico, Turkey, Saudi, etc.

  7. Oliver Budde

    The 5% “fee” referred to in the fourth paragraph of the FT excerpt above is not the interest rate charged on the loan but instead is the over-collateralization amount provided by Lehman in exchange for a short-term cash loan. A normal repo loan is over-collateralized at perhaps 2%. Lehman’s and its outside auditors Ernst & Young’s ‘genius’ was in discovering some language in 2001 or so in the then recently amended FAS 157 accounting guidance (all such guidance has been revised and renumbered in the meantime) which suggested indirectly that if the rate of over-collateralization was bumped up enough, you could pretend you sold the collateral instead of pledging it as collateral. So instead of pledging the normal 102% of the loan amount in collateral, Lehman asked lenders to please take more than that: 105%, hence “Repo 105.”

    Most of Lehman’s lenders wouldn’t touch the scam because it was so obvious, but a few non-U.S. banks were happy to oblige Lehman. One was Deutsche Bank, to the tune of many billions of dollars over the years. Not that that had anything to do with ex-Deutsche General Counsel for the Americas Rob Khuzami’s decision, once he became Obama’s Enforcement Head at the SEC beginning in 2009, to give Lehman, EY, Deutsche and the other lenders a pass on all that.

    The few banks who did dare to help out Lehman of course charged higher than market rates for those loans, even though they held an extra 3% in collateral, which was always made up of high quality Treasury bonds and the like. Those lenders charged more anyway, because they knew what Lehman was up to and knew they could wring out some extra cash in exchange for ‘aiding’ Lehman in its needs. Lehman gladly paid the higher interest.

    In no way did the drafters of the accounting guidance ever say, here’s a way to scam the market, have at it. But then again those drafters are a committee of CPAs from all the big firms and elsewhere, including several from EY. So who knows how deliberate the set up was.

    The scam began in 2001 or so and while it may not have been what blew up Lehman in 2008, it did importantly mislead a lot of people in 2007 and 2008, when its use was ramped up dramatically. And it put extra bonus money into the Lehman executives’ pockets, year in and year out. No wonder others seek to emulate it.

  8. Tom

    Deutsche Bank has hugely profited from the end of the Deutschland AG at which head it once was. Thanks to chancellour Schroeder and his finance minister Eichle (the successor after Lafontaine was kicked who went on to found the left party) Deutsche and the other big German banks got to sell their industry portfolios without paying a penny of tax. It is common knowledge among industry watchers that this money ended up as bonuses for the “masters of the universe” at the Anglo-Saxon part of the bank which basically took over the whole bank. First invisibly and then all to visible when Jain became CEO. German industry is now owned by Blackrock and the like. Homi soit qui mal y pense

  9. RBHoughton

    Geithner’s amorality and dereliction of duty has been apparent since his testimony in Starr v USA. Somehow these big names are protected by the supine media.

    Thank Heavens for NC – one of the most important of a handful of sites that fearlessly report. Fingers crossed we can build a new media industry around this nexus of quality.

  10. Pearl


    Couldn’t the NY State Superintendent of Financial Services pull Deutsche’s U.S. Banking License?

    I thought this is what Ben Lawsky was intimating in this (nearly) one year old interview on Bloomberg, in which he (hints at?) the pulling of Deutsche’s license, even though he was not at the time talking about Repo 105:

    I know it may not be likely that Deutsche’s U.S. banking license would get pulled, but it is possible, isn’t it?

    (btw, here is what Lawsky is doing now:)

    If enough folks became vocal (enough) about the issue–couldn’t we make a difference this time? (“We,” as in ordinary housewives from Roswell, GA and humble bloggers such as the illustrious Yves Smith?”.) ;-)

    I think you are waaaay more famous than you think you are, Yves. Indeed, you are universally one of the most well-respected and straight-shooting authors/academics/authorities on such subjects. And I think Mr. Lawsky would take your call or reply to an email if written by you.

    I spoke with his staff (yes, me–a housewife from Roswell, GA) when he was at DFS during my “Ocwiteration Perseveration” days of yore, and his staff was unusually generous with their time and they seemed genuinely appreciative to get info and feedback from just regular folks.

    I think Mr. Lawsky himself would be thrilled to hear from someone like you.

    And I think the two of you would be an extremely formidable team.

    I just don’t want to give up on this. It’s too important. At the very least, I will forward to him this post of yours.

    Thanks again for everything you do, Yves.

  11. vlade

    I’d encourage you to look at Total Return Swaps in this area – it’s been a tool of choice for the more exotic collateral for this stuff for years now. Contact me if you want some more stuff.

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