Is it a liquid asset or collateral? Both! That’s the magic of Repo 105.
A report on the Lehman Brothers bankrupcy lifts the curtain on the unregulated market in repurchase agreements (repos). In repos, financial instruments are sold with an agreement to buy them back at a later date.
“Lehman’s trick was to use a clause in the accounting rules to classify [a] deal as a sale, even though it was still obliged to repurchase the assets at a later date. That meant the assets disappeared from the balance sheet, and it could use the cash it received to temporarily pay down other liabilities…. [Repo 105] was crucial for maintaining the group’s credit rating as rating agencies and investors began to focus more on leverage and demanded lower risk.” – Simon Kennedy, Market Watch.
A British law firm provided Lehman with cover for double-counting billions pledged to back short-term loans as liquid assets. A U.S. law firm had previously disapproved the practice. Lehman’s auditors, Ernst & Young, did not object.