Views on improving the integrity of global capital markets
02 February 2011

The End to Misleading 105s

One of the most worrisome items to emerge from the 2008 financial market wreckage was the realization that Lehman Brothers had deliberately used accounting gimmicks to hide tens of billions of dollars of leverage from investors, counterparties, and regulators. Through the use of “Repo 105s” and “108s,” the firm sold securities at a discount near quarter-end, used the cash to repay debt to lower its debt ratio, then borrowed even more after quarter-end to raise cash to repurchase its securities. As the investigator into Lehman’s collapse put it, the purpose of these activities was “to create a materially misleading picture of the firm’s financial condition.”

Now rulemakers in the United States have responded to try to at least increase the friction for such shell games. The Financial Accounting Standards Board (FASB) has proposed to change certain of its rules regarding effective control in contracts such as repurchase agreements so that the determination regarding whether a financial asset has been sold will be centered more on the rights and obligations of the institution transferring the financial asset rather than being focused on the percentage of collateral exchanged. The goal is to have accounting standards treat economically similar transactions in a more consistent manner.

The SEC also has proposed a new rule to stop Lehman-like abuses. The Commission’s proposal would complement the new accounting rules by requiring increased transparency about a company’s short-term funding sources and uses. The disclosures would not only provide information about period-end transactions, but also require companies to disclose average and maximum levels of short-term funding used during the period.

In both cases, the goal is to give investors better information about a company’s liquidity and use of short-term funding sources. CFA Institute generally agrees with both as advances in financial reporting and disclosures due to the likelihood that they will enhance the ability of investors to recognize what firms are up to with regard to short-term funding sources.

Still, there is room for improvement. For example, the FASB’s proposals need additional disclosures to enable investors to determine when “economically similar transactions” receive different accounting treatment and what the use of proceeds are in such transactions. The SEC’s use of leverage ratios to enhance understanding is a good idea, but should correspond with those leverage ratios proposed for financial institutions by the Basel III Committee.

By making such sale transactions harder to achieve and more transparent, the new rules will force future Lehmans to engage in even more complicated maneuverings. The hope is that the complexity will raise enough red flags for investors and regulators alike to put a halt to the practices before the situation threatens the financial system.

One can only hope.

Read the CFA Institute letter to FASB on this subject (PDF).

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

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