(photo: Bindaas Madhavi)

When health insurance companies triumphantly announced they had found a loophole which would permit them to deny coverage to children with pre-existing conditions, Jon Stewart asked the right question: why were you looking for loopholes? Why are you screwing over the children? We all know the answer. These companies are in the money-making business, and health insurance is just a sideline operation. Gaming the system is a profit center.

The report (.pdf) of the court-appointed Examiner in the Lehman Brothers case gives an excellent example a finance company gaming the system. The issue is proper accounting treatment of what Lehman called Repo 105 transactions. A repo, short for repurchase agreement, is a short-term financing vehicle. Lehman sells securities to another company under a contract that requires Lehman to buy the securities back a short time later at the same price plus interest. Repos are commonly used by brokers to finance their securities inventories. The borrower gets cash, and uses it to pay for the securities it is transferring. Typically, the borrower transfers securities with a market value slightly higher than the amount of cash it gets, so that the lender is protected from short-term loss.

In repo transactions, assets decrease by the value of the securities transferred, and increase by the amount of cash received. Liabilities increase by the amount borrowed, but the borrowed money is used to pay an equal amount of debt. That returns the balance sheet close to its prior position. After the transaction, the net worth of the transferor is unchanged. Leverage is the ratio of assets to net worth. If the repo is properly recorded, leverage doesn’t change.

One of the relevant accounting rules says that a transaction in which a transferor surrenders control over assets is to be accounted for as a sale. The Examiner explains this rule as follows.

SFAS 140 also states that “The transferor has surrendered control over transferred assets if and only if all of the following [three] conditions are met”:
….
● The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or ….

Report, Vol. 3, 773. The first two conditions, which are omitted, are no-brainers. That third one looks exactly like a repo, now doesn’t it? But Lehman figured out a loophole. Lehman claimed that if the amount of collateral transferred was more than 105% of the amount received, the transaction is a sale. Lehman used that loophole to reduce the amount of leverage it reported.

As an example, suppose Lehman did a repo with Fannie Mae preferred stock. It gives stock with a value of $105 to lender and gets $100 back. It records the transfer as a sale, meaning its securities inventory goes down $105. It records an increase in an asset called “derivatives” of $5 to reflect the profit it will make when it pays off the repo at $100 and gets securities worth $105 back. Cash goes up $100. It uses the $100 to repay a short-term loan with its bank. Its liability to repurchase the securities is not recorded. After the repayment, assets are lower by $100, and liabilities are lower by $100, so net worth is unchanged.

With the same net worth but lower assets, leverage is lower than it was before the transaction. The Examiner says the effective reduction in leverage ranged from about 10% to about 13%. The Examiner asserts that this is a material difference, and gives rise to colorable claims against several Lehman employees. The Examiner also asserts that it creates a colorable claim against Lehman’s auditors, Ernst and Young. In general terms, these claims relate to the obligations of these parties to insure that the financial statements accurately reflect the financial position of the company.

The Examiner acknowledges that both the individuals and the accountants may have valid defenses. They’d better have defenses: it looks like the cops may have woken from a deep slumber, probably because the screaming from every side has been pretty loud.

Whatever those defenses are, they need to be removed. Congress has to impose liability for company management and professionals who aid and abet gaming the systems set up to protect investors and the whole economy. There isn’t any point in regulating if people can escape liability by creating fake technical compliance.