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When Are Repo Transactions Fraud?

On Friday, The Wall Street Journal* *revealed that major Wall Street banks regularly use repurchase-agreement, or repo, transactions to reduce their debt levels and leverage shortly before reporting their quarter-end data. The revelations came after the Valukas Report showed that failed investment bank Lehman Brothers used a type of repo transaction, the so-called Repo 105, to move billions in debt off of its books in the months before it collapsed. Lawyers have argued that Lehman Brothers’ transactions likely broke the law — but the other investment banks’ likely did not.

To help explain the legal issues — particularly in light of the upcoming push for regulatory reform in Congress — I spoke with Jennifer S. Taub, a lecturer at the Isenberg School of Management at the University of Massachusetts, Amherst, and a member of the Economists’ Committee for Stable, Accountable, Fair and Efficient Financial Reform. She formerly worked as an associate general counsel at Fidelity and as assistant vice president for the Fidelity Fixed Income Funds.

I lightly condensed and edited the interview for clarity.

So, on Friday, the Journal reported that a number of major Wall Street investment banks, including Goldman Sachs and Bank of America, are routinely using repo transactions to lower their debt and leverage levels before making their quarterly reports. And I think everyone’s question is: Isn’t that fraud?

That is the question. Thus far, it seems that this is lawful. However, we just don’t have enough facts about what they were actually doing. The SEC is in the midst of an investigation into repurchase agreement-financing transactions at these firms, and we haven’t seen the SEC report yet. These investment banks say that they were not performing any Repo 105 transactions — the kind Lehman Brothers was performing — and that they recorded their repo transactions on their books properly. It seems clear what was going on in Repo 105 is criminally actionable, for example, under the Sarbanes-Oxley Act, which requires that periodic reports fairly represent in all material respects the company’s financial condition. And the question at Lehman is whether this was fair reporting.

Right — looking as an outsider with not much understanding of securities law, looking at Wall Street from Main Street, it seems that even if this wasn’t fraud, it should have been.

Yes, it definitely *seems *off, even if it was legally OK. I think you can take two paths looking at these transactions. You can say: Is this criminal or not? We can’t determine that yet, we just don’t have enough facts. But then you can say: Even if it is perfectly legal, it still seems that this is an issue because there is the question whether investors were being misled and whether this business model threatens the entire financial system.

These transactions involve very short-term borrowing to finance long-term, illiquid assets. Even Lloyd Blankfein, the head of Goldman Sachs, has described this maturity mismatch as very dangerous. This is especially the case, where prior to the crisis, the investment banks were using short-term, often overnight loans to finance up to 50 percent of the assets they held.

That is why I think that we should not focus exclusively on the question of whether or not this was illegal, but on the point of fact that it is dangerous, because of the magnifying effect of leverage. This was the problem during the financial crisis. If any one firm loaning to you starts to get nervous that you aren’t creditworthy, they pull their financing, all of a sudden, you can’t get loans, you have to sell assets, then everyone is doing the same — you have the same death spiral that seized the credit markets.

To me, in the interest of fairness and deterrence, securing convictions is important. However, I don’t want us to get distracted by what’s criminal and ignore whether what’s “perfectly legal” makes us unstable.

And you’ve done some work describing how these repo transactions came to be a systemic risk problem — describing their dramatic growth around 2005, as possibly due to a change in the U.S. bankruptcy code. Could you explain that?

This is a hypothesis, and I need to dig deeper. But, my initial sense is that there is a connection between a recent change in the bankruptcy law and the growth of repo transactions.

Say that you are on the investment side of a repo transaction — you’re the cash-rich investor who is going to loan money overnight or for a week to an investment bank, who will give you Treasuries or other collateral. If you’re the investor, you want to make sure that if the other side can’t give you back the cash the next morning or next week, you can keep the collateral. Investors are also concerned that even if they hold onto that collateral, if the bank goes into bankruptcy, they might not be able to keep it.

When a company files for bankruptcy, something called the “automatic stay” comes into effect. The trustee (or the debtor-in-possession) stops all transactions. He can freeze almost anything. But, that isn’t actually true for everybody. If you’re a “secured creditor,” the freeze does not apply to you. In addition, the ability for the trustee to claw back your collateral is prevented. And one way to be a secured is to be in possession of collateral whether directly or through a custodian bank. That means that investors who loan through repo are in a better position than other kinds of unsecured lenders.

But if I loaned to you through repo — say I gave you $1 billion in cash, and you gave me $1.01 billion in collateral — I get to keep that collateral. If you’re a secured creditor you feel comfortable lending, even in really bad circumstances. And repo transactions are secured.

But it wasn’t always like that? Something changed to make repo a secure way to lend?

Right. Before 2005, where the bankruptcy code covered repurchase financing, it was only clear that some kinds of repos, backed by a limited list of collateral types, were secured. Only Treasuries, agencies, and a few other types were. If I were going to loan to you overnight, and you gave me Treasuries, then the bankruptcy code said, “Yes, you’re secured and if your business goes under, you get to keep it.”

In 2005, the code expanded to list a whole bunch of other types of collateral such as mortgage loans and interests in mortgage-related securities were. This encouraged the purchase of these assets, because financing through the repo market was more available. That meant, if I have a lot of money to park overnight, I’m willing to take not just Treasuries but these other riskier assets as well. I am exploring whether there is a connection between this legal change and the growth of repo transactions from approximately $4.9 trillion in 2004 to $7 trillion by the first quarter of 2009. That’s a preliminary take, though. And I need to dig deeper.

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