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Saturday, 13 March 2010

More window dressing than Bloomingdales

"Smart" financial deals come in 3 flavours:

  1. The true value arbitrage, where assets are sold in one market for a better price than they would receive in another.
  2. Tax "efficient" transactions, where the rate of return on an investment is enhanced or the cost of a borrowing is reduced compared to a similar profile loan
  3. Accounting scams.

The first type might be exemplified by securitisation, where packaging up assets such as credit-card receivables and selling them into the capital markets secures a lower cost of funding for the seller than their own marginal cost of funding if they kept them on their books. There are many other examples in the financial markets when taking a bit more effort and being a bit smarter and working a bit harder can produce real savings. Project finance is an obvious example.

Then there are the tax plays. Some are as straight forward as leasing, where a company that does not pay a lot of tax (often in a capital intensive business such as transport) cannot use all of the tax depreciation available and so it leases some of its assets from a bank that can use the depreciation charge on a timely basis. Other tax schemes are more complicated, but I usually have no problem with these, because everybody has the right to arrange their affairs as they wish, tax outcomes are usually clearly defined by laws and the correct application of the laws are decided by impartial courts. If there is a problem, the government can change the laws.

I have much more of an issue with accounting scams, which I often liken to a fat man weighting himself with one foot on the scales and one foot on the floor. In the long run nobody is fooled and in the case of the company, they rarely fool anyone but themselves (and their shareholders). Analysts and competitors often see the true picture after a time, or as Monty Python put it, after a few times.

With that in mind let us consider Lehman Brothers and Repo 105, an arrangement by which Lehman underreported their economic assets and liabilities by many billion dollars. It may not have been the reason why the bank failed but it explains how an apparently healthy bank could disappear so quickly.

Let us not bother too much with the details of the arrangements, because the precise details are not that important, but a repo is in essence a trade whereby one party sells assets to another party for cash together with an undertaking to buy the assets back at a later date at a preagreed price. In substance this is effectively a secured loan and may be treated as such by either lawyers and accountants.

But not always. In more "primitive" legal and accounting systems the repo might be treated as a sale for cash and the ongoing purchase obligation left out of the accounts, which is how many Japanese banks managed to flatter their balance sheets in the 1990's when capita was tight and asset books were bloated. A quick one week repo with a bank with a different balance sheet dates could wipe billions of crappy loans off the books and the cash proceeds could pay down lots of market debt just before the balance sheet date, only to be reborrowed a few days later to finance the repurchase.

But the Anglo-Saxon accounting systems weren't so naive, or so they told us, but it seems that Lehman and maybe others had little problem in arbitraging the US and UK legal and accounting systems. In both countries it is likely that a plain vanilla repo would have been classified as a borrowing, but Lehman found a simple way through the two systems to achieve their intended result.

The US accounting for repos is ostensibly similar to UK or European GAAP, with the notable difference that in common with much of US accounting, classification of certain transactions will turn on the legal classification, whereas in the UK, the accountants will form their view more independently from the legal form.

Now nobody doubts that is US law Repo 105 would have been classified as a loan, with all the implications that follow in other areas of the law, such as tax, bankruptcy, banking and usury laws to name but a few, and hence under US GAAP the accounting treatment would be clear that the transaction was to be treated as a loan.

The UK legal system operates differently, stating that the sale is indeed a true sale, but with more specific rules in other parts of the law such as banking law and tax law to treat the transaction as a loan rather than relying on a legal recharacterisation as in the US. Likewise the UK accountants would give an opinion that the transaction should be treated as a borrowing, not withstanding the legal form.

And this is how Lehman executed the arbitrage. By showing their US auditors a UK legal opinion that the transaction was a true sale, they persuaded them to accept that the transaction should be booked as a sale, notwithstanding the fact that (a) if they had asked UK accountants for the same opinion they would have told them to book a loan, and (b) if they had asked US lawyers for the same legal opinion, they would have said the same.

Of course, Lehman, would have argued, the transaction was executed in England under English law, so the only valid legal opinion would have been an English law opinion, but in the end, like the fat man with one foot on the floor, they were fooling nobody but themselves .... and maybe the Fed.