End our smoke and mirrors economy

Allister Heath
AMERICANS are great at producing lengthy, blow-by-blow investigations into crises, debacles and disasters. Last week’s 2,200 pager into the Lehman Brothers collapse from US examiner Anton Valukas is a case in point. His revelations about how Lehman was able to downplay the size of its balance sheet are especially riveting. It is clear that the accounting rules were far too weak and need to be tightened drastically.

Every single day in the City, financial institutions engage in short-term repurchase agreements (or repos) to borrow money. A deal may stipulate that £1bn of collateral (such as government bonds) be sold by one firm to another institution in return for £1bn in cash. Then, a few days later, the first institution buys back the collateral for £1bn plus a small commission or interest rate. It is a very useful system; the deal is correctly booked as a loan under accounting standards.

But what happened in Lehman’s case was that it found a loophole in the accounting rules: anybody who posts more than $102 in collateral in return for $100 in cash is able to temporarily classify the transaction as a permanent sale of assets, until of course they are repurchased. The assets can be removed from the balance sheet, replaced instead by cash, if only for a few days. This obviously makes no sense – if you post $101, it is a loan, if you post $103 it is a sale – but was legal.

Lehman spotted this in 2001. Under its “repo 105” and “repo 108” deals, it posted $105 or $108 every time it wanted to get $100 in cash. These deals – conducted out of its Canary Wharf offices by its European division – were timed just prior to the end of a quarter, with the transaction being unwound at the beginning of the next reporting period. The repos were classified as a sale of assets (rather than a loan), allowing it to move $50bn off its balance sheet (and replace it by $50bn in cash) just in time for the quarterly snapshots it would release to its shareholders.

Tragically, this device helped (at least temporarily) assuage the fears of the financial markets and Lehman’s customers and counter-parties in the run-up to its collapse. Its leverage ratio was cut from a real 13.9 times to an artificial 12.1. What makes this sort of off-balance sheet accounting even more pernicious than the more usual kind (such as the structured investment vehicles commonly used before 2008) was that it was entirely hidden (and legally so). SIVs were always disclosed to investors with the eyes to look and the brains to register (what went wrong was that when the markets froze, the banks often took SIVs back onto their balance sheets, which was never meant to happen and made a mockery of the whole exercise).

Accounting laws are always pushed to the legal limit (and well beyond the bounds of decency) by firms, governments (Greece, Italy and Britain all have huge off-balance sheet liabilities) and individuals. That is just life; decrying it won’t help. What is needed instead is to make the rules much tougher to cut back on wriggle-room.

Accounting standards should ban transactions that are only conducted to artificially reduce balance sheets or that are devoid of any real commercial substance. Everything should be on the books. That would have stopped the Lehman nonsense – and would have prevented Greece’s shenanigans. We must no longer tolerate a smoke and mirrors economy – which is why proper accounting rules are essential.