Thursday, April 22, 2010

Repo 105

As the US courts have been investigating the causes behind the sub-prime morgage financial crisis, we have learned a new term: Repo 105. It is a series of transactions as follows:
1. Company AAA holds some poor quality assets (i.e., sub-prime morgages). AAA's leverage ratio also does not look attractive (it is too deep in debt). It is coming close to the end of a quarter and AAA does not want all that debt and the poor quality assets to show up on it's balance sheet when it issues it's quarterly financial statements.
2. Company BBB offers to buy the poor quality assets from AAA with one of the terms of the contract stipulating that AAA will buy the assets back at a specified date in the future at a reduced price.
3. AAA prepares its end of quarter financial statements. Since the title for the assets is transfered from AAA to BBB, then AAA does not have to record the risky assets on its financial statements. This makes the investors think the company is solid and helps maintain the stock price and rating.
4. After AAA has issued its quarterly financial statements, it buys back the risky assets.

This is what Lehman brother did as it was begining to sink in months coming up to its collapse.

The purpose of financial statements to provide an accurate account of the financial position and health of a company. Such activities clearly oppose the primary purpose of financial statements.

Why are accurate financial statements so important? Because we live in a capitalistic society. One of the tenants of a capitalistic society is that the people who own the capital should be the ones that benefit from the income earned off that capital. Another feature of capitalistic societies is that the person owning the capital is not the person who is actually putting the capital to work. For example, a capitalist my own a factory, but he has other people doing the work of running the factory and doing the labour in the factory.

We didn't alway live in a capitalistic society. Before the industrial revolution, the workers were also the owners of their own business. When the workers are also the owners, there is no motivation for the workers to decieve the owners.

However, when there is a division between ownership of the capital and management of the capital as exists in a capitalistic society, the managers of the capital will always be motivated to hide information from the owners in an attempt to maximize their benefit. In an attempt to curtail this deception, complicated accounting systems such as Sarbanes Oxley and audits are created to try to maintain honesty. It looks like the government needs to add some more complexity to their rules track down the inginuity of the managers of capital.

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