The Effect Of Off Balance Sheet Financing In Failure Of Lehman Brothers Off Balance Sheet Financing:
Off balance sheet financing is an accounting method whereby companies record certain assets or liabilities in a way that keeps from appearing on the balance sheet.
Example: Supposed that company A has an operating lease on land on which company A has to pay £25,000 per annum for the next 50 years. But due to nature of lease and IAS17, which allow Company to record yearly rental expense, but IFRS framework state that Liability is “Present obligation, arising from past event, which is expected to lead to an outflow of future economic benefit from the entity”, and company should record liability to of paying rent for next 49 year under current and non current liabilities.
But when there is conflict between IAS and Framework, IAS should follow and this help director to hide a massive amount of liability and asset from companies balance sheet.
Other examples of off balance sheet financing are selling receivable, joint ventures, special purpose vehicles, convertible debt, sales and repurchase agreement, which used by Lehman Brothers as REPO 105.
Causes Of Lehman Brother Failure:
Lehman Brother collapse is one of the biggest financial crises in US history. But there is no single reason behind the collapse of Lehman Brothers. There are misuse of accounting tools and standards, unethical management and weak corporate governance, which lead to the failure of such giant investment bank.
Examiner “ANTON R. VALUKAS” wrote the detailed report on the failure of Lehman Brother on about approx. 2200 pages, which I used to study cause of Lehman Brother failure.
Off balance sheet finance with use of accounting tool Repo, play an important role in the collapse of Lehman Brothers.
What is REPO 105?
A repurchase agreement (Repo) involves a temporary transfer of assets to counterparty for cash accompanied by an agreement to repurchase the same asset at a specified amount in future. At later date often ten or less than ten days, the transferee return the asset to the borrower who repay cash with interest.
The number 105 was appended to the term Repo to describe the amount of loan collateral and reflect the use is the transaction as a vehicle to achieve an accounting result. For example to secure $100 cash loan a borrower provide an asset with the fair value of $105. As describe by Hallman (2010).
Repo 105 begin when Lehman’s London affiliate unit transferring 105% worth of bonds to a counter party in exchange of 100% cash. Lehman in US then used that cash to pay of its short-term liabilities, that help them to report low leverage at the end of each quarter end to satisfy rating agencies and investors.
As per report Lehman executive start using Repo repeatedly in late 2007 and manage to hide about $50billion of assets from its balance sheet to mange to look better than its actually look.
According to Wilchins, Dan & DaSilva (2010), they first bought bond from street using its LBSF in United States. Just before the quarter-end, the US unit transfers the bond to LBIE a London affiliate, then the London affiliate “sells” the bonds to counter party and raise cash and agreed to buy it back at the beginning of next quartered by paying back cash and interest or at bit high price.
At the beginning of next quartered, LBHI inject some cash in LBIE to buy back bonds from counter party to take back Lehman assets & liabilities its original position.
As per Anton R. Valukas, they used $38.60bn, $49.10bn and $50.38bn in repo105 in Q4 of 2007, Q1 2008 and Q2 2008 respectively and reduced their leverage from 16.1 to 12.1.
According to FAS140 paragraph 98 clear that the transfer of assets in a repo shall be treated as sale of financial asset, if the transferor has:
a. The transferred assets have been isolated from the transferor–put presumptively beyond the reach of the transferor and its creditors, even...
REPORT OF ANTON R. VALUKAS, EXAMINER
Lehman Brothers “Quantitative Risk Management Policy Manual” update September 2007
“Getting Bank Governance Right- The Bank Board Member’s Guide To Risk Management Oversight”, Deloitte, 2009, Page 4.
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