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Reviewing repo risk
The repo market may have triggered the Lehman crash, but Ian Sanderson argues repurchases are still high-risk for auditors
When Lord Turner, chairman of the Financial Services Authority, made a recent speech at John Hopkins University calling for the need for more regulation of the shadow banking sector, I was reminded of the collapse of Lehman in 2008 and its use of short-term repo market purchases to manipulate its financial statements.
Repos, or repurchases, are a means of boosting short-term cashflows by exchanging less liquid assets for cash with a promise to repurchase the less liquid assets back at a slightly higher price in the future. The repo market is in essence a kind of pawn shop.
The repo market is criticised as being unregulated and opaque but with the current state of many banks’ balance sheets limiting their lending capacities the use of repos is likely to grow; hence the desire of regulators to oversee the market.
Repos were considered by many observers to have contributed to the economic crisis because the margin with which potential lenders would enter the repo market increased (as an obvious consequence of the increased risk they faced) meaning many businesses lacked access to affordable liquidity. For an auditor, repos can represent significant risks because they must be marked to market.
Rocket science
Compared to other accounting scandals at the time such as Satyam (was it really true the auditors did not verify the bank balances?) and Madoff (were there any auditors?), the Lehman scandal was close to rocket science. Lehman exploited weaknesses in US accounting standards, which allowed a repo to be considered as an asset sale (and taken off the balance sheet to improve capital ratios) if the seller could demonstrate it had lost control of the asset.
Lehman argued a repo was a sale if the promise to buy it back was for 105% or 108% of its sale price (depending on the type of asset) because at such prices it must clearly have lost control of the asset. Lehman was able to convince its auditors because it was supported by a legal opinion; however, Lehman had to go to England to get the legal opinion and construct repo sale contracts under English Law.
For an auditor this should have raised numerous red flags especially considering that Lehman’s business was struggling in 2008. The auditor, understanding the risks in Lehman’s business, would have been aware that Lehman had an incentive to mis-state its financial statements and had gone to the extent of getting a legal opinion to validate its accounting policies.
However, against these red flags the auditor was also required to report against an accounting framework which allowed such accounting to occur; the auditor faced a Catch-22 situation. The Financial Accounting Standards Board (FASB) later closed the loophole that allowed this to occur.
No loopholes
The report into the Lehman scandal (Valukas report) came to the conclusions that when taken in its entirety US GAAP had no loopholes because its overall purpose, shared by the securities laws, is ‘to increase investor confidence by ensuring transparency and accuracy in financial reporting’.
Against such arguments the auditor of Lehman was in a no-win situation; it is similar to being told the Bible is the fully accurate word of God although some of the stories may not be historically reliable. Accounting and auditing scandals do not easily get forgotten; audit is based on stakeholders having confidence in the assurance that the audit opinion provides, and the Lehman accounting scandal clearly added weight to those at the European level asking for a shakeup of the profession.
While it is easy to represent ‘the dog that didn’t bark’ as incompetent or complicit (please try to put Satyam and Madoff out of your mind for a minute), the Lehman scandal did not necessarily evidence this. Reform of the auditing profession is clearly coming in Europe whether fully warranted or not. It will be interesting to see if such changes, combined with many firms’ huge investments in their audit approaches to more thoroughly address risk of material misstatements in financial reporting, will turn the profession into a pack of howling wolves.
Author
Ian Sanderson FCA, a former Big Four partner, now lives and works in Brussels for a global NGO
CCH is a trading name of Wolters Kluwer (UK) Limited. Registered in England & Wales, No. 450650. Registered office: 145 London Road, Kingston upon Thames, Surrey KT2 6SR. Wolters Kluwer (UK) Ltd is authorised and regulated by the Financial Services Authority for general insurance business.