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Repo Fraud

March 15, 2010

Yesterday, I wrote about the possibility of control fraud existing in the for-profit trade school industry. The weapon of choice when it comes to control fraud is accounting fraud.

This morning, I read an article from the Christian Science Monitor about how Lehman Brothers employed accounting fraud “amid [the] financial crisis.”

It appears Lehman was using repurchase agreements (repos) “at the end of each quarter to make its finances appear less shaky than they really were.”

A repurchase agreement is a financial instrument or contract. According to Phillipe Jorion, a repo is:

An agreement between two parties under which one part agrees to sell a security and buy it back on an agreed-upon date and at an agreed-upon price. In return, the seller receives cash. The difference between the original sale price and the subsequent repurchase price acts as interest on a loan, which, when expressed as an interest rate, is commonly known as the repo rate. (Jorion, p168)

In Lehman’s case, the repo was reported as an “outright sale of securities” which created “a materially misleading picture of the firm’s financial condition in late 2007 and 2008.” Essentially, Lehman overstated its assets and understated its liabilities.

Repos are also vulnerable to interest-rate risk and very extreme risks if you leverage them. Should yields go up, the value of the securities goes down. (Jorion, p34)

Reference: Big Bets Gone Bad, Jorion, P., 1995

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