Peeling away financial reporting issues one layer at a time

Repo Accounting: After Lehman, another Debacle was Just a Matter of Time

Last January, as the FASB proposed closing that 'Lehman loophole' in repo accounting while leaving three other loopy conditions to be met for "sale accounting" intact, I predicted that it would just be a matter of time for history to repeat itself, albeit through exploitation of some other gap in rules-based GAAP. As it turned out, it took less than a year for another major debacle to occur. This is how the Grumpy Old Accountants describe what happened at MF Global:

"MF Global structured the repo so that it matured when the [European sovereign] bonds [being transferred] matured. The assertion is that the firm doesn't control the debt instrument during the repo period, and when the repo matures, the firm will not regain control of the instrument because it matures on that date. Nice try.

MF Global in fact did not relinquish control of the securities. If the firm had relinquished control in reality, then it would not have received those coupons [on the bonds]."

Just as I had concluded, Grumpy Old Accountants (namely, academics Ed Ketz and Anthony Catanach) find that the FASB is not doing its job. "It should have fixed repo accounting ages ago," and they endorsed my suggested change to sale accounting whenever it applied:

The following procedures would apply to securities for which legal ownership (as opposed to 'effective control') has transferred:

  1. At the inception of the agreement, a transferor would recognize an asset for the cash received and derecognize the securities transferred. Any difference between these two amounts would preferably be reflected on the balance sheet as a change in shareholders' equity through net income.
  2. To recognize the commitment to repurchase the transferred securities, a receivable for the future return of the transferred securities would be recognized at its fair value; and a payable would be recognized at its fair value for the price to be paid for the return of the transferred securities. In contrast to existing accounting rules, these two amounts must be presented "gross"— i.e., they may not be offset. And again, any difference between these two amounts would be reflected on the balance sheet as a change in shareholders' equity through net income.

Although I still like my solution, I am well aware that others dislike violations of the general rule of not recognizing assets and liabilities related to contracts for which mutual performance must occur – i.e., executory contracts. There are exceptions (capital lease accounting most prominently), but the FASB could spend its time going around in circles debating whether this particular executory contract merits a treatment that is inconsistent with other executory contracts, where to draw the line, etcetera, etcetera.

So, I'll make it even easier for the FASB. It can even keep that silly "effective control" thing if it wants; however, if a transferor were to apply sale accounting for a repo, it must separately and prominently disclose the fair values of the right to receive the security and the obligation to pay cash. With such disclosures present, not even an understaffed government regulator like the SEC could miss the risk implications of an obligation to pay a fixed amount of cash for a security whose future value is uncertain. And, any analyst could easily make pro forma adjustments to published financial statements as it suits one's own views and preferences.

For the most part, GAAP doesn't do a very good job of providing information about risk; and I am not aware that the SEC's requirements to provide qualitative and quantitative information about market risks (see Reg. S-K, Item 305) are very helpful, either. Which leads me to a related suggestion: to require separate fair value information on both the receivable and payable legs of all financial derivatives. Just a very few numbers would be worth much more than thousands of words worth of sleep-inducing narrative disclosures that, even when provided in good faith, are far too subjective and lacking in comparability across companies or time.

In short, the disclosures I am suggesting would be super straightforward, highly informative, and easily enforceable. Consequently, for every future derivatives-based accounting scandal, I'll be asking whether fair value disclosures of the asset and liability legs could have prevented, or mitigated investors' losses and still further erosion in the public's confidence in our capital markets and financial institutions.

 

3 Comments

  1. Reply RPN10 November 21, 2011

    I don’t think fair value helps without describing what it’s a fair value of. If the asset and liability positions inherent in the repo are hung up on the balance sheet everyone can see the size of the punts (and a repo’s just a leveraged punt) being run.
    With better disclosure of the underlying investments and the cash (by way of margin calls) and income sensitivities based on market movements the readers are better able to assess the risks.

  2. Reply coyote November 21, 2011

    I think you may have missed one rational on the repo to maturity. In addition to being structured to evade the effective control definitions, it was at least nominally meant to deal with the risk issue. You write about the danger of the “obligation to pay a fixed amount of cash for a security whose future value is uncertain.” Historically, the value at maturity of AAA European sovereign debt has been pretty predictable — its just the principle. So if the main fluctuation in the value of a debt instrument is due to changes in interest rates rather than repayment expectations, then repo to maturity would be somewhat safer.
    If European governments did not default on their debt in the next year, then MF Global would have been fine letting the repo run to maturity. My understanding is that the MF Global position blew up when there was a margin call (or the repo equivilent, whatever that is called) as the market value of the underlying securities fell. This was the failure. The repo to maturity concept made it look immune to market fluctuations when in fact it was not.
    There is nothing about this that changes your conclusions, of course. Even with your suggested disclosure, the current treatment is absurd. As a minimum, if one is subject to margin calls based on changes in value of a security, that should certainly trigger “effective control” should it not?

  3. Reply Independent Accountant November 22, 2011

    TS:
    I saw you quoted in the WSJ. Congrats. I have awaited this type of fiasco too. My suggestion: leave the accounting alone and let PWC get sued over this and pay say $500 million. Maybe that will learn ’em. The substance and form of the transactions seems clear enough to me.
    IA

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