For some time I have been trying to understand the link between fall of Lehman and Repo 105. I now have a fair degree of clarity on it and I want to share it. Lets discuss what was Lehman's problem. But before that, a recap of some basics.
What is a repo?
Imagine two banks 'A' & 'B'. 'A' needs cash and 'B' has cash on hand. 'A' transfers a stable security like a T-Bill to 'B', promising to buy it back at a certain date at same price of the security + some interest. The transaction is called a repo transaction and is normally used by banks as a short term measure to meet their SLR/CRR needs. Usually, a normal repo is named repo 100. Meaning, you pledge $100 worth securities, raise $100 cash and at a later date buy back the instrument at $100 + repo rate.
What is Repo 105?
If the security in question is not stable or standard, pledgers tend to pay a premium on the value and raise cash. In a repo 105 transaction, to raise $100 cash from this security, the receiver pledges securities worth $105. It provides a sort of protection to the lender in case the value of the asset falls below $100.
What is Leverage and why is it so important?
The extent to which assets are created through equity is called leverage. Leverage demonstrates how the assets are financed. A higher leverage means assets are financed through debt. It in turn means higher debt and higher interest payments. Everyone is cautious about lending to firms with higher leverage and Lehman bros had a very high leverage of around 40 during that time.
Leverage has to be lowered for three crucial reasons. One, should there be losses, share holders money can better absorb losses. Two, shareholders were increasingly focusing on balance sheets and ratios to measure the financial health of a company and three, credit ratings were very sensitive to leverage and a drop in ratings would rock the firm.
What is a repo?
Imagine two banks 'A' & 'B'. 'A' needs cash and 'B' has cash on hand. 'A' transfers a stable security like a T-Bill to 'B', promising to buy it back at a certain date at same price of the security + some interest. The transaction is called a repo transaction and is normally used by banks as a short term measure to meet their SLR/CRR needs. Usually, a normal repo is named repo 100. Meaning, you pledge $100 worth securities, raise $100 cash and at a later date buy back the instrument at $100 + repo rate.
What is Repo 105?
If the security in question is not stable or standard, pledgers tend to pay a premium on the value and raise cash. In a repo 105 transaction, to raise $100 cash from this security, the receiver pledges securities worth $105. It provides a sort of protection to the lender in case the value of the asset falls below $100.
What is Leverage and why is it so important?
The extent to which assets are created through equity is called leverage. Leverage demonstrates how the assets are financed. A higher leverage means assets are financed through debt. It in turn means higher debt and higher interest payments. Everyone is cautious about lending to firms with higher leverage and Lehman bros had a very high leverage of around 40 during that time.
Leverage has to be lowered for three crucial reasons. One, should there be losses, share holders money can better absorb losses. Two, shareholders were increasingly focusing on balance sheets and ratios to measure the financial health of a company and three, credit ratings were very sensitive to leverage and a drop in ratings would rock the firm.
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