Off Balance Sheet Repo Risks Come Back to Bite

By Guest Contributor
November 16, 2011

By Christopher Elias

NEW YORK, Nov.16 (Business Law Currents) - Off balance sheet items and undisclosed liabilities are coming back to bite companies, as repo-to-maturity disclosures prove to be a jarring reminder of pre-crisis risk proclivity.

Symptomatic of a wider problem gripping U.S. banks, MF Global’s bankruptcy has drawn attention to the danger of financial services firms hiding their true liabilities, no matter how safe they think they are.

The revelation that MF Global’s off balance sheet leveraged repo-to-maturity play was stuffed full of toxic Eurozone debt proved to be its downfall. The prospect of a Eurozone default spooked markets and MF Global’s liquidity drained away. A review of U.S. banks’ SEC disclosures reveals, however, some troubling implications of the gaps in U.S. GAAP filings as the true nature of hidden debt exposure becomes apparent. 

SEC filings from Nomura, Santander and Merrill Lynch have all acknowledged the heavy use of off-balance sheet repo-to-maturity transactions, and some even admitted to including Eurozone debt within these structures.

REPOS

By way of background, repos are used by many banks as a way to increase liquidity and involve the sale of a security (e.g. bonds) together with an agreement for the seller (the bank) to repurchase the securities at a later date. In return for “selling” the securities, the seller receives a purchase price with an agreement to repurchase the securities at a later date and probably for a greater price – effectively representing the “interest” (known as the “repo rate”). A repo is the economic equivalent of a secured loan with the buyer receiving securities as collateral and the seller receiving the purchase price as the loan principle, although as seen in Lehman Brothers’ collapse, this can be abused for accountancy purposes.

When a repo is set to mature at the same time as its underlying security (a “repo-to-maturity”), a company can treat these repos as sales and remove both assets and liabilities from its balance sheet. The problem is that banks remain exposed to the risks of repo assets defaulting or decreasing in value. A reduction in value can result in margin calls (a call for additional security) or can leave a repo seller exposed to off balance sheet defaults.

NOMURA

Most transparent over its exposure to off balance sheet transactions is Nomura who acknowledged in recent filings that as of 31 March 2011, it had derecognized Yen 160.9 billion into repo-to-maturity transactions, a figure that had increased to Yen 169.7 billion by the end of 30 June 2011. In other words, Nomura has derecognized (removed) Yen 169.7 of assets and liabilities from its balance sheet, despite the fact it remained economically exposed to those assets.

Summed up in this concise note to its balance sheet, Nomura acknowledged that its filed balance sheet does not include the full extent of its liabilities:

Reconciles to the total assets amount disclosed on the face of Nomura’s consolidated balance sheets and therefore excludes the fair value of securities transferred to counterparties under repo-to-maturity and certain Japanese securities lending transactions which are accounted for as sales rather than collateralized financing arrangements.

To make matters worse, Nomura disclosed in a recent 8K that it has a credit risk concentration that includes significant amounts of EU debt. Nomura disclosesdthat:

Nomura has credit risk concentrations on bonds issued by the Japanese Government, U.S. Government, Governments within the European Union (“EU”), their states and municipalities, and their agencies. These concentrations generally arise from taking trading securities positions and are reported within Trading assets in the consolidated balance sheets.

According to the same filing Nomura’s total exposure to the EU was Yen 2.6 billion, but allowing for the additional Yen 169.7 billion in repo-to-maturity transactions not included in this figure, the true exposure is likely much higher.

MERRILL LYNCH

Also disclosing significant use of repo-to-maturity transactions was Merrill Lynch although whether these include Eurozone debts is much harder to determine.

Merrill Lynch stated that:

Merrill Lynch enters into repo-to-maturity sales only for high quality, very liquid securities such as U.S. Treasury securities or securities issued by the government-sponsored enterprises (“GSEs”). Merrill Lynch accounts for repo-to-maturity transactions as sales and purchases in accordance with applicable accounting guidance, and accordingly, removes or recognizes the securities from the Condensed Consolidated Balance Sheet and recognizes a gain or loss, as appropriate, in the Condensed Consolidated Statement of Earnings.

While one might be mistaken for thinking that Merrill Lynch only invests in U.S. government debt from this disclosure, the wording is perhaps tellingly more vague than many of its competitors.

According its filing, Merrill Lynch only undertakes repo-to-maturity transactions for “high quality, very liquid securities such as U.S. Treasury Securities” but it does not, unlike many other banks, discount the possibility that these transactions include Eurozone debt.

Although Merrill Lynch disclosed that the use of repo-to-maturity transactions were not “material” for the period it does recognise the potential impact that these and other OTC contracts could have on it business if confidence was to be lost in its ability to pay its creditors. Merrill Lynch stated:

In addition, under the terms of certain OTC derivative contracts and other trading agreements, the counterparties to those agreements may require us to provide additional collateral or to terminate these contracts or agreements which could cause us to sustain losses and/or adversely impact our liquidity. If Bank of America’s or ML & Co’s short−term credit ratings, or those of our bank or broker−dealer subsidiaries, were downgraded by one or more levels, the potential loss of access to short−term funding sources such as repo financing, and the effect on our incremental cost of funds could be material.

OPPENHEIMER HOLDINGS

Contrast Merrill Lynch’s disclosures with those of Oppenheimer Holdings, a U.S. investment bank that has a notional exposure to $1.75 billion in repo-to-maturity transactions out of total repurchase agreements (including short term repos) of $7.2 billion.

Oppenheimer goes to great lengths to clarify what its repo-to-maturity debts include. It stated that:

Recent events have caused increased review and scrutiny on the methods utilized by financial service companies to finance their short term requirements for liquidity. The Company utilizes commercial bank loans, securities lending, and repurchase agreements (through overnight, term, and repo−to−maturity transactions) to finance its short term liquidity needs (See “Liquidity”). All repurchase agreements and reverse repurchase agreements are collateralized by short term U.S. Government obligations and U.S. Government Agency obligations.

BANK OF AMERICA

As well as going into great detail to spell out what assets might be behind off balance sheet transactions, some banks, such as Bank of America, make a point of advertising that they no longer engage in this kind of behaviour. According to Bank of America’s most recent annual report, it no longer engages in repo-to-maturity transactions despite having an exposure of $6.5 billion at the end of 2009.

Bank of America stated:

In repurchase transactions, typically, the termination date for a repurchase agreement is before the maturity date of the underlying security. However, in certain situations, the Corporation may enter into repurchase agreements where the termination date of the repurchase transaction is the same as the maturity date of the underlying security and these transactions are referred to as “repo−to−maturity” (RTM) transactions. The Corporation enters into RTM transactions only for high quality, very liquid securities such as U.S. Department of the Treasury (U.S. Treasury) securities or securities issued by government−sponsored enterprises (GSE). The Corporation accounts for RTM transactions as sales in accordance with applicable accounting guidance, and accordingly, removes the securities from the Consolidated Balance Sheet and recognizes a gain or loss in the Consolidated Statement of Income. At December 31, 2010, the Corporation had no outstanding RTM transactions compared to $6.5 billion at December 31, 2009, that had been accounted for as sales.

EUROPEAN DISCLOSURES

Perhaps surprisingly, and not without some irony, disclosures from Europe reveal a slightly healthier picture. Despite the crisis raging across the continent, European banks generally file under IFRS rather than U.S. GAAP. The different accounting principles mean that repo-to-maturity transactions are much less likely to be treated as sales and more as financing. This means that although European banks (e.g. Dexia) carry substantial PIIGS exposure, this exposure is less likely to be in the form of off balance sheet transactions and more likely to be accounted for.

Unable to treat its repos as sales under IFRS, Santander’s SEC disclosure noted significant exposure to Eurozone debt as at 30 June 2011, although these are in the form of “financing” rather than repo sales of sovereign debt. According to Santander it has £1.5 billion in reverse repos which were collateralised by OECD Government (but not Spanish) securities.

Similarly, Royal Bank of Scotland (RBS) discloses significant on sheet exposure to Eurozone debt in the form of assets and derivatives. In its recent annual report, RBS stated that its net exposure to Portugal and Greece (combined) was around £3 billion. HSBC also disclosed that it had a combined exposure to Greece and Portugal debt of around £1.6 billion and both companies booked impairment charges as a result of the ongoing instability in the region.

Ironically, while IFRS filing banks acknowledge and disclose Eurozone debts, the full extent of U.S. banks’ debt exposure may never be fully known. While these debts may not, in some instances, include Eurozone debt, they are not risk free and their off balance sheet characterization makes them difficult to assess and perhaps even harder to prepare for.

The downgrading of U.S. treasury debt only highlighted the fall from grace of sovereign debt as the safest form of assets. With U.S. debt no longer seemingly risk free, few people would argue that the off sheet treatment of treasury bonds was appropriate. Should U.S. treasury debt suffer further problems, then U.S. banks use of off balance sheet repo transactions could come back to haunt them.

 

(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at http://currents.westlawbusiness.com. )

 

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