I used to work in a business that, among other things, helped clients get financing against securities. One thing that you learn quickly in that business, and then spend the rest of your career trying to forget, is that the simplest way to get financing against securities is to sell them. You've got $100 of stock and want to borrow $80 of cash against it? Just sell the stock, now you have $100, you're welcome.1
This is not a perfect solution, of course, because you presumably owned the stock for a reason, and that reason was presumably that you thought it would go up.2 And if you sell it you lose the chance to participate in that upside. So one thing you could do is (1) sell your stock for $100 today and (2) enter into some sort of transaction that gives you some or all of the upside in the stock over some period of time. Like, you could buy a call option struck at $100, giving you all the upside and none of the downside, though at the cost of having to pay premium for the call option. Or you could enter into a total return swap struck at $100, giving you all of the upside and all of the downside at a zero-ish cost. Or you could enter into a forward contract to buy back the stock, which is the same as the swap, more or less. That last one - sell stock today, enter into a forward to buy it back in the future - is so common that it has a name, and the name is "repo."
A thing that people sometimes say is that a repo is just a secured loan. Which is true: if I sell you a bond for $95 today, and we agree that you'll sell it back to me at $96 in a month, then really I've just loaned you $95 against the bond. Though also: I "really" sold it to you for $95 and I "really" entered into a forward contract to buy it back. The "really"s aren't doing much work there. The thing happened, you can call it a loan or you can not call it a loan but it's just a thing, whatever.
Accountants have pretty boring jobs so one thing that they spend a lot of time on is trying to figure out whether a thing is "really" a loan or "really" a sale and some sort of derivative contract. This is all super important: if you borrow money against an asset than you have a $100 asset and a $90 liability, or whatever, which makes your balance sheet all big and leveraged, but if you just get rid of the asset and agree to buy it back later, then you've sort of got nothing (except a forward purchase agreement, which tends to not have a lot of value, for accounting purposes3), so your balance sheet is all small and untroubled-looking. Among many, many people who figured this out were Lehman Brothers, who had a thing called Repo 105 that let them make their balance sheet look smaller than it was, for some value of "was." Anyway that worked out poorly for them.
Today Bloomberg has a story about how Deutsche Bank was doing this sort of thing and it's pretty interesting though the details are just a touch hazy:
In the no-balance-sheet transactions, Deutsche Bank received the collateral, sold it and used the cash to make the loan. By selling the collateral -- government bonds, in the deals reviewed by Bloomberg News -- Deutsche Bank created an obligation to return the securities, allowing it to net to essentially zero its assets and liabilities, the documents show. ... Deutsche Bank was able to sell the collateral because it didn’t have to return the bonds under the terms of the agreement. Instead, the borrower agreed that Deutsche Bank could return the “cheapest-to-deliver” equivalent in the event of default, the documents show.
The German lender sold insurance against possible defaults of securities linked to the collateral, in effect moving the risk that the loan wouldn’t be repaid onto its trading book and away from public scrutiny, according to accountants who reviewed the documents for Bloomberg News.
DB seems to have netted these transactions - (1) handing money to the customer, (2) selling the bonds for the customer, and (3) having a forward (5-year-ish) agreement to unwind the whole thing - under IAS 32, which provides that:
A financial asset and a financial liability shall be offset and the net amount presented in the statement of financial position when, and only when, an entity:
(a) currently has a legally enforceable right to set off the recognised amounts; and
(b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously
I gather that "I have to return you Bond X and you have to return me $100" is not nettable but "I have to return you the value of the cheapest-to-deliver bond of Issuer X and you have to return me $100" is, though the logic somewhat escapes me. The logic also escapes a bunch of people who talk to Bloomberg, most of whom say stuff like:
“It goes against the spirit of any regulation,” said Arturo Bris, a finance professor at the IMD business school in Lausanne, Switzerland, who examined the Deutsche Bank documents. “Risks, like energy, get transformed but don’t disappear.”
“The figures should be disclosed,” said Edgar Loew, an honorary professor at WHU-Otto Beisheim School of Management in Vallendar, Germany, who examined the Deutsche Bank documents for Bloomberg News. “This type of accounting was not intended by the rules.”
Though some of them are kind of into it:
“They cleverly found a way to exploit the law and followed the rules to the letter,” said Barry Epstein, a principal of forensic accounting and litigation consulting at Chicago-based Cendrowski Corporate Advisors, who reviewed deal documents.
Like Barry Epstein I'm inclined to award points for cleverness though unlike him I haven't reviewed the deal documents4 so I'm not quite sure how many points to award. It's Deutsche Bank, though, so I'm inclined to think it's pretty good.
Is this against the intent of the rules? I ... I mean, I'm not a metaphysician, what do I know. Like here, you're Dexia or whatever, one of the customers who did or thought about doing these trades with Deutsche:
- You want to get 5-year financing against some government bonds.
- You hire Deutsche Bank to sell them.
- Now you have money.
- You enter into a mark-to-market 5-year swap, with Schmeutsche Bank, on some different bonds of the same government, with like a similar blended duration etc. to the ones you sold.
- Now you have the exposure you wanted.
- Deutsche Bank has nothing.
- Schmeutsche Bank has a mark-to-market swap which, initially, doesn't do much to its balance sheet.5
- Nobody has a loan.
- In five years, the swap settles.
- You take the money you got day one, and the settlement you get on the swap, and hire Deutsche Bank to buy back your original bonds.
- I submit to you that, with minor slippage, you have recreated a 5-year loan against your bonds.
- But nobody's ever given you a loan.
This trade is basically that, only it replaces Schmeutsche Bank with Deutsche Bank, meaning that they do both the selling of the bonds and the swapping of the oh-so-slightly-different thing back to you. Does that transform a trade where no one gave you a loan to a trade where Deutsche Bank gave you a loan? Meh, sure, maybe. But the spirit that is or is not being violated here is a little beyond me.
1.Or: sell 80% of it, now you have $80 of cash and $20 of stock, even better. I posit that the other more complicated thing you were going to do probably had a delta of less than 20% anyway.
2.Each of those presumptions is extremely questionable, in the general case. Particularly the second: the reason you own the stock is often "because you've got a lockup" or "because selling it would generate a big tax bill."
3.Like, it's just a derivative with a mark-to-market value; day one its value is more or less the strike price minus the price of the asset. (Er grown at the forward but whatever.) If you enter it at a market price then its day-one value is mostly zero.
4.If you have them, you know where to reach me.
5.One of Bloomberg's experts says:
“They’re running a market risk,” said Theodore Krintas, managing director of Athens-based Attica Wealth Management, which oversees 100 million euros, including Deutsche Bank stock. “From an investor point of view, I’d like very much to know.”
Well sure but running a market risk doesn't by itself create balance sheet, in this world of ours. Even IFRS doesn't put derivative notional on your balance sheet.