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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

Before its 2008 bankruptcy Lehman Brothers relied heavily on short-term repo funding to finance long-term, illiquid assets such as commercial real estate. Which combination best describes the vulnerability and the accounting practice that obscured it?

Lehman financed long-term illiquid assets with short-term repo, creating rollover and funding risk when lenders withdrew. Repo 105 transactions, treated as sales rather than financings, temporarily removed assets from the balance sheet at quarter-ends and made reported leverage look lower.

  1. ADuration mismatch refinancing risk, with Repo 105 transactions treated as sales to temporarily lower reported leverage at quarter-endsCorrect
  2. BCounterparty concentration in a single central clearing house, with netting that overstated leverage
  3. CForeign exchange mismatch, with hedge accounting that overstated leverage
  4. DExcessive long-term debt maturing in 2008, with off-balance-sheet pensions that hid liabilities

Explanation

Lehman funded long-term assets with overnight and short-term repo, so it had to roll funding daily and lost access as confidence fell. Repo 105 transactions were accounted as sales, removing assets from the balance sheet around reporting dates and lowering reported leverage. The other options do not describe Lehman's circumstances.

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