Investor alert: repo agreements.

• Author: Madalena, Ralph J.
• Position: Repurchase agreements

GFOA's Subcommittee on Investments, made up of members from GFOA's Standing Committee on Cash Management, is preparing an update to Considerations for Governments in Developing a Master Repurchase Agreement, Second Edition (GFOA 1988) to address recent changes to The Bond Market Association's (TBMA, formerly known as the Public Securities Association) Master Repurchase Agreement. In the course of preparing this update, the subcommittee became aware that GFOA members were being contacted by their broker/dealers regarding changes to the accounting treatment for repurchase transactions under the Financial Accounting Standards Board (FASB) Statement 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities."

Although governments may not be bound by FASB pronouncements, Statement 125 affects counterparties to repurchase transactions with governments and may change the nature of the underlying repurchase agreement from a buy-sell transaction to a collateralized loan. Treating repurchase transactions as collateralized loans would make them illegal for local governments in many states.

The Issue

The subcommittee has reviewed the matter, and advises investors to consider the following points.

In general, FASB 125 provides that if the transferee (i.e., repo buyer or the government entity) has the right to sell or repledge the securities under a repurchase agreement and the transferor (i.e., repo seller or the broker/dealer) does not have the right to substitute the securities or terminate the contract on short notice, the repo buyer will be required to record both the securities, together with any obligation to return the securities, on its balance sheet. The repo seller will be required to reclassify the securities from a securities inventory or investment account to a securities pledged account on its balance sheet.

As a result, and at the request of TBMA members active in the repurchase transaction markets, the Trading Practices Committee of the TBMA Funding Division published an optional substitution/termination provision to the TBMA Master Repurchase Agreement. The provision, if agreed to by the parties to the repurchase transaction, would allow the repo seller (broker/dealer) to retain effective control over the purchased securities. Or the repo seller could elect to terminate the transaction prior to maturity on short notice to the repo buyer (government entity) once the repo buyer has offered such an...