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Everyone Knew About Lehman Brothers

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March 19, 2010

A March 18 report by Henny Sender at the Financial Times revealed that former officials from Merrill Lynch had contacted the Securities and Exchange Commission as well as the Federal Reserve of New York to complain that Lehman Brothers had been incorrectly calculating a key measure of its financial health.  The regulators received this warning several months before Lehman filed for bankruptcy in September of 2008.  Apparently Lehman’s reports of robust financial health were making Merrill look bad:

Former Merrill Lynch officials said they contacted regulators about the way Lehman measured its liquidity position for competitive reasons.  The Merrill officials said they were coming under pressure from their trading partners and investors, who feared that Merrill was less liquid than Lehman.

*   *   *

In the account given by the Merrill officials, the SEC, the lead regulator, and the New York Federal Reserve were given warnings about Lehman’s balance sheet calculations as far back as March 2008.

*   *   *

The former Merrill officials said they contacted the regulators after Lehman released an estimate of its liquidity position in the first quarter of 2008.  Lehman touted its results to its counterparties and its investors as proof that it was sounder than some of its rivals, including Merrill, these people said.

*   *   *

“We started getting calls from our counterparties and investors in our debt.  Since we didn’t believe the Lehman numbers and thought their calculations were aggressive, we called the regulators,” says one former Merrill banker, now at another big bank.

Could the people at Merrill Lynch have expected the New York Fed to intervene and prevent the accounting chicanery at Lehman?  After all, Lehman’s CEO, Richard Fuld, was also a class B director of the New York Fed.  Would any FRBNY investigator really want to make trouble for one of the directors of his or her employer?  This type of conflict of interest is endemic to the self-regulatory milieu presided over by the Federal Reserve.  When people talk about protecting “Fed independence”, I guess this is what they mean.

The Financial Times report inspired Yves Smith of Naked Capitalism to emphasize that the New York Fed’s failure to do its job, having been given this additional information from Merrill officials, underscores the ineptitude of the New York Fed’s president at the time — Tim Geithner:

The fact that Merrill, with a little digging, could see that Lehman’s assertions about its financial health were bogus says other firms were likely to figure it out sooner rather than later.  That in turn meant that the Lehman was extremely vulnerable to a run.  Bear was brought down in a mere ten days.  Having just been through the Bear implosion, the warning should have put the authorities in emergency preparedness overdrive.  Instead, they went into “Mission Accomplished” mode.

This Financial Times story provides yet more confirmation that Geithner is not fit to serve as a regulator and should resign as Treasury Secretary.  But it may take Congress forcing a release of the Lehman-related e-mails and other correspondence by the New York Fed to bring about that outcome.

Those “Lehman-related e-mails” should be really interesting.  If Richard Fuld was a party to any of those, it will be interesting to note whether his e-mail address was “@LehmanBros”, “@FRBNY” or both.

The Lehman scandal has come to light at precisely the time when Ben Bernanke is struggling to maintain as much power for the Federal Reserve as he can — in addition to getting control over the proposed Consumer Financial Protection Agency.  One would think that Bernanke is pursuing a lost cause, given the circumstances and the timing.  Nevertheless, as Jesse of Jesse’s Cafe Americain points out — Bernanke may win this fight:

The Fed is the last place that should receive additional power over the banking system, showing itself to be a bureaucracy incapable of exercising the kind of occasionally stern judgment, the tough love, that wayward bankers require.  And the mere thought of putting Consumer Protection under their purview makes one’s skin crawl with fear and the gall of injustice.

They may get it, this more power, not because it is deserved, but because politicians themselves wish to have more power and money, and this is one way to obtain it.

The next time the financial system crashes, the torches and pitchforks will come out of the barns and there will be a serious reform, and some tar and feathering in congressional committees, and a few virtual lynchings.  The damage to the people of the middle class will be an American tragedy.  But this too shall pass.

It’s beginning to appear as though it really will require another financial crisis before our graft-hungry politicians will make any serious effort at financial reform.  If economist Randall Wray is correct, that day may be coming sooner than most people expect:

Another financial crisis is nearly certain to hit in coming months — probably before summer.  The belief that together Geithner and Bernanke have resolved the crisis and that they have put the economy on a path to recovery will be exposed as wishful thinking.

Although that may sound a bit scary, we have to look at the bright side:  at least we will finally be on a path toward serious financial reform.



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Deceptive Oversight

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March 17, 2010

March 16 brought us a few more provocative essays about the Lehman Brothers scandal.  The most prominent subject discussed in the reactions to the Valukas Report has been the complete lack of oversight by the Federal Reserve Bank of New York — the entity with investigators in place inside of Lehman Brothers after the collapse of Bear Stearns.  The FRBNY had the perfect vantage point to conduct effective oversight of Lehman.  Not only did the FRBNY fail to do so — it actually helped Lehman maintain a false image of being financially solvent.  It is important to keep in mind that Lehman CEO Richard Fuld was a class B director of the FRBNY during this period.  Does that sound like a conflict of interest to anyone besides me?  The Securities and Exchange Commission (under the direction of Christopher Cox at the time) has become another subject of scrutiny for its own dubious semblance of oversight.

Eliot Spitzer and William Black (a professor of economics and law at the University of Missouri – Kansas City) recently posted a great article at the New Deal 2.0 website.  Among the memorable points from that piece is the assertion that accounting is “the weapon of choice” for financial deception.  The Valukas Report has exposed such extensive accounting fraud at Lehman, it will be impossible for the Federal Reserve Bank of New York to feign ignorance of that activity.  Another memorable aspect of the Spitzer – Black piece is its reference to those “too big to fail” financial institutions as “SDIs” or systemically dangerous institutions.  Here is some of what Spitzer and Black had to say about how the FRBNY became enmeshed in Lehman’s sleazy accounting tactics:

The FRBNY knew that Lehman was engaged in smoke and mirrors designed to overstate its liquidity and, therefore, was unwilling to lend as much money to Lehman.  The FRBNY did not, however, inform the SEC, the public, or the OTS  (which regulated an S&L that Lehman owned) of what should have been viewed by all as ongoing misrepresentations.

The Fed’s behavior made it clear that officials didn’t believe they needed to do more with this information. The FRBNY remained willing to lend to an institution with misleading accounting and neither remedied the accounting nor notified other regulators who may have had the opportunity to do so.

*   *   *

The FRBNY acted shamefully in covering up Lehman’s inflated asset values and liquidity.

The consequences of the New York Fed’s involvement in this scam were discussed in an article by Andrew Ross Sorkin from the March 16 edition of The New York Times.  (You may recall that Andrew Ross Sorkin is the author of the book, Too Big To Fail.)  He pointed out that the consequences of the Lehman scandal could be very far-reaching:

Indeed, it now appears that the federal government itself either didn’t appreciate the significance of what it saw (we’ve seen that movie before with regulators waving off tips about Bernard L. Madoff).  Or perhaps they did appreciate the significance and blessed the now-suspect accounting anyway.

*   *   *

There’s a lot riding on the government’s oversight of these accounting shenanigans.  If Lehman Brothers executives are sued civilly or prosecuted criminally, they may actually have a powerful defense:  a raft of government officials from the S.E.C. and Fed vetted virtually everything they did.

On top of that, Lehman’s outside auditor, Ernst &Young, and a law firm, Linklaters, signed off on the transactions.

The problems at Lehman raise even larger questions about the vigilance of the SEC and Fed in overseeing the other Wall Street banks as well.

The question as to whether similar accounting tricks were being performed at “other Wall Street banks as well” opens a very huge can of worms.  It’s time for the government to step back and assess the larger picture of what the systemic problem really is.  In a speech before the Senate, Delaware Senator Ted Kaufman emphasized that the government needs to return the rule of law to Wall Street:

We all understood that to restore the public’s faith in our financial markets and the rule of law, we must identify, prosecute, and send to prison the participants in those markets who broke the law.  Their fraudulent conduct has severely damaged our economy, caused devastating and sustained harm to countless hard-working Americans, and contributed to the widespread view that Wall Street does not play by the same rules as Main Street.

*   *   *

Many have said we should not seek to “punish” anyone, as all of Wall Street was in a delirium of profit-making and almost no one foresaw the sub-prime crisis caused by the dramatic decline in housing values.  But this is not about retribution.  This is about addressing the continuum of behavior that took place — some of it fraudulent and illegal — and in the process addressing what Wall Street and the legal and regulatory system underlying its behavior have become.

As part of that effort, we must ensure that the legal system tackles financial crimes with the same gravity as other crimes.

The nagging suspicion that those nefarious activities at Lehman Brothers could be taking place “at other banks as well” became a key point in Senator Kaufman’s speech:

Mr. President, I’m concerned that the revelations about Lehman Brothers are just the tip of the iceberg.  We have no reason to believe that the conduct detailed last week is somehow isolated or unique.  Indeed, this sort of behavior is hardly novel.  Enron engaged in similar deceit with some of its assets.  And while we don’t have the benefit of an examiner’s report for other firms with a business model like Lehman’s, law enforcement authorities should be well on their way in conducting investigations of whether others used similar “accounting gimmicks” to hide dangerous risk from investors and the public.

We can only hope that a continued investigation into the Lehman scandal will result in a very bright light directed on those privileged plutocrats who consider themselves above the law.



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The Lehman Fallout

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March 16, 2010

Everyone is speculating about what will happen next.  The shock waves resulting from the release of the report by bankruptcy examiner Anton Valukas, pinpointing the causes of the collapse of Lehman Brothers, have left the blogosphere’s commentators with plenty to discuss.  Unfortunately, the mainstream media isn’t giving this story very much traction.  On March 15, the Columbia Journalism Review published an essay by Ryan Chittum, decrying the lack of mainstream media attention given to the Lehman scandal.  Here is some of what he said:

Look, I know that Lehman collapsed a year and a half ago, but this is a major story — one that finally gets awfully close to putting the crimes in the crisis.  I’ll go ahead and say it:  If you’ve wanted to know about the Valukas report and its implications, you’ve been better served by reading Zero Hedge and Naked Capitalism than you have The Wall Street Journal or New York Times.  This on the biggest financial news story of the week — and one of the biggest of the year.  These papers have hundreds of journalists at their disposal.  The blogs have one non-professional writer and a handful of sometime non-pro-journalist contributors.

I’m hardly the only one who has noticed this.  James Kwak of Baseline Scenario wrote this earlier today:

Overall, I’m surprised by how little interest the report has gotten in the media, given its depth and the surprising nature of some of its findings.

At the Zero Hedge website, Tyler Durden reacted to the Columbia Journalism Review piece this way:

Only a few days have passed since its release, and already the Mainstream Media has forgotten all about the Lehman Examiner Report, with barely an occasional mention.  As the CJR points out, this unquestionably massive story of corruption and vice, is being covered up by powered interests controlling all the major news outlets, because just like in the Galleon case, the stench goes not only to the top, (in this case the NewYork Fed and the SEC), but very likely to various corporations that have vested interests in the conglomerates controlling America’s key media organizations.

One probable reason why the Lehman story is being buried is because its timing dovetails so well with the unveiling of Senator “Countrywide Chris” Dodd’s financial reform plan.  The fact that Dodd’s plan includes the inane idea of expanding the powers of the Federal Reserve was not to be ignored by John Carney of The Business Insider website:

Why do we think these are such bad ideas?  At the most basic level, it’s hard to see how the expansion of the scope of the Federal Reserve’s authority to cover any large financial institution makes sense.  The Federal Reserve was not able to prevent disaster at the firms it was already charged with overseeing.  What reason is there to think it will do a better job at regulating a wider universe of firms?

More concretely, the Federal Reserve had regulators in place inside of Lehman Brothers following the collapse of Bear Stearns.  These in-house regulators did not realize that Lehman’s management was rebuking market demands for reduced risk and covering up its rebuke with accounting sleight-of-hand.  When Lehman actually came looking for a bailout, officials were reportedly surprised at how bad things were at the firm.  A similar situation unfolded at Merrill Lynch.  The regulators proved inadequate to the task.

Just think:  It was only one week ago when we were reading those fawning, sycophantic stories in The New Yorker and The Atlantic about what a great guy “Turbo” Tim Geithner is.  This week brought us a great essay by Professor Randall Wray, which raised the question of whether Geithner helped Lehman hide its accounting tricks.  Beyond that, Professor Wray emphasized how this scandal underscores the need for Federal Reserve transparency, which has been so ardently resisted by Ben Bernanke.  (Remember the lawsuit by the late Mark Pittman of Bloomberg News?)  Among the great points made by Professor Wray were these:

Not only did the NY Fed fail to blow the whistle on flagrant accounting tricks, it also helped to hide Lehman’s illiquid assets on the Fed’s balance sheet to make its position look better.  Note that the NY Fed had increased its supervision to the point that it was going over Lehman’s books daily; further, it continued to take trash off the books of Lehman right up to the bitter end, helping to perpetuate the fraud that was designed to maintain the pretense that Lehman was not massively insolvent. (see here)

Geithner told Congress that he has never been a regulator. (see here)  That is a quite honest assessment of his job performance, although it is completely inaccurate as a description of his duties as President of the NY Fed.

*   *   *

More generally, this revelation drives home three related points.  First, the scandal is on-going and it is huge. President Obama must hold Geithner accountable.  He must determine what did Geithner know, and when did he know it.  All internal documents and emails related to the AIG bailout and the attempt to keep Lehman afloat need to be released.  Further, Obama must ask what has Geithner done to favor his clients on Wall Street?  It now looks like even the Fed BOG, not just the NY Fed, is involved in the cover-up.  It is in the interest of the Obama administration to come clean.  It is hard to believe that it does not already have sufficient cause to fire Geithner.  In terms of dollar costs to the government, this is surely the biggest scandal in US history.  In terms of sheer sleaze does it rank with Watergate?  I suppose that depends on whether you believe that political hit lists and spying that had no real impact on the outcome of an election is as bad as a wholesale handing-over of government and the economy to Wall Street.

It remains to be seen whether anyone in the mainstream media will be hitting this story so hard.  One possible reason for the lack of significant coverage may exist in this disturbing point at the conclusion of Wray’s piece:

Of greater importance is the recognition that all of the big banks are probably insolvent.  Another financial crisis is nearly certain to hit in coming months — probably before summer.  The belief that together Geithner and Bernanke have resolved the crisis and that they have put the economy on a path to recovery will be exposed as wishful thinking.

Oh, boy!  Not good!  Not good at all!  We’d better change the subject to March Madness, American Idol or Rielle Hunter!  Anything but this!



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The Longest Year

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September 14, 2009

As I write this, President Obama is preparing another fine-sounding, yet empty speech.  His subject this time is financial reform.  You may recall last week’s lofty address to the joint session of Congress, promoting his latest, somewhat-less-nebulous approach to healthcare reform.  He assured the audience that the so-called “public option” (wherein a government-created entity competes with private sector healthcare insurers) would be an integral part of the plan.  Within a week, two pieces of political toast from the Democratic Party (Nancy Pelosi and Harry Reid) set about undermining that aspect of the healthcare reform agenda.  This is just one reason why, on November 2, 2010, the people who elected Democrats in 2006 and 2008 will be taking a “voters’ holiday”, paving the way for Republican majorities in the Senate and House.  The moral lapse involving the public option was documented by David Sirota for Danny Schechter’s NewsDissector blog:

House Speaker Nancy Pelosi for the first time yesterday suggested she may be backing off her support of the public option – the government-run health plan that the private insurance industry is desperately trying to kill.  According to CNN, Pelosi and Senate Majority Leader Harry Reid “said they would support any provision that increases competition and accessibility for health insurance – whether or not it is the public option favored by most Democrats.”

This announcement came just hours before Steve Elmendorf, a registered UnitedHealth lobbyist and the head of UnitedHealth’s lobbying firm Elmendorf Strategies, blasted this email invitation throughout Washington, D.C. I just happened to get my hands on a copy of the invitation from a source – check it out:

From: Steve Elmendorf [mailto:steve@elmendorfstrategies.com]
Sent: Friday, September 11, 2009 8:31 AM
Subject: event with Speaker Pelosi at my home
You are cordially invited to a reception with

Speaker of the House
Nancy Pelosi

Thursday, September 24, 2009
6:30pm ~ 8:00pm

At the home of
Steve Elmendorf
2301 Connecticut Avenue, NW
Apt. 7B
Washington, D.C.

$5,000 PAC
$2,400 Individual

Again, Elmendorf is a registered lobbyist for UnitedHealth, and his firm’s website brags about its work for UnitedHealth on its website.

The sequencing here is important: Pelosi makes her announcement and then just hours later, the fundraising invitation goes out. Coincidental?  I’m guessing no – these things rarely ever are.

I wrote a book a few years ago called Hostile Takeover whose premise was that corruption and legalized bribery has become so widespread that nobody in Washington even tries to hide it. This is about as good an example of that truism as I’ve ever seen.

Whatever President Obama proposes to accomplish in terms of financial reform will surely be met with a similar fate.  Worse yet, his appointment of “Turbo” Tim Geithner as Treasury Secretary and his nomination of Ben Bernanke to a second term as Federal Reserve chairman are the best signals of the President’s true intention:  Preservation of the status quo, regardless of the cost to the taxpayers.

On this first anniversary of the demise of Lehman Brothers and the acknowledgment of the financial crisis, many commentators have noted the keen observations by Simon Johnson, a former chief economist at the International Monetary Fund, published in the May, 2009 issue of The Atlantic.  The theme of Johnson’s article, “The Quiet Coup” was that the current economic and financial crisis in the United States is “shockingly reminiscent” of those experienced in emerging markets (i.e. banana republics and proto-capitalist regimes).  The devil behind all the details in setting these systems upright after a financial crisis is the age-old concept of moral hazard or more simply:  sleaze.  In making the comparison of the United States to the emerging market countries he encountered at the IMF, Mr. Johnson began this way:

But there’s a deeper and more disturbing similarity:  elite business interests — financiers, in the case of the U.S. — played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse.  More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive.  The government seems helpless, or unwilling, to act against them.

Here are a few more passages from “The Quiet Coup” that our political leaders would be well-advised to consider:

Even leaving aside fairness to taxpayers, the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason:  it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior must change.  As an unnamed senior bank official said to The New York Times last fall, “It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.”  But there’s the rub:  the economy can’t recover until the banks are healthy and willing to lend.

*   *   *

The second problem the U.S. faces—the power of the oligarchy— is just as important as the immediate crisis of lending.  And the advice from the IMF on this front would again be simple:  break the oligarchy.

Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.

Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business.  Where this proves impractical—since we’ll want to sell the banks quickly— they could be sold whole, but with the requirement of being broken up within a short time.  Banks that remain in private hands should also be subject to size limitations.

Mr. Johnson pointed out the need to overhaul our current antitrust laws – not because any single institution controls so much market share as to influence prices – but because the failure of any one “to big to fail” bank could collapse the entire financial system.

One of my favorite reporters at The New York Times, Gretchen Morgenson, observed the anniversary of the Lehman Brothers failure with an essay that focused, in large part, on a recent paper by Edward Kane, a finance professor at Boston College, who created the expression: “zombie bank” in 1987.   This month, the Networks Financial Institute at Indiana State University published a policy brief by Dr. Kane on the subject of financial regulation.  In her article:  “But Who Is Watching Regulators?”, Ms. Morgenson summed up Professor Kane’s paper in the following way:

This ugly financial episode we’ve all had to live through makes clear, Mr. Kane says, that taxpayers must protect themselves against two things:  the corrupting influence of bureaucratic self-interest among regulators and the political clout wielded by the large institutions they are supposed to police. Finally, he argues, taxpayers must demand that the government publicize the costs of efforts taken to save the financial system from itself.

Although you may have seen widely-publicized news reports about an “overwhelming number” of academicians opposing the current efforts to require transparency from the Federal Reserve, Professor Kane provides a strong argument in favor of Fed transparency as well as scrutiny of the Treasury and the other government entities enmeshed the complex system of bailouts created within the past year.

At thirty-eight pages, his paper is quite a deep read.  Nevertheless, it’s packed with great criticism of the Federal Reserve and the Treasury.  We need more of this and when someone of Professor Kane’s stature provides it, there had better be people in high places taking it very seriously.  The following are just a few of the many astute observations made by Dr. Kane:

Agency elitism would be evidenced by the extent to which its leaders use crises to establish interpretations and precedents that cover up its mistakes, inflate its powers, expand its discretion, and extend its jurisdiction. According to this standard, Fed efforts to use the crisis as a platform for self-congratulation and for securing enlarged systemic-risk authority sidetracks rather than promotes effective reform.

*   *   *

A financial institution’s incentive to disobey, circumvent or lobby against a particular rule increases with the opportunity cost of compliance. This means that, to sort out the welfare consequences of any regulatory program, we must assess not only the costs and benefits of compliance, but include the costs and benefits of circumvention as well.

*   *   *

Realistically, every government-managed program of disaster relief is a strongly lobbied and nontransparent tax-transfer scheme for redistributing wealth and shifting risk away from the disaster’s immediate victims.  A financial crisis externalizes – in margin and other collateral calls, in depositor runs, and in bank and borrower pleas for government assistance – a political and economic struggle over when and how losses accumulated in corporate balance sheets and in the portfolios of insolvent financial institutions are to be unwound and reallocated across society.  At the same time, insolvent firms and government rescuers share a common interest in mischaracterizing the size and nature of the redistribution so as to minimize taxpayer unrest.

In principle, lenders and investors that voluntarily assume real and financial risks should reap the gains and bear the losses their risk exposures generate.  However, in crises, losers pressure government officials to rescue them and to induce other parties to share their pain.

The advocates of crony capitalism and their tools (our politicians and regulatory bureaucrats) need to know that we are on to them.  If the current administration is willing to facilitate more of the same, then it’s time for some new candidates to step forward.