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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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More Windfalls For Wall Street

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August 3, 2009

At a time when states and municipalities are going broke, foreclosures are on the rise and bankruptcies are skyrocketing, it’s nice to know that the Federal Reserve keeps coming up with new and inventive ways to enrich the investment banks on Wall Street.

I’ve often discussed the involvement of the Federal Government in “propping up” (manipulating) the stock markets since the onset of the financial crisis, nearly one year ago.  The so-called “Plunge Protection Team” or PPT was created during the Reagan administration to prevent stock market crashes after the October 19, 1987 event.  Although the PPT has been called an “urban myth” by many skeptics, there is plenty of documentation as to its existence.  Its formal name is the Working Group on Financial Markets.  It was created by Executive Order 12631 on March 18, 1988, which appears at 53 FR 9421, 3 CFR 559, 1988 Comp.  You can read the Executive Order here.  Much has been written about the PPT over the years since 1988.  Brett Fromson wrote an article about it for The Washington Post on February 23, 1997.  Here is a paragraph from that informative piece:

In the event of a financial crisis, each federal agency with a seat at the table of the Working Group has a confidential plan.  At the SEC, for example, the plan is called the “red book” because of the color of its cover.  It is officially known as the Executive Directory for Market Contingencies.  The major U.S.stock markets have copies of the commission’s plan as well as the CFTC’s.

In October of 2006, two years before the financial meltdown, Ambrose Evans-Pritchard wrote an interesting piece about the PPT for the Telegraph.  Here’s some of what he had to say:

The PPT was once the stuff of dark legends, its existence long denied.  But ex-White House strategist George Stephanopoulos admits openly that it was used to support the markets in the Russia/LTCM crisis under Bill Clinton, and almost certainly again after the 9/11 terrorist attacks.

“They have an informal agreement among major banks to come in and start to buy stock if there appears to be a problem,” he said.

“In 1998, there was the Long Term Capital crisis, a global currency crisis.  At the guidance of the Fed, all of the banks got together and propped up the currency markets.  And they have plans in place to consider that if the stock markets start to fall,” he said.

Back on September 13, 2005, The Prudent Investor website featured a comprehensive report on the PPT.  It referenced a paper by John Embry and Andrew Hepburn.  Here is an interesting passage from that essay:

A thorough examination of published information strongly suggests that since the October 1987 crash, the U.S. government has periodically intervened to prevent another destabilizing stock market fall.  And as official rhetoric continues to toe the free market line, manipulation has become increasingly apparent.  Almost every floor trader on the NYSE, NYMEX, CBOT and CME will admit to having seen the PPT in action in one form or another over the years.

The conclusion reached in The Prudent Investor‘s article raises the issue of moral hazard, which continues to be a problem:

But a policy enacted in secret and knowingly withheld from the body politic has created a huge disconnect between those knowledgeable about such activities and the majority of the public who have no clue whatsoever.  There can be no doubt that the firms responsible for implementing government interventions enjoy an enviable position unavailable to other investors.  Whether they have been indemnified against potential losses or simply made privy to non-public government policy, the major Wall Street firms evidently responsible for preventing plunges no longer must compete on anywhere near a level playing field.

That point brings us to the situation revealed in a recent article by Henny Sender for the Financial Times on August 2.  Although, the PPT’s involvement in the equities markets has been quite low-profiled, the involvement one PPT component (the Federal Reserve) in the current market for mortgage-backed securities has been quite the opposite.  In fact, the Fed has invoked “transparency” (I thought the Fed was allergic to that) as its reason for tipping off banks on its decisions to buy such securities.  As Mr. Sender explained:

The Fed has emerged as one of Wall Street’s biggest customers during the financial crisis, buying massive amounts of securities to help stabilise the markets.  In some cases, such as the market for mortgage-backed securities, the Fed buys more bonds than any other party.

However, the Fed is not a typical market player.  In the interests of transparency, it often announces its intention to buy particular securities in advance.  A former Fed official said this strategy enables banks to sell these securities to the Fed at an inflated price.

The resulting profits represent a relatively hidden form of support for banks, and Wall Street has geared up to take advantage.  Barclay’s, for example, e-mails clients with news on the Fed’s balance sheet, detailing the share of the market in particular securities held by the Fed.

“You can make big money trading with the government,” said an executive at one leading investment management firm.  “The government is a huge buyer and seller and Wall Street has all the pricing power.”

A former official of the US Treasury and the Fed said the situation had reached the point that “everyone games them.  Their transparency hurts them.  Everyone picks their pocket.”

*   *   *

Larry Fink, chief executive of money manager BlackRock, has described Wall Street’s trading profits as “luxurious”, reflecting the banks’ ability to take advantage of diminished competition.

So let’s get this straight:  When Republican Congressman Ron Paul introduced the Federal Reserve Transparency Act (HR 1207) which would give the Government Accountability Office authority to audit the Federal Reserve and its member components for a report to Congress, there was widespread opposition to the idea of transparency for the Fed.  However, when Wall Street banks are tipped off about the Fed’s plans to buy particular securities and the public objects to the opportunistic inflation of the pricing of those securities by the tipped-off banks, the Fed emphasizes a need for transparency.

Perhaps Ron Paul might have a little more luck with his bill if he could demonstrate that its enactment would be lucrative for the Wall Street banks.  HR 1207 would find its way to Barack Obama’s desk before the next issue of the President’s Daily Brief.