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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.

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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.

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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.

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“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.

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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.

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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.

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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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