April 12, 2010 – On Friday, the Wall Street Journal revealed details of a cover up by the nations largest banks that have been engaged in potentially-criminal accounting activities to conceal the amount of debt on their balance sheets. The SEC has been notified of the allegations and has launched a probe to determine whether further action is needed. Among the banks implicated, are Goldman Sachs, JP Morgan, Bank of America, and Citigroup. According to the WSJ:
â€œMajor banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York. A group of 18 banks….understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters.â€ (â€œBig Banks Mask Risk Levelsâ€, Kate Kelly, Tom McGinty, Dan Fitzpatrick, Wall Street Journal)
The article, titled â€œBig Banks Mask Risk Levelsâ€, has set off alarm bells on Wall Street because of the similarity between Lehman Bros. â€œrepo 105â€ transactions and these new signs of obfuscation by other large banks. â€œRepo 105â€ is an arcane accounting device that Lehman used to hide $50 billion in debt off its balance sheet in an attempt to mislead investors about the true condition of its financial health. The WSJ story suggests that the practice may be more widespread than originally thought. The â€œrepo 105â€ scandal is further complicated by suspicions that Lehman was assisted in its effort by the Federal Reserve Bank of New York which, at the time, was headed by Timothy Geithner. Here is a short recap of what transpired between the Geithnerâ€™s NY Fed and Lehman according to ex-regulator William Black and former NY governor Eliot Spitzer from an article on Huffington Post:
â€œThe 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 Fedâ€™s behavior made it clear that officials didnâ€™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…… We now know from Valukas and from former Treasury Secretary Paulson that the Treasury and the Fed knew that Lehman was massively overstating its on-book asset values.â€ (Time for the Truthâ€ William Black and Eliot Spitzer, Huffington Post)
So the question is whether the NY Fed helped other banks conceal important financial information from investors, too. And–if thatâ€™s the case–then how can the public be confident that the biggest banks in the country are truly solvent?
According to the WSJ: â€œAn official at the Federal Reserve Board noted that the Fed continuously monitors asset levels at the large bank-holding companies, but the financing activities captured in the New York Fedâ€™s data fall under the purview of the Securities and Exchange Commission, which regulates brokerage firms.â€ The Fedâ€™s explanation is a tacit denial of its responsibility to regulate or report suspicious accounting practices to the appropriate agencies. The response is not just â€œbuck passingâ€, but also suggests collusion . So far, thereâ€™s no clear link between the Fed and the shady bookkeeping at the banks. But many now believe that–in the case of Lehman–the Fed acted as an â€œenablerâ€, either by serving as a counterparty in repo 105 deals or by looking the other way while the transactions were executed. Either way, the situation demands an independent investigation.
To put the WSJ article in context, it helps to review the details of the Lehman case. Hereâ€™s an excerpt from an article by Eric Dash in the NY Times:
â€œNewly released report on the collapse of Lehman Brothers … sheds surprising new light on Lehmanâ€™s dealings with the New York Fed. Lehman engaged in a series of transactions with the New York Fed that were similar to the ones that drew criticism from the bankruptcy court examiner who investigated its collapse….
The report by Mr. Valukas nonetheless raises fresh questions about the role of the New York Fed in supporting Lehman during the frantic months leading up to its collapse. It suggests that Lehman executives believed the Fed would be able to help the bank avert disaster and provide it with a business opportunity…
â€œLehman, desperate for financing, seized its chance. It packaged billions of dollars of troubled corporate loans into an investment called Freedom CLO. Then, in a series of transactions, it shifted Freedom back and forth to the New York Fed, in exchange for cash. Those moves helped make Lehman look healthier.
â€œEssentially, Lehman was able to temporarily warehouse illiquid investments that were worrying its investors at the New York Fed in return for cash. The Fed created this facility immediately after the near collapse of Bear Stearns. Some suspect that other banks engaged in similar maneuvers. (â€œFed Helped Bank Raise Cash Quicklyâ€, Eric Dash, New York Times)
So why did â€œLehman executives believe the Fed would be able to help the bank avert disaster and provide it with a business opportunityâ€? Most likely, because that had been standard operating procedure. The Fed was merely acting as it had before. Lehman used the repo market to amplify leverage to maximize profits, (the same as the other banks) and when they couldnâ€™t find a counterparty to accept their garbage collateral, the Fed would step in and provide short-term loans and â€œwarehouseâ€ their toxic assets. In essence, the Fed was helping to defraud investors who believed the banks reports were accurate. Hereâ€™s Yves Smith at Naked Capitalism who sums it up perfectly:
â€œThe NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations…â€¦at a minimum, the NY Fed helped perpetuate a fraud on investors and counterparties. This pattern further suggests the Fed, which by its charter is tasked to promote the safety and soundness of the banking system, instead, via its collusion with Lehman management, operated to protect particular actors to the detriment of the public at large. â€œAnd most important, it says that the NY Fed, and likely Geithner himself, undermined, perhaps even violated, laws designed to protect investors and markets.â€ naked capitalism
So if the NY Fed had no moral qualms about its â€œrepo 105â€ dealings with Lehman, than why would hesitate to do the same thing for the other banks? Tyler Durden at Zero Hedge answers the question like this:
â€œWe contend that Repo 105 type book-cooking and quarter end balance sheet window dressing was a prevalent phenomenon among all the banks. The fact that over the past two and a half years this resulted in a differential from the peak quarterly assets of over $65 billion is unbelievable, and the fact that this had slipped through the regulatorsâ€™ fingers is inexcusable…..
We are confident that armed with this data, the SEC will be able to provide a prompt and logical response why the primary dealers have such a peculiar pattern in downshifting their assets toward quarter end, and much more relevantly, who the counterparties are that would consistently take the other side of these quarter end window-dressing trades.â€ (â€œEvidence That Primary Dealers Have Collectively Engaged In Repo 105 And Qtr-End Book Cooking Type Schemes For Yearsâ€ zero hedge, 4-9-10)
Durdenâ€™s logic is flawless. If Lehman was being aided in itâ€™s â€œbook cookingâ€ by the NY Fed, then the other banks were probably being helped, as well. It looks like Geithner left his fingerprints everywhere.
If we add these new developments to the fact that the Financial Accounting Standards Boardâ€™s (FASB) â€œmark to marketâ€ rule has been suspended (allowing banks to arbitrarily assign whatever value they choose to the own illiquid assets) and, the fact that the Federal Reserve still refuses to allow an independent audit of the dodgy collateral it accepted from the banks in exchange for Treasuries and other loans; then it still looks like the banking system is either teetering or insolvent.
And donâ€™t expect the Securities and Exchange Commission to get to the bottom of this either. SEC chairman Mary Schapiro is a proven financial industry loyalist who has no intention of upsetting her Wall Street overlords by digging too deep or issuing subpoenas. If she pursues the investigation at all, it will only be to placate the public and to apply liberal amounts of whitewash to the whole matter.