Is There Another Lehman Lurking On Wall Street?

¹²Is There A Lehman Lurking On Wall Street?

By David Weidner, Marketwatch | 1 April 2010

NEW YORK (MarketWatch)— The bank-appointed examiner's report on Lehman Brothers Inc. shocked the public on its release two weeks ago. Who would believe a Wall Street firm would be so devious in attempting to hide the poisonous cancer on its balance sheet? Well, just about every one of its rivals for starters. Repo 105, the accounting trick Lehman used to hide its leverage, may have been a Lehman-only phenomenon, but if you think it's the only way financial firms cook their books, get ready for Top Chef: Wall Street edition. See story on Wall Street's use of repurchase agreements.

Fast-and-loose accounting is a way of life on Wall Street. It encompasses sleight of hand including off-balance sheet entities called 'special purpose vehicles', 'short-term repurchase agreements', securities that banks label "available for sale", and all varieties of "intent-based accounting". There are plenty of ways financial firms can massage the numbers to make them look more profitable, stable and solvent than they really are.

The problem of dubious numbers didn't die with Lehman and its deposed chief executive, Dick Fuld. Ernst & Young LLP, which audits or has audited such banks as State Street Corp. (STT) , UBS AG (UBS) and Comerica Inc. (CMA), didn't raise a red flag on Repo 105, even though it apparently knew about the problems. See text of Ernst & Young's statement on Lehman.

Ernst & Young's performance scouring Lehman's numbers, along with Federal Reserve examiners inability to catch the maneuvers, and "legal advice" [[on US securities laws: normxxx]] from the U.K. law firm Linklaters, suggest auditors, regulators and attorneys are about as effective as Tiger Woods' marriage vows or Joe Biden's inhibitions. Making matters worse, the rules on the books, always easy enough to get around, have been diluted and defanged. In 2004 Securities and Exchange Commission rolled back capital requirements, effectively letting broker-dealers set their own. See SEC rule on broker-dealer capital requirements.

Rules governing commercial banks weren't much better. They used the ratings of conflicted agencies such as Standard & Poor's, a unit of McGraw Hill Cos. (MHP) and Moody's Investors Service (MCO) to mark up questionable mortgage securities. The bottom line quarterly reports and federal filings have more holes than the CNBC prime-time line-up.

Sunlight On Wall Street

The lesson of the Lehman examiner's report is that disclosure could have prevented Lehman's failure. Imagine if investors knew of Repo 105 when it was first used in the fourth quarter of 2006. Does anyone think Lehman could have faked its way another 20 months?

And what of capital requirements? Lehman's leverage ratio stood as high as 30.7-to-1, or about three times the leverage ratio most big banks carry now [[or in prior years when financial sanity reined, before the financial laws were completely gutted: normxxx]]. If investors were able to actually see which assets Lehman held and could independently look at the quality of those assets, could Lehman have built that position? Would the firm have been able to borrow billions every night to meet its obligations?

By now you get it. Disclosure and transparency could have been the single biggest tool in preventing the financial crisis. The question is will there be enough rulemaking in the proposed financial reform bill to ensure adequate disclosure in the future.

The answer is mixed. Sen. Chris Dodd's, D-Conn., bill includes new rules for ratings agencies. They will have to disclose their methods and data that they use in determining their ratings. More terms of derivative contracts must be made public.

But there's not much in the way of accounting rules. Banks are still operating under pre-crisis rules. If anything, those rules have been softened, witness the changes in 'mark-to-market accounting' invoked last year [[which arguably rescued as many as a half dozen 'big' banks from immediate bankruptcy: normxxx]]. Those rules are believed to have allowed banks to "write-up" the values of assets that had few, if any, buyers [[no question about it; that is exactly what was intended and exactly what happened: normxxx]].

Critics, including Frank Portnoy, a finance law professor, also have pointed out that off-balance sheet entities are hardly mentioned in the Dodd bill. See Portnoy's analysis of the Dodd bill in The Daily Beast. And, of course, whatever new rules are enacted to provide the kind of transparency that would have outed another Lehman, there will always be [more than sufficient] lawyers and 'advisors' [to] 'help' banks find another accounting trick.

[[Note that this is not a general weakness of law; in the U.K. where the laws are directed to results and intent, ie, outcomes, rather than procedure, ie, the way things are done, they have been quite successful in maintaining some semblence of control over their banks and other financial entities.: normxxx]]

Take Lehman's use of Repo 105. Lehman used it to move assets off its balance sheet before the quarter closed only to have those assets bought back a few days later. Lehman couldn't get a U.S. firm to sign off on the practice, so it went to a U.K. law firm to OK the move. [[That should be forbidden right there; only legal opinions from "qualified" sources should be a protection against charges of civil and criminal fraud.: normxxx]]

Legal and accounting arbitrage [[ie, shopping around for the answer you want: normxxx]] isn't just a Lehman issue. It's a problem across Wall Street. The only question is what sort and how much dealing is happening. Each quarter the financial industry asks us to take its numbers at face value. Beauty is only skin deep. In some cases, there may not be anything there at all [[or even less!: normxxx]].