The good Senator Dodd is trying to get his “banking regulatory” reform bill passed. But do we really understand what is going on. The answer is more of the same old game that got us in this mess in the first place. The key element of this bill is that “the Fed” will be the regulatory oversight for the largest 40 banking institutions. Let’s examine that just for a moment. To do so let’s look at how well the Fed and for that matter the SEC and the Treasury department did in conducting oversight functions at Lehman Brothers.
The court examiner, Anton R. Valukas laid out what the report characterized as “materially misleading” accounting gimmicks that Lehman used to mask the perilous state of its finances. Lehman executives engaged in what the report characterized as “actionable balance sheet manipulation”.
A large portion of the [examiner’s] nine-volume report centers on the accounting maneuvers, known inside Lehman as “Repo 105″. First used in 2001, long before the crisis struck, Repo 105 involved transactions that secretly moved billions of dollars off Lehman’s books at a time when the bank was under heavy scrutiny.
In a legal case against Lehman Brothers, The examiner said in a report publicly released that senior officials failed to disclose key practices, opening them up to legal claims . The report concludes that the firm’s auditor, Ernst & Young, failed to meet “professional standards. The exhaustive report was unsealed by Judge James M. Peck, who said the report reads “like a best-seller.”
The examiner, Anton Valukas, also found that parties have claims to pursue against JPMorgan Chase and Citibank in connection with their behavior regarding the modification of agreements with Lehman and their increasing collateral demands in Lehman’s final days. These demands had a “direct impact” on Lehman’s diminishing liquidity — its cash on hand — which was a prime reason behind the firm’s demise.
The examiner’s report notes:
The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule. But the decision not to disclose the effects of those judgments does give rise to colorable claims [i.e. valid legal claims] against the senior officers who oversaw and certified misleading financial statements — Lehman’s CEO Richard S. Fuld, Jr., and its CFOs Christopher O’Meara, Erin M. Callan and Ian T. Lowitt.
There are colorable claims against Lehman’s external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements. The examiner notes that the issue giving rise to these potential claims was Lehman’s creative use of repurchase agreements, otherwise known as repo. These are agreements between financial firms that essentially act as loans for cash — one firm pledges collateral to another in exchange for cash with a promise that they’ll buy back that collateral.
The examiner said the sole function of Lehman’s use of repo was “balance sheet manipulation,” according to the report. Although Repo 105 transactions may not have been inherently improper, there is a colorable claim that their sole function as employed by Lehman was balance sheet manipulation. Lehman’s own accounting personnel described Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end.” Lehman used Repo 105 to reduce balance sheet at the quarter‐end. The reason for that, the report notes, was to lower Lehman’s leverage — a critical component of the firm’s credit rating.
In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties; in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet at quarter end.
The next day ‐- on June 13, 2008 ‐- Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee’s assertions, despite an express direction from the Committee to advise on all allegations raised by Lee. Ernst & Young took virtually no action to investigate the Repo 105 allegations. Ernst & Young took no steps to question or challenge the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions.
For example, when the examiner questioned Lehman executives and other witnesses about Lehman’s financial health and reporting, a recurrent theme in their responses was that Lehman gave full and complete financial information to Government agencies, and that the Government never raised significant objections or directed that Lehman take any corrective action.
True? Let’s see what the examiner had to say: “although various Government agencies had information that raised serious questions about Lehman’s reported liquidity and about the sufficiency of its capital and liquidity to withstand stress scenarios, the agencies generally limited their activities to collecting data and monitoring.”
After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress-testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank. The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.” Lehman failed both tests. The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed. However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed. It does not appear that any agency required any action of Lehman in response to the results of the stress testing.
So let’s see what we got here. They ran two sets of stress tests and the firm failed both. Not satisfied with the results they then designed a third set, which the firm also failed (we can reasonably presume the third had less stringent requirements than the other two!)
Instead of applying any of these three, FRBNY, which was run by TIMOTHY GEITHNER, NOW OUR TREASURY SECRETARY, WHO REPORTED TO BEN BERNANKE, instead took Lehman’s word that all was ok and did nothing.
Further, The SEC inspection revealed significant problems at Lehman. The SEC found that Lehman’s Price Valuation Group was understaffed; and it found that Lehman’s asset pricing function was overly “process driven.” But the SEC did not release its findings or formally present them to Lehman prior to Lehman’s demise.
Now this last week, Ben Bernanke testifies before the senate to raise support for the Fed being the regulatory agency over big banks and he says the following:
“On the regulatory side, we have played a key role in international efforts to ensure that systemically critical financial institutions hold more and higher-quality capital, have enough liquidity to survive highly stressed conditions, and meet demanding standards for company-wide risk management. We have also been taking the lead in addressing flawed compensation practices by issuing proposed guidance to help ensure that compensation structures at banking organizations provide appropriate incentives without encouraging excessive risk-taking.6 Less formally, but equally important, since 2005 the Federal Reserve has been leading cooperative efforts by market participants and regulators to strengthen the infrastructure of a number of key markets, including the market for securities repurchase agreements and the markets for credit derivatives and other over-the-counter derivative instruments.
To improve both our consolidated supervision and our ability to identify potential risks to the financial system, we have made substantial changes to our supervisory framework. So that we can better understand linkages among firms and markets that have the potential to undermine the stability of the financial system, we have adopted a more explicitly multidisciplinary approach, making use of the Federal Reserve’s broad expertise in economics, financial markets, payment systems, and bank supervision to which I alluded earlier. We are also augmenting our traditional supervisory approach that focuses on firm-by-firm examinations with greater use of horizontal reviews that look across a group of firms to identify common sources of risks and best practices for managing those risks. To supplement information from examiners in the field, we are developing an off-site, enhanced quantitative surveillance program for large bank holding companies that will use data analysis and formal modeling to help identify vulnerabilities at both the firm level and for the financial sector as a whole. This analysis will be supported by the collection of more timely, detailed, and consistent data from regulated firms.
Many of these changes draw on the successful experience of the Supervisory Capital Assessment Program (SCAP), also known as the banking stress test, which the Federal Reserve led last year. As in the SCAP, representatives of primary and functional supervisors will be fully integrated in the process, participating in the planning and execution of horizontal exams and consolidated supervisory activities.
Improvements in the supervisory framework will lead to better outcomes only if day-to-day supervision is well executed, with risks identified early and promptly remediated. Our internal reviews have identified a number of directions for improvement. In the future, to facilitate swifter, more-effective supervisory responses, the oversight and control of our supervisory function will be more centralized, with shared accountability by senior Board and Reserve Bank supervisory staff and active oversight by the Board of Governors. Supervisory concerns will be communicated to firms promptly and at a high level, with more-frequent involvement of senior bank managers and boards of directors and senior Federal Reserve officials. Greater involvement of senior Federal Reserve officials and strong, systematic follow-through will facilitate more vigorous remediation by firms. Where necessary, we will increase the use of formal and informal enforcement actions to ensure prompt and effective remediation of serious issues.”
When you understand what really has gone on. When you realize in real terms nothing has changed. When you realize the fox is guarding the hen house. Then and only then you can see how “rigged: the whole situation is and that this so called regulatory reform bill is a total shame. It is like threatening the banking industry with a severe lashing with a wet noodle! OOOOHHHHH!
But Senator Dodd, Bernanke, Geithner et al are counting on two things. One, we are totally ignorant and won’t understand anything and secondly, the CONgress is bought and paid for, lock stock and barrel! Some of the Republican harlots are even protesting this shame of a regulation as too much!!!
How bold I say is guilt! How insulting to our intelligence. I remember the lines from the Moody Blues. “It riles them to believe you perceive the web they weave.” We need real reform. What we don’t need is a PRIVATE CORPORATION, the Fed, acting as a regulatory agency. Think about this just for a moment. Where in the constitution or the history of the republic have we allowed a private corporation to regulate other corporations? We need a real governmental agency that has at its core a responsibility to insure the safety and security of the investment public. This is the only way to restore the confidence to be investors and consumers again. This is the real engine to get the economy off of dead bottom.