NY Fed Under Geithner Implicated in Lehman Accounting Fraud Allegation

Quite a few observers, including this blogger, have been stunned and frustrated at the refusal to investigate what was almost certain accounting fraud at Lehman. Despite the bankruptcy administrator's effort to blame the gaping hole in Lehman's balance sheet on its disorderly collapse, the idea that the firm, which was by its own accounts solvent, would suddenly spring a roughly $130+ billion hole in its $660 balance sheet, is simply implausible on its face. Indeed, it was such common knowledge in the Lehman flailing about period that Lehman's accounts were sus that Hank Paulson's recent book mentions repeatedly that Lehman's valuations were phony as if it were no big deal.

Well, it is folks, as a newly-released examiner's report by Anton Valukas in connection with the Lehman bankruptcy makes clear. The unraveling isn't merely implicating Fuld and his recent succession of CFOs, or its accounting firm, Ernst & Young, as might be expected. It also emerges that the 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.

We need to demand an immediate release of the e-mails, phone records, and meeting notes from the NY Fed and key Lehman principals regarding the NY Fed's review of Lehman's solvency. If, as things appear now, Lehman was allowed by the Fed's inaction to remain in business, when the Fed should have insisted on a wind-down (and the failed Barclay's said this was not infeasible: even an orderly bankruptcy would have been preferrable, as Harvey Miller, who handled the Lehman BK filing has made clear; a good bank/bad bank structure, with a Fed backstop of the bad bank, would have been an option if the Fed's justification for inaction was systemic risk), the NY Fed at a minimum 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.

And most important, it says that the NY Fed, and likely Geithner himself, undermined, perhaps even violated, laws designed to protect investors and markets. If so, he is not fit to be Treasury secretary or hold any office related to financial supervision and should resign immediately.

I am reading the report, and will provide an update later, but here are the key bits (hat tip reader John M). As much as Karl Denninger has done some terrific initial reporting, he does not go far enough as far as the wider implications are concerned.

The key revelation is that Lehman as of late 2007 was routinely using repo transactions at the end of the quarter to mask how levered it truly was:

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.2850 Lehman's periodic reports did not disclose the cash borrowing from the Repo 105 transaction - i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851 Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.

Denninger raises one question: were other banks engaging in this type of accounting chicanery? But there is another question: surely some of Lehman's counterparties must have suspected what was going on. How many had an idea that Lehman was engaging in massive window dressing and chose to play along?

But here is the part of the report that discussed how the Fed aided and abetted Lehman misconduct:

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.

Yves here. So get this: even though Lehman dressed up its accounts for the great unwashed public, it did not try to fool the authorities. Its games playing was in full view to those charted with protecting investors and the financial system.

So what transpired? The SEC (which in all fairness, has never had much expertise in credit markets, this is a major regulatory problem) handed assessing Lehman over to the Fed, which bent over backwards to give it a clean bill of health:

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.5753 The FRBNY developed two new stress scenarios: "Bear Stearns" and "Bear Stearns Light."5754 Lehman failed both tests.5755 The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed.5756 However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed.5757 It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

Yves here. So get this: the stress tests were a sham. Only one outcome was permissible: that Lehman pass. So after the Fed was unable to come up with an objective-looking stress test that Lehman could satisfy, they permitted Lehman to devise a test with low enough standards to give itself a clean bill of health.

So why should we trust ANY government designed stress test, particularly when the same permissive grader, Timothy Geithner, was the moving force behind the ones dreamed up last year, which have been widely decried by banking experts, including Bill Black, Chris Whalen, and Josh Rosner? We linked to a simple analysis by Mike Konczal that demonstrates that for the biggest four banks alone, merely on their second mortgage portfolios, the stress tests of 2009 were too permissive to the tune of at least $150 billion.

Lehman type accounting, in other words, is being institutionalized, with the active support from senior government officials.

It is time for Geithner to go. He is not fit to serve as Treasury secretary.

And the time is overdue for a full audit of the Fed, and in particular the New York Fed, from the start of the Bear crisis through and including all the retrades of the AIG bailout.