The Rule of Law and Wall Street
March 15, 2010
Mr. President, last Thursday, the bankruptcy examiner for Lehman Brothers Holdings Inc. released a 2,200 page report about the demise of the firm and which included riveting detail on the firm’s accounting practices. That report has put in sharp relief what many of us have expected all along: that fraud and potential criminal conduct were at the heart of the financial crisis. Now that we’re beginning to learn many of the facts, at least with respect to the activities at Lehman Brothers, the country has every right to be outraged. Lehman was cooking its books, hiding $50 billion in toxic assets by temporarily shifting them off its balance sheet in time to produce rosier quarter-end reports. According to the bankruptcy examiner's report, Lehman Brothers’ financial statements were "materially misleading" and its executives had engaged in "actionable balance sheet manipulation." Only further investigation will determine whether the individuals involved can be indicted and convicted of criminal wrongdoing.
According to the examiner’s report, Lehman used accounting tricks to hide billions in debt from its investors and the public. Starting in 2001, that firm began abusing financial transactions called repurchase agreements, or “repos.” Repos are basically short-term loans that exchange collateral for cash in trades that may be unwound as soon as the next day. While investment banks have come to over-rely upon repos to finance their operations, they are neither illegal nor questionable; assuming, of course, they are clearly accounted for.
Lehman structured its repo agreements so that the collateral was worth 105 percent of the cash it received – hence, the name “Repo 105.” As explained by the New York Times' DealBook, “That meant that for a few days – and by the fourth quarter of 2007 that meant end-of-quarter – Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was.”
Even worse, Lehman’s management trumpeted how the firm was decreasing its leverage so that investors would not flee from the firm. But inside Lehman, according to the report, someone described the Repo 105 transactions as “window dressing,” a nice way of saying they were designed to mislead the public.
Ernst & Young, Lehman's outside auditor, apparently became “comfortable” with, and never objected to, the Repo 105 transactions. And while Lehman never could find a U.S. law firm to provide an opinion that treating the Repo 105s as a sale for accounting purposes was legal, the British law firm Linklaters provided an opinion letter under British law that they were sales and not mere financing arrangements. And so Lehman ran the transactions through its London subsidiary and used several different foreign bank counterparties.
Mr. President, the SEC and Justice Department should pursue a thorough investigation, both civil and criminal, to identify every last person who had knowledge that Lehman was misleading the public about its troubled balance sheet – and that means everyone from the Lehman executives, to its board of directors, to its accounting firm, Ernst & Young. Moreover, if the foreign bank counterparties who purchased the now infamous "Repo 105s" were complicit in the scheme, they should be held accountable as well.
Returning the Rule of Law to Wall Street
Mr. President, it is high time that we return the rule of law to Wall Street, which has been seriously eroded by the deregulatory mindset that captured our regulatory agencies over the past 30 years, a process I described at length in my speech on the floor last Thursday. We became enamored of the view that self-regulation was adequate, that “rational” self-interest would motivate counterparties to undertake stronger and better forms of due diligence than any regulator could perform, and that market fundamentalism would lead to the best outcomes for the most people. Transparency and vigorous oversight by outside accountants were supposed to keep our financial system credible and sound.
The allure of deregulation, instead, led to the biggest financial crisis since 1929. And now we’re learning, not surprisingly, that fraud and lawlessness were key ingredients in the collapse as well. Since the fall of 2008, Congress, the Federal Reserve and the American taxpayer have had to step into the breach – at a direct cost of more than $2.5 trillion – because, as so many experts have said: "We had to save the system."