The Autopsy Report Shows Repo 105 In The Soul

Michael J. de la Merced and Andrew Ross Sorkin in NYT:

It is the Wall Street equivalent of a coroner’s report — a 2,200-page document that lays out, in new and startling detail, how Lehman Brothers used accounting sleight of hand to conceal the bad investments that led to its undoing.

The report, compiled by an examiner for the bank, now bankrupt, hit Wall Street with a thud late Thursday. The 158-year-old company, it concluded, died from multiple causes. Among them were bad mortgage holdings and, less directly, demands by rivals like JPMorgan Chase and Citigroup, that the foundering bank post collateral against loans it desperately needed.

But the examiner, Anton R. Valukas, also for the first time, laid out what the report characterized as “materially misleading” accounting gimmicks that Lehman used to mask the perilous state of its finances. The bank’s bankruptcy, the largest in American history, shook the financial world. Fears that other banks might topple in a cascade of failures eventually led Washington to arrange a sweeping rescue for the nation’s financial system.

According to the report, Lehman used what amounted to financial engineering to temporarily shuffle $50 billion of assets off its books in the months before its collapse in September 2008 to conceal its dependence on leverage, or borrowed money. Senior Lehman executives, as well as the bank’s accountants at Ernst & Young, were aware of the moves, according to Mr. Valukas, the chairman of the law firm Jenner & Block and a former federal prosecutor, who filed the report in connection with Lehman’s bankruptcy case.

Naked Capitalism:

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.

Tim Cavanaugh in Reason:

But in his brief appearances in the 336-page report, Geithner’s main concern seems to be with preventing a panic over the diseased state of Lehman. Geithner not only acknowledges his efforts at concealment, but seems to believe they were the right thing to do:

In addition to the losses Lehman would incur by selling “sticky” assets at firesale prices, deleveraging also raised the additional problems of market perception and valuation.3187 As Secretary Timothy Geithner explained to the Examiner, selling “sticky” assets at discounts could hurt Lehman by revealing to the market that Lehman “had a lot of air in [its] marks” and thereby further draining confidence in the valuation of the assets that remained on Lehman’s balance sheet.3188

The first sentence is drawn from a November interview between Geithner and Valukas, the second from “Reducing Systemic Risk In A Dynamic Financial System,” a speech Geithner delivered in June 2008. To say dressing up Lehman’s bleeding sores was wrong, you need to acknowledge that a central bank should not engage in the suppression of information, and I’m pretty sure we lost that argument a long time ago.

Smith suspects (not without reason) that this mission to regulate the market’s feelings toward Lehman led Geithner to connive at what certainly looks to have been a fraud: the erroneous counting of “501 Repos” — assets Lehman sold with an agreement to repurchase — as straightforward sales. That is, the outside world thought these toxic assets were gone from Lehman’s books, when in fact they were merely festering. Smith has some interesting words about whether, and why, Lehman counterparties went along with this charade. (Likeliest answer: They were all betting on the come like the rest of America.)

Tyler Durden at Zero Hedge:

That this scam was going unsupervised (just who the hell were the counterparties?) for many years, and that many banks are likely using it right now to fool investors, regulators, rating agencies, and the idiots at the FRBNY (who certainly also know about this), is beyond criminal. Yet that nobody will go to jail for this is as certain as the market going up another 10% tomorrow. A full investigation has to be conducted immediately into whether existing Wall Street firms, and in particular those who use Ernst & Young as auditors, are currently abusing public confidence via such transactions.

Stephen Gandel at Curious Capitalist at Time:

This seems like fraud to me. The examiner calls it “actionable” and he says the moves open Lehman and its executives up to suits from shareholders who could claim, it appears rightly so, that they were mislead. Still I am not convinced accounting played as big a role in this crisis as past ones. Here’s why:

Yes, Lehman does seem to have hid some of its loans. And that means other banks were probably using this trick as well. But how much did the trick distort Lehman’s books. Not much. In fact, even if Lehman had made all of its loans available for everyone to see it’s not clear that any investors would have cared, or the NY Fed would have spent one more minute thinking about the firm’s solvency.

That’s because the vast majority of its loans and illiquid investments were out there for all to see. In fact, if you add back in the $50 billion the firm was hiding the firm’s net leverage ratio moves from 12.1 to a whopping 13.8. Merrill Lynch had a leverage ration of more than three times that.

What the moves did do was to shield the firm from criticism from the likes of short-sellers like David Einhorn who claimed the situation at Lehman was getting worse, but couldn’t prove it. On the margin, Lehman’s accounting trick made it look like its leverage ratio was either stable or improving. Nonetheless, people like Einhorn didn’t need another reason to short Lehman Brothers. They already knew something smelled at Lehman. They just didn’t know what they were smelling was slightly worse than they thought.

Perhaps the biggest takeaway from this is that Sarbanes-Oxley has again proven useless in preventing corporate fraud. Accounting fraud is exactly the type of thing Sarbox was supposed to stop by beefing up corporate boards and imposing new accounting oversight all the way up to the board level. But the Lehman examiner’s report says the investment bank’s executives were able to keep its board in the dark. The examiner says board members appear to have had no knowledge of the “Repo 105” accounting trick. Just another sign that the true failing that caused the financial crisis was at its heart a regulatory one.

Larry Doyle at Wall Street Pit:

Reports that Lehman was effectively ‘cooking its books’ prior to its ultimate demise are not a surprise.

Reports that Dick Fuld, then CEO of Lehman, was not aware of the nature of this cooking are both ridiculous and pathetic.

The lifeblood of every financial institution on Wall Street is access to financing for its operations. That financing very often comes in the form of repurchase agreements (repo financing), in which the institution borrows funds while pledging assets. These short term loans, often overnight loans, are unwound at a preset date and preset prices. The rates borrowers have to pay for funds borrowed depend on the credit quality of the borrower itself and the quality of the assets pledged.

UPDATE: Mike Konczal at Rortybomb

James Kwak at Baseline Scenario

Naked Capitalism

Kevin Drum

Felix Salmon

Jon Stewart

Everybody’s Got An Evil Twin Except For Me And My Monkey

Mike Konczal at Rortybomb:

Maybe it is because I’ve binged on Michael Sandel’s Justice series on youtube over the holidays, but I want to create a moral dilemma to see how far you are willing to go in thinking this justification works for our current financial system. But first I’ll need to go into Evil Financial Rortybomb mode. Ever see that Star Trek where in the Mirror Universe everyone is evil and has a goatee? It’s like that.

I want to pitch to the credit card and financial industry a new innovative online survey. It is targeted for older, more mature long-time users of our services. We’ll give a $10 credit for anyone who completes it. Here is a sense of what the questions will look like:

– 1) What is your age?
– 2) What day of the week are you taking this survey?
– 3) Many rewards offered are for people with more active lifestyles: vacations, flights, hotels, rental cars. Do you find that your rewards programs aren’t well suited for your lifestyle?
– 4) What is the current season where you live? Are any seasons harder for you in getting to a branch or ATM machine?
– 5) Would rewards that could be given as gifts to others, especially younger people, be helpful for what you’d like to do with your benefits?
– 6) Would replacing your rewards program with a savings account redeemable for education for your grandchildren be something you’d be interested in?
– 7) Write a sentence you’d like us to hear about anything, good or bad!
– 8 ) How worried are you you’ll leave legal and financial problems for your next-of-kin after your passing?

Did you catch it? Questions 1,2,4,7 are taken from the ‘Mini-mental State Examination’ which is a quick test given by medical professionals to see if a patient is suffering from dementia. (It’s a little blunt, but we can always hire some psychologist and marketers for the final version. They’re cheap to hire.) We can use this test to subtly increase limits, and break out the best automated tricks and traps mechanisms, on those whose dementia lights up in our surveys. Anyone who flags all four can get a giant increase in balance and get their due dates moved to holidays where the Post Office is slowest! We’d have to be very subtle about it, because there are many nanny-staters out there who’d want to coddle citizens here.

E.D. Kain at The League:

The point he’s making is basically that the whole “irresponsible borrowers deserve what they get” argument is a false one, and I tend to agree.

The whole process of luring in irresponsible borrowers and then saddling them with fines, fees, and extremely high interest rates strikes me as fairly awful. People with very little credit and fairly poor credit – high risk people like college kids, poor people, and so forth – are nevertheless given high credit limits, are lured in with perks and benefits, and are then pushed into a cycle of debt that is often extraordinarily hard to recover from. Many of these people were high enough risks that responsible lenders should never have extended so much easy credit to them to begin with.

At the very least, already we have two irresponsible parties – the borrowers and the lenders. Both have incentives to get into bed with one another.  The borrowers are typically low income or young. Having a line of credit increases their standard of living, at least at first, giving them some financial wiggle room, more purchasing power between paychecks, and a lifeline in case of emergencies. A relatively short line of credit is usually enough for this. A thousand dollars in case the car breaks down or in case you run short on bills and still need to pay for food and gas.

The lender has a more insidious incentive: when the borrower inevitably fails to “act responsibly” the irresponsible lender starts making some real money. That’s why they don’t give out just a thousand dollar credit limit but rather two, three, five thousand dollars – on top of other credit card companies who have already extended similar lines to the same borrower.

People who don’t see a problem with this relationship usually focus on the borrower rather than the lender as the sole irresponsible party, but that’s a wrong-headed way to look at things, especially since many of the people who get into these situations are young, ill-informed, and not prosperous or wise enough yet to manage the sort of responsibility that comes with having credit. In America, this sort of borrower is considered fair game, and the people who lend to them are called “bankers”. In more civilized places we refer to these people as “loan sharks”. In civilized places the burden of determining who is a responsible borrower falls on the lender’s head. This is what separates bankers from loan sharks.

Andrew Sullivan:

A Libertarian Litmus Test

Mike Konczal transforms into his evil twin to propose a way for credit card companies to rip off old people suffering from dementia.

Megan McArdle:

I’m not sure why this is supposed to be a hard question for libertarians.  I mean, I might argue that preventing people from ripping off the marginally mentally impaired would, in practice, be too difficult.  Crafting a rule that prevented companies from identifying people who are marginally impaired might well be impossible–I’m pretty sure that if I wanted to, I could devise subtler tests than “What day of the week is it?”  And while the seniors lobby is probably in favor of not ripping off seniors, they’re resolutely against making it harder for seniors to do things like drive or get credit, which is the result that any sufficiently strong rule would probably have.

But it’s pretty much standard libertarian theory that you shouldn’t take advantage of people who do not have the cognitive ability to make contracts.  Marginal cases are hard not because we think it’s okay, but because there is disagreement over what constitutes impairment, and the more forcefully you act to protect marginal cases, the more you start treating perfectly able-minded adults like children.

The elderly are a challenge precisely because there’s no obvious point at which you can say:  now this previously able adult should be treated like a child.  Either you let some people get ripped off, or you infringe the liberty, and the dignity, of people who are still capable of making their own decisions.

Konzcal is, I take it, in favor of more paternalism.  But the objection that I have to paternalism is not that it prevents companies from more effectively ripping off their customers.  The presumption that a majority of American adults are essentially children puts the state in loco parentis, which hands too much power to people who are not nearly as clever and wise as they believe themselves.  It is morally wrong for companies to attempt to capitalize on dementia, just as I believe it is morally wrong for casinos to attempt to identify, and monetize, their customers with serious gambling problems.  But giving that moral belief force of law is not necessarily a good idea, particularly if it involves eroding the presumption that we are adults capable of, and responsible for, running our own lives.

Jason Kuznicki at Cato:

I’d add two responses of my own.

First, I can’t believe there’s all that much money to be had here. Anyone who wanders into Tiffany’s and back out again without remembering what they bought is, generally speaking, a bad credit risk. Mildly irresponsible people — those who slightly overspend, then have to make it up later — those are probably great for creditors. Lesson learned: If you’re not demented, don’t be irresponsible. (If you are demented, you’re not going to follow my advice anyway.)

Second, I am always amazed at how border cases are dragged out, again and again, as if they proved something against libertarianism. Border cases — How old before you can vote? How demented before a contract doesn’t bind? — are a problem in all political systems, because all systems start with a presumed community of citizens and/or subjects. We always have to draw boundaries between the in-group and the outliers before we have a polity in the first place.

What makes the classical liberal/libertarian approach so valuable is in fact that it draws so few boundaries. Where other systems depend on class boundaries, race boundaries, religious boundaries, and so forth — with annoying boundary issues at every stop along the way — libertarians make it as simple as I think it can be. We presume that all mentally competent adults are worthy of liberty until they prove themselves otherwise.

The boundary cases are still there, but they are fewer and more tractable. Konczal just wandered into one of them. It proves much less than he thinks.