Fraud on the Street

The Securities and Exchange Commission announced Monday it had begun an inquiry into two dozen financial companies to determine whether they followed accounting practices similar to those recently disclosed in an investigation of Lehman Brothers (LEHMQ).

Where on earth has the SEC been?

It’s now clear Lehman Brothers’ balance sheet was bogus before the bank collapsed in 2008, catapulting the Street and the world into the worse financial crisis since 1929. The Lehman bankruptcy examiner’s recent report details what just about everyone on the Street has known since the firm imploded – that Lehman defrauded its investors. Even Hank Paulson, in his recent memoir, referred to Lehman’s balance sheet as bogus.

In order to look like it could borrow $30 for every dollar of its own money, Lehman shifted liabilities off its books at the end of each quarter. Its CPA, Ernst and Young, approved of this fraud against the advice of its own whistle blower, whom Ernst and Young fired.

Lehman’s practices couldn’t have been all that different from those of every other big bank on the Street. After all, they were all competing for the same business, and using many of the same techniques. Lehman was just the first to go under, causing a financial run that led George W. to warn “this sucker could go down” unless the federal government came up with hundreds of billions to bail out the others.

In other words, the TARP covered the other bankers’ assets and asses.

We now know, for example, Goldman Sachs (GS) helped Greece hide its public debt and then placed financial bets that Greece would default, using credit-default swaps to avoid risking its own capital. It’s the same tactic Goldman used for (and against) American International Group (AIG): Hide the ball, and then bet against the ball and fob off the risk to investors and taxpayers, using derivatives to remove the risky tactics from the balance sheets. Even today no one knows the fair value of the complex derivatives underlying these and related maneuvers, which is exactly the point.

Congress is now struggling to come up with legislation to stop this from happening again. And the Street is struggling to stop Congress. As of now, the Street’s political payoffs seem to be working. Proposed legislation still allows secret derivative trading in foreign-exchange swaps (similar to what Goldman used to help Greece hide its debt) and in transactions between big banks and many of their corporate clients (as with AIG).

But wait. We already have a law designed to stop this sort of fraud. It’s called the Sarbanes-Oxley Act of 2002.

Think back to the corporate looting scandals that came to light almost a decade ago when the balance sheets of Enron, WorldCom, and others were shown to be fake, causing their investors to lose their shirts. Nearly every major investment bank played a part in the fraud — not only advising the companies but also urging investors to buy their stocks when the banks’ own analysts privately described them as junk.

Sarbanes-Oxley – Sarbox, as it’s come to be known – was designed to stop this. It requires CEOs and other senior executives to take personal responsibility for the accuracy and completeness of their companies’ financial reports and to set up internal controls to assure the accuracy and completeness of the reports. If they don’t, they’re subject to fines and criminal penalties.

Sarbox is directly relevant to the off-the-balance-sheet derivative games the Street played and continues to play. No bank CEO can faithfully attest to the accuracy and completeness of its financial reports when derivatives guarantee that the reports are incomplete and deceptive.

So where has the SEC been?

I was on a panel a few weeks ago with a former chair of the Securities and Exchange Commission who was asked why the commission has so far failed to enforce Sarbox against Wall Street. He had no response except to mumble that legislation is meaningless unless adequately enforced. Exactly.

Bottom line: While financial reform is needed, there’s no reason to wait for it. Sarbox is already there. And even if financial reform is enacted without loopholes, there’s no reason to think it will be enforced if laws already on the books, such as Sarbox, aren’t.

(adapted from my column in The American Prospect)

About Robert Reich 545 Articles

Robert Reich is the nation's 22nd Secretary of Labor and a professor at the University of California at Berkeley.

He has served as labor secretary in the Clinton administration, as an assistant to the solicitor general in the Ford administration and as head of the Federal Trade Commission's policy planning staff during the Carter administration.

He has written eleven books, including The Work of Nations, which has been translated into 22 languages; the best-sellers The Future of Success and Locked in the Cabinet, and his most recent book, Supercapitalism. His articles have appeared in the New Yorker, Atlantic Monthly, New York Times, Washington Post, and Wall Street Journal. Mr. Reich is co-founding editor of The American Prospect magazine. His weekly commentaries on public radio’s "Marketplace" are heard by nearly five million people.

In 2003, Mr. Reich was awarded the prestigious Vaclev Havel Foundation Prize, by the former Czech president, for his pioneering work in economic and social thought. In 2005, his play, Public Exposure, broke box office records at its world premiere on Cape Cod.

Mr. Reich has been a member of the faculties of Harvard’s John F. Kennedy School of Government and of Brandeis University. He received his B.A. from Dartmouth College, his M.A. from Oxford University, where he was a Rhodes Scholar, and his J.D. from Yale Law School.

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4 Comments on Fraud on the Street

  1. Your “Fraud on the Street” column is shameful in its inaccuracy. You refer to the bankruptcy examiner’s report at detailing that “Lehman defrauded its investors.” I have actually read the entire report, and there was not a single reference that the accounting used by Lehman was not in accordance with generally accepted auditing standards. In fact, if you knew accounting rules you would know that those rules REQUIRE a company to account for those transactions in the manner in which Lehman did.

    You also say “Its CPA, Ernst and Young, approved of this fraud against the advice of its own whistle blower, whom Ernst and Young fired.” In fact, the “whistle blower” worked for Lehman, not Ernst and Young, and it was Lehman who fired him.

    Lehman failed due to a classic “run on the bank.” Any leveraged financial institution has this risk if there is a crisis in confidence leading to a sudden “run on the bank”.

    You suggest that additional regulation and enforcement would have prevented this. I remind you that Harry Markopolos clearly laid out the Madoff fraud nearly two dozen times over ten years to this same regulatory/enforcement regime (the SEC), and even then they failed to detect it.

  2. P.S. As for TARP “cover(ing) the other bankers assets and asses”, I remind you that nearly all of the TARP money provided to financial institutions has since been repaid by those banks to the government. The primary exceptions remain FNMA and Freddie Mac, for which it is unfortunately unlikely that the government will recover its TARP outlay. (But I remind you that those two entities were so significant that they had THEIR OWN government regulatory agency devoted solely to those two institutions.) AIG also has not yet repaid all of its TARP loans, however they have announced over $50 billion of asset sales and at that rate they may yet repay the government

  3. The SEC systematically failed but do not forget that to a very large extent Wall Street is a self-regulated industry. The Financial Industry regulatory Authority (FINRA) is Wall Street’s SRO.

    America hardly knows FINRA. None other than Harry Markopolos said FINRA was ‘in bed’ with the industry.

    It is long overdue for an independent investigation of this organization.

    Sense on Cents Calls for Independent Investigation of FINRA.
    http://www.senseoncents.com/2010/03/sense-on-cents-calls-for-independent-investigation-of-finra/

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