An Insolvent System?

Is the Fed Helping the Big Banks to Cook Their Books?

by Mike Whitney

counterpunch.org (April 12 2010)


On Friday, the Wall Street Journal revealed details of a cover up by the nation's largest banks that have been engaged in potentially-criminal accounting activities to conceal the amount of debt on their balance sheets. The SEC has been notified of the allegations and has launched a probe to determine whether further action is needed. Among the banks implicated, are Goldman Sachs, JP Morgan, Bank of America, and Citigroup. According to the Wall Street Journal:

Major banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York. A group of eighteen banks ... understated the debt levels used to fund securities trades by lowering them an average of 42 per cent at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters. {1}

The article has set off alarm bells on Wall Street because of the similarity between Lehman Brothers. "repo 105" transactions and these new signs of obfuscation by other large banks. "Repo 105" is an accounting device that Lehman used to hide $50 billion in debt off its balance sheet in an attempt to mislead investors about the true state of its financial health. The Wall Street Journal story suggests that the practice may be more widespread than originally thought. The "repo 105" scandal is further complicated by suspicions that Lehman was assisted in its effort by the Federal Reserve Bank of New York which, at the time, was headed by the present Secretary of the Treasury, Timothy Geithner. Here is a short recap of what transpired between the Geithner's New York Fed and Lehman according to ex-regulator William Black and former New York governor Eliot Spitzer from an article on Huffington Post:

The Federal Reserve Bank of New York [that is, New York Fed] knew that Lehman was engaged in smoke and mirrors designed to overstate its liquidity and, therefore, was unwilling to lend as much money to Lehman. The Federal Reserve Bank of New York did not, however, inform the SEC, the public, or the Office of Thrift Supervision (which regulated an S&L that Lehman owned) of what should have been viewed by all as ongoing misrepresentations.

The Fed's behavior made it clear that officials didn't believe they needed to do more with this information. The Federal Reserve Bank of New York remained willing to lend to an institution with misleading accounting and neither remedied the accounting nor notified other regulators who may have had the opportunity to do so ... We now know from Valukas and from former Treasury Secretary Paulson that the Treasury and the Fed knew that Lehman was massively overstating its on-book asset values. {2}

So the question is whether the New York Fed helped other banks conceal important financial information from investors, too. And - if that's the case - then how can the public be confident that the biggest banks in the country are truly solvent?

According to the Wall Street Journal: "An official at the Federal Reserve Board noted that the Fed continuously monitors asset levels at the large bank-holding companies, but the financing activities captured in the New York Fed's data fall under the purview of the Securities and Exchange Commission, which regulates brokerage firms".

The Fed's explanation is a tacit denial of its responsibility to regulate or report suspicious accounting practices to the appropriate agencies. The response is not just "buck passing", but also suggests collusion. So far, there's no clear link between the Fed and the shady bookeeping at the banks. But many now believe that - in the case of Lehman - the Fed acted as an "enabler", either by serving as a counterparty in repo 105 deals or by looking the other way while the transactions were executed. Either way, the situation demands an independent investigation.

To put the Wall Street Journal article in context, it helps to review the details of the Lehman case. Here's an excerpt from an article by Eric Dash in the New York Times:

Newly released report on the collapse of Lehman Brothers ... sheds surprising new light on Lehman's dealings with the New York Fed. Lehman engaged in a series of transactions with the New York Fed that were similar to the ones that drew criticism from the bankruptcy court examiner who investigated its collapse ...

The report by Mr Valukas nonetheless raises fresh questions about the role of the New York Fed in supporting Lehman during the frantic months leading up to its collapse. It suggests that Lehman executives believed the Fed would be able to help the bank avert disaster and provide it with a business opportunity ...

Lehman, desperate for financing, seized its chance. It packaged billions of dollars of troubled corporate loans into an investment called Freedom CLO. Then, in a series of transactions, it shifted Freedom back and forth to the New York Fed, in exchange for cash. Those moves helped make Lehman look healthier.

Essentially, Lehman was able to temporarily warehouse illiquid investments that were worrying its investors at the New York Fed in return for cash. The Fed created this facility immediately after the near collapse of Bear Stearns. Some suspect that other banks engaged in similar maneuvers. {3}

So why did "Lehman executives believe the Fed would be able to help the bank avert disaster and provide it with a business opportunity"? Most likely, because that had been standard operating procedure. The Fed was merely acting as it had before. Lehman used the repo market to amplify leverage to maximize profits (the same as the other banks), and when they couldn't find a counterparty to accept their garbage collateral, the Fed would step in and provide short-term loans and "warehouse" their toxic assets. In essence, the Fed was helping to defraud investors who believed the banks reports were accurate. Here's Yves Smith at Naked Capitalism who sums it up perfectly:

The New York 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 ... at a minimum, the New York Fed 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 New York Fed, and likely Geithner himself, undermined, perhaps even violated, laws designed to protect investors and markets. {4}

So if the New York Fed had no moral qualms about its "repo 105" dealings with Lehman, than why would it hesitate to do the same thing for the other banks? Tyler Durden at Zero Hedge answers the question like this:

We contend that Repo 105 type book-cooking and quarter end balance sheet window dressing was a prevalent phenomenon among all the banks. The fact that over the past two and a half years this resulted in a differential from the peak quarterly assets of over $65 billion is unbelievable, and the fact that this had slipped through the regulators' fingers is inexcusable ...

We are confident that armed with this data, the SEC will be able to provide a prompt and logical response to why the primary dealers have such a peculiar pattern in downshifting their assets toward quarter end, and much more relevantly, who the counterparties are that would consistently take the other side of these quarter end window-dressing trades. {5}

Durden's logic looks good. If Lehman was being aided in its "book cooking" by the New York Fed, then the other banks were probably being helped, as well. It looks like Geithner left his fingerprints everywhere.

If we add these new developments to the fact that the Financial Accounting Standards Board's (FASB) "mark to market" rule has been suspended (allowing banks to arbitrarily assign whatever value they choose to the own illiquid assets) and, the fact that the Federal Reserve still refuses to allow an independent audit of the dodgy collateral it accepted from the banks in exchange for Treasuries and other loans; then it still looks like the banking system is either teetering or insolvent.

And don't expect the Securities and Exchange Commission to get to the bottom of this either. SEC chairman Mary Schapiro is a proven financial industry loyalist who has no intention of upsetting her Wall Street overlords by digging too deep or issuing subpoenas. If she pursues the investigation at all, it will only be to placate the public and to apply liberal amounts of whitewash to the whole matter.

Notes:

{1} "Big Banks Mask Risk Levels" by Kate Kelly, Tom McGinty and Dan Fitzpatrick, Wall Street Journal
http://online.wsj.com/article/SB10001424052702304830104575172280848939898.html

{2} "Time for the Truth" by William Black and Eliot Spitzer, Huffington Post
http://www.huffingtonpost.com/eliot-spitzer/time-for-truth-three-card_b_500867.html

{3} "Fed Helped Bank Raise Cash Quickly" by Eric Dash, New York Times
http://www.nytimes.com/2010/03/13/business/13freedom.html

{4} http://www.nakedcapitalism.com/2010/03/ny-fed-under-geithner-implicated-in-lehman-accounting-fraud.html

{5} "Evidence That Primary Dealers Have Collectively Engaged In Repo 105 And Qtr-End Book Cooking Type Schemes For Years", zero hedge, April 09 2010
http://www.zerohedge.com/article/evidence-primary-dealers-have-collectively-engaged-repo-105-and-qtr-end-book-cooking-type-sc

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Mike Whitney lives in Washington state. He can be reached at fergiewhitney@msn.com

http://www.counterpunch.org/whitney04122010.html

Bill Totten http://www.ashisuto.co.jp/english/index.html