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Geithner and the NY Fed Accused of Willfully Ignoring Fraud and Covering Up Lehman’s Bad Assets by Senior Regulator During the S&L Crisis

Inquiring minds are digging into a 27 page statement made by William Black before the Financial Services committee. Black is an Associate Professor of Economics and Law, at the University of Missouri.

Professor Black’s statements regarding the collapse of Lehman and the role the Fed played in that collapse are refreshingly candid.

Please consider “Public Policy Issues Raised by the Report of the Lehman Bankruptcy Examiner“. Emphasis, highlighting, and subtitles are mine.

I begin with a short description of my background that is relevant to your questions. My primary appointment is in economics. I have a joint appointment in law. I am a white-collar criminologist. My research specialization is financial fraud by elites and financial regulation. I was a senior regulator during the S&L debacle (and had the honor of testifying many times before this Committee).

Valukas Report Documents Three Major Deficiencies In Lehman Governance

The [Valukas] Report documents at least three major deficiencies in Lehman’s corporate governance that need to be addressed globally. First, it points out that Lehman, and many other Delaware corporations, have eliminated the fiduciary duty of “care.”

… Alan Greenspan has admitted that he had a similar view and that events have falsified this naïve account. It is insane to withdraw accountability for negligence. Doing so encourages negligence. Congress should mandate that corporate officers and directors be subject to the fiduciary duties of care and loyalty. They will still, of course, have the very substantial protection of the business judgment rule.

Second, the same individual should not serve as the CEO and Chair of the Board of Directors of a large corporation. The imperial CEO is a consistent problem in this and prior crises.

Third, Lehman ignored its stated risk “limits” and simply increased its limits retroactively to accommodate its violations of its risk limits. In plain English, that means it had no meaningful limits. ….

I have a different view than Mr. Valukas about the overall state of Lehman’s corporate governance. First, Lehman’s nominal corporate governance structure was a sham. Lehman was deliberately out of control with regard to “risk” in its dominant operation – making “liar’s loans.” Lehman did not “manage” the risk of making liar’s loans. It engaged in massive, fraudulent transactions that were “sure things”.

The Valukas Report bears witness to the consequences of these transactions. The Report provides further evidence of the accuracy of Akerlof’s and Romer’s famous article – “Looting: Bankruptcy for Profit.”

Lehman’s principal source of (fictional) income and real losses was making (and selling) what the trade accurately called “liar’s loans” through its subsidiary, Aurora. (The bland euphemism for liar’s loans was “Alt-A.”) Liar’s loans are “criminogenic” (they create epidemics of mortgage fraud) because they create strong incentives to provide false information on loan applications.

The FBI began warning publicly about the epidemic of mortgage fraud in 2004 (CNN). Liar’s loans also produce intense “adverse selection” – even the borrowers who are not fraudulent will tend to be the least creditworthy. The combination of these two perverse incentives means that liar’s loans, in economics jargon, have a deeply “negative expected value” to the lender. In English, that means that the average dollar lent on a liar’s loan creates a loss ranging from 50 – 85 cents.

That loss, however, may not be recognized for many years – particularly if the liar’s loans become so large that they help hyper-inflate a financial bubble. In the near-term, making massive amounts of liar’s losses loans creates a mathematical guarantee of producing record (albeit fictional) accounting income. (As long as the bubble inflates, the liar’s loans can be refinanced – creating additional fictional income and delaying (but increasing) the eventual loss. The industry saying for this during the S&L debacle was: “a rolling loan gathers no loss.”

Lehman Hid Its Insolvency

Lehman’s underlying problem that doomed it was that it was insolvent because it made so many bad loans and investments. It hid its insolvency through the traditional means – it refused to recognize its losses honestly. It could not resolve its liquidity crisis because it was insolvent and its primary source of fictional accounting income collapsed with the collapse of the secondary market in nonprime loans. If Lehman sold its assets to get cash it would have to recognize these massive losses and report that it was insolvent. Investors knew that Lehman was grossly inflating its asset values, so they were generally unwilling buy stock in Lehman or acquire it.

There is no way to “manage” the “risk” of making massive amounts of liar’s loans. Lehman was the world leader in making liar’s loans. As the name makes clear, Lehman’s top managers knew that their principal source of income was making fraudulent loans. It was necessary, therefore, that Lehman not document that its liar’s loans were frequently fraudulent. Lehman, instead, classified its massively fraudulent liar’s loans as “prime” loans. Its disclosures did not identify how many of the “prime” loans it held were actually liar’s loans. As I will discuss in more detail in response to your final question, Lehman personnel that pointed out the fraudulent liar’s loans were attacked, even fired, by Lehman’s management. Honest managers, of course, would be delighted if employees identified frauds.

That same pattern of conscious managerial indifference to pervasive mortgage and accounting fraud was the norm at other nonprime mortgage participants that have been investigated. I refer to it as the financial “don’t ask; don’t tell” policy.

Making liar’s loans is not risky – it is suicidal. That is why every significant lender specializing in liar’s loans failed. The pervasive fraud cannot be admitted – for Lehman’s entire business model was premised on massive sales of liar’s loans to others.

Lehman’s senior managers consciously chose to take the unethical path because they viewed it as extraordinarily profitable. ….

Black Accuses Geithner and the NY Fed of Willfully Ignoring Fraud

It was a painful, as a former regulator, to read the Valukas report’s discussion of the FRBNY staff’s open disdain for working cooperatively with the SEC to protect the public. The Valukas report exposes the sick relationship between the country’s main regulatory bodies and the systemically dangerous institutions (SDIs) they are supposed to be policing. The FRBNY, led by President Geithner, had a clear statutory mission — promote the safety and soundness of the banking system and compliance with the law – stood by while Lehman deceived the public through a scheme that FRBNY officials likened to a “three card monte routine”. …

Translation: The FRBNY knew that Lehman was engaged in fraud designed to overstate its liquidity and, therefore, was unwilling to loan as much money to Lehman. The FRBNY did not, however, inform the SEC, the public, or the OTS (which regulated an S&L that Lehman owned) of the fraud.

The Fed official doesn’t even make a pretense that the Fed believes it is supposed to protect the public. The FRBNY remained willing to lend to a fraudulent systemically dangerous institution (SDI). This is an egregious violation of the public trust, and the regulatory perpetrators must be held accountable. ….

The FRBNY acted shamefully in covering up Lehman’s inflated asset values and liquidity. It constructed three, progressively weaker, stress tests – Lehman failed even the weakest test. The FRBNY then allowed Lehman to administer its own stress test. Surprise, it passed.

The Fed’s defense of its disgraceful refusal to protect the public is meritless. It argues that it was not there in its regulatory capacity and that it sent only a few staffers that laced the capacity or the leverage to accomplish any supervisory goals. This is either a deliberate obfuscation or a confession of a core failure.

Structural Problems at the Fed

The Fed has inherent problems even in safety & soundness regulation due to its structure. First, the regional FRBs have boards of directors dominated by the industry. Congress already made the policy decision, in removing all regulatory functions from the FHLBs in the 1989 FIRREA legislation, that this is an unacceptable conflict of interest.

Second, supervision is, at best, a tertiary activity at the Fed and regional banks. Monetary policy gets all the emphasis, the credit windows come second, and economic research and safety & soundness regulation vie for a distant third place. (Consumer regulation is a bastard step child at the Fed and most agencies.)

Third, the Fed is far too close to the systemically dangerous institutions. The SDIs are in an ideal position to exploit opportunities for regulatory “capture.”

Fourth, the Fed is dominated by neo-classical economists that have no theory of, experience with, or interest in the complex financial frauds that are the dominant cause of our recurring, intensifying financial crises. Bernanke appointed an economist, Patrick Parkinson, with no examination or supervision experience to head all Fed examination and supervision.

Fifth, the Fed is addicted to opaqueness and its senior ranks believe the bankers when they claim that the people must never be allowed to learn the truth about asset losses. One of the conflicts of interest that a banking regulator must never succumb to is the temptation to encourage or allow the regulated entity to lie about its financial condition for the purported purpose of preventing a run on the bank. Geithner, unfortunately, embraced that temptation and stated it openly to the Bankruptcy Examiner.

It is very easy, psychologically, to believe that you are letting a bank lie to the public for a noble reason – protecting the public. The bankers always tell the regulators that the world will end if the banks tell the truth – but that is a lie. Regulators’ greatest asset is their integrity.

The relevant issue was never: can Lehman be saved? The relevant issue, one that the SEC and the Fed appear never to have even asked, was: how can we stop Lehman from serving as a vector spreading the epidemic of liar’s loans? They should have asked themselves that question — and acted — no later than 2001.

That is a very damning appraisal of the competence of Ben Bernanke and the entire Fed.

It is also grounds for indictment of Tim Geithner and the board of directors at Lehman. Assuming Bernanke was a willing conspirator in the ongoing coverup of Lehman, he should be indicted for criminal fraud as well.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com
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So, Mr. Bernanke – who is lying?!

New Merrill Lynch Disclosure Shines A Perjurious Light On Ben Bernanke’s Sworn Testimony; JP “Fed Lite” Morgan Also Dabbled In Repo 105-type Scams

Submitted by Tyler Durden

It seems it was just yesterday that Bernanke was on the edge of committing perjury and lying that the Federal Reserve of New York knew nothing about Lehman’s “more peculiar” off balance sheet transactions. Oh wait, it was: as a reminder in his cross by Scott Garrett, the New Jersey representative asked the Fed Head whether the “Fed was aware of the Repo 105 and the accounting irregularities going on?” Bernanke answers “No – they were hidden.” Oops. Because a story just released by the Financial Times seems to indicate otherwise, and unless Merrill Lynch is lying out of their derriere, Mr. Bernanke should be immediately investigated for potential perjury before the American people. “Securities and Exchange Commission and Federal Reserve officials were warned by [Merrill Lynch] that Lehman Brothers was incorrectly calculating a key measure of its financial health months before its collapse in 2008…In the account given by the Merrill officials, the SEC, the lead regulator, and the New York Federal Reserve were given warnings about Lehman’s balance sheet calculations as far back as March 2008.”  Amusingly, the sole purpose why Merrill would rat out Lehman is to make its own disastrous situation more agreeable, as often happens when the rats realize the sinking of the ship is inevitable. Well, unlike Merrill, whose liquidity situation was equally as disastrous on the weekend of September 14th, which found a pressed suitor in the form of BofA (and its Fed/Goldman-puppet CEO Ken Lewis), Lehman was not quite so lucky (one wonders why). Yet the bigger issue is why does the Fed keep on lying to the American public without any trace of consequence? When will someone finally wake up and sue the Federal Reserve (and we don’t mean FOIA), or at least slap a racketeering lawsuit on “those people?” Oh yeah, the market is up, American Idol is on TV, G-Pap has done all that was needed to (not) be bailed out, so all shall be well. This is better known as “if the other Ponzi dude was thrown in jail, you must acquit” defense.

Further troubling evidence from the FT that the FRBNY may be nothing more than a sinister cabal of Wall Street-acquired criminals:

Former Merrill Lynch officials said they contacted regulators about the way Lehman measured its liquidity position for competitive reasons. The Merrill officials said they were coming under pressure from their trading partners and investors, who feared that Merrill was less ­liquid than Lehman.

The warnings take on a special significance after last week’s report by Anton Valukas, the Lehman bankruptcy court examiner, who found that Lehman had used questionable financing tools to flatter its balance sheet before its September 2008 collapse.

The findings raise questions over what federal regulators knew about Lehman’s accounting and when they knew it. In the account given by the Merrill officials, the SEC, the lead regulator, and the New York Federal Reserve were given warnings about Lehman’s balance sheet calculations as far back as March 2008.

Former and current Fed officials say even in the competitive world of Wall Street, it is un­usual for rival bankers to relay such concerns to the Fed.

The Fed is currently scouring thru its emails, but unfortunately has no confirmation that any exchange like the one mentioned above has ever occurred:

The New York Fed said it were unable to verify that the conversation with Merrill Lynch bankers took place.

When in doubt deny, deny, deny. And what recourse do the American people have anyway? It’s not like the Fed is, you know, transparent, or willing to open its books to anyone, to demonstrate just how deep the criminal rabbit hole actually goes.

And also from the FT we learn that none other than JP Morgan was also using Repo 105 comparable transactions. At least Jamie Dimon’s firm not only was fully transparent about this gimmick, but it promptly ended the practice some time in 2005.

Unlike Lehman, which never disclosed the effects of its repo deals on the firm’s balance sheet, JPMorgan detailed the year-end values of its repo sales and purchases in annual reports beginning in 2001, after a new accounting rule was introduced.The practice ended in 2005 when the company merged with Bank One. “The transactions were done in very small amounts and were fully disclosed,” a spokesman said.

So let’s paraphrase the question for Mr. Bernanke – was the Fed at least aware of those disclosed SFAS 140 transactions? And also, for our own curiosity, can we get a roster of all the FRBNY people who are and have been supposed to oversee SFAS 140 implementations by various banks (hello Steven Manzari)?

What?   You mean it was all a Fed/Treasury/Too-Big-To-Fail Bank scam perpetrated on the American People?  Oh surely, that can’t be it.

Geithner’s E-Mails, Phone Logs Subpoenaed by House

Jan. 13 (Bloomberg) — The Federal Reserve Bank of New York was ordered by a House committee to provide Timothy Geithner’s e-mails, phone logs and meeting notes tied to the bailout of American International Group Inc.

The subpoena from House Oversight and Government Reform Committee Chairman Edolphus Towns demands by Jan. 19 all documents related to the New York Fed decision to fully reimburse banks that bought protection from AIG and efforts to persuade AIG to keep information about the payments from the public, Towns said in a statement today.

“We need to understand why and how taxpayer dollars were used to bail out the same people who helped cause the financial crisis in the first place,” Towns said in a statement. Geithner, who was president of the New York Fed when AIG was rescued, is now President Barack Obama’s Treasury secretary.

The New York Fed had resisted since November calls to provide documents without a subpoena, Darrell Issa, the ranking Republican on the oversight committee, said yesterday in a letter. The New York Fed asked AIG in 2008 and 2009 to remove information about the bank payments from regulatory filings, according to e-mails released by Issa last week.

The subpoena also called for documents from New York Fed General Counsel Thomas Baxter, Stephen Friedman, a former New York Fed director and current Goldman Sachs Group Inc. director, and Sarah Dahlgren, a New York Fed senior vice president who manages its AIG oversight team. Towns also demanded term sheets related to payments to AIG’s credit-default swap counterparties.

Full Payment

Deborah Kilroe, a spokeswoman for the New York Fed, declined to comment. She said yesterday that the New York Fed will “work with the committee to provide relevant information as appropriate.”

Geithner made the decision to pay banks 100 cents on the dollar for their AIG swaps tied to subprime mortgages even though the underlying assets had declined in value, according to a November report by the government watchdog overseeing the bailout program. Banks including Goldman Sachs Group Inc. and Societe Generale SA were among beneficiaries of AIG’s rescue, called by lawmakers a “backdoor bailout” for financial firms.

The insurer’s rescue “provided AIG’s counterparties with tens of billions of dollars they likely would have not otherwise received,” wrote Neil Barofsky, the special inspector of the U.S. Troubled Asset Relief Program.

Reference Crossed Out

AIG planned to disclose in December 2008 that it fully reimbursed the banks to retire the swaps contracts. The New York Fed crossed out the reference to the full payments in a draft of a regulatory filing, according to the e-mails released by Issa, and AIG excluded the language when the filing was made public Dec. 24, 2008.

Geithner was also asked by the oversight committee last week to testify in public hearings about what he knew of the New York Fed’s efforts to limit the disclosure. Baxter said last week that Geithner wasn’t aware of the issue because the lawyer didn’t think it merited Geithner’s attention.

Andrew Williams, a spokesman for the Treasury, declined to comment on the demand for Geithner’s e-mail from his time at the New York Fed.

To contact the reporters on this story: Hugh Son in New York at hson1@bloomberg.net; Andrew Frye in New York at afrye@bloomberg.net.

Last Updated: January 13, 2010 18:11 EST

Aig And Geithner: More Lies?

Posted by Karl Denninger

In a letter to Darrell Issa and Edolphus Towns the NY Fed’s General Counsel asserted: