Timmy-Gate: Did Geithner Help Hide Lehman’s Fraud?

Timmy-Gate Takes a Turn For The Worse: Did Geithner Help Lehman Hide Accounting Tricks?

By L. Randall Wray

Just when you thought that nothing could stink more than Timothy Geithner’s handling of the AIG bailout, a new report details how Geithner’s New York Fed allowed Lehman Brothers to use an accounting gimmick to hide debt. The report, which runs to 2200 pages, was released by Anton Valukas, the court-appointed examiner. It actually makes the AIG bailout look tame by comparison. It is now crystal clear why Geithner’s Treasury as well as Bernanke’s Fed refuse to allow any light to shine on the massive cover-up underway.
Recall that the New York Fed arranged for AIG to pay one hundred cents on the dollar on bad debts to its counterparties—benefiting Goldman Sachs and a handful of other favored Wall Street firms. (see here) The purported reason is that Geithner so feared any negative repercussions resulting from debt write-downs that he wanted Uncle Sam to make sure that Wall Street banks could not lose on bad bets. Now we find that Geithner’s NYFed supported Lehman’s efforts to conceal the extent of its problems. (see here) Not only did the NYFed fail to blow the whistle on flagrant accounting tricks, it also helped to hide Lehman’s illiquid assets on the Fed’s balance sheet to make its position look better. Note that the NY Fed had increased its supervision to the point that it was going over Lehman’s books daily; further, it continued to take trash off the books of Lehman right up to the bitter end, helping to perpetuate the fraud that was designed to maintain the pretense that Lehman was not massively insolvent. (see here)

Geithner told Congress that he has never been a regulator. (see here) That is a quite honest assessment of his job performance, although it is completely inaccurate as a description of his duties as President of the NYFed. Apparently, Geithner has never met an accounting gimmick that he does not like, if it appears to improve the reported finances of a Wall Street firm. We will leave to the side his own checkered past as a taxpayer, although one might question the wisdom of appointing someone who is apparently insufficiently skilled to file accurate tax returns to a position as our nation’s chief tax collector. What is far more troubling is that he now heads the Treaury—which means that he is not only responsible for managing two regulatory units (the FDIC and OCC), but also that he has got hold of the government’s purse strings. How many more billions or trillions will he commit to a futile effort to help Wall Street avoid its losses?
Geithner has denied that he played any direct role in the AIG bail-out—a somewhat implausible claim given that he was the President of the NYFed and given that this was a monumental and unprecedented action to funnel government funds to AIG’s counterparties. He may try to deny involvement in the Lehman deals. (Again, this is implausible. Lehman executives claimed they “gave full and complete financial information to government agencies”, and that the government never raised significant objections or directed that Lehman take any corrective action. In fairness, the SEC also overlooked any problems at Lehman. (see here) But here is what is so astounding about the gimmicks: Lehman used “Repo 105” to temporarily move liabilities off its balance sheet—essentially pretending to sell them although it promised to immediately buy them back. The abuse was so flagrant that no US law firm would sign off on the practice, fearing that creditors and stockholders would have grounds for lawsuits on the basis that this caused a “material misrepresentation” of Lehman’s financial statements. (see here) The court-appointed examiner hired to look into the failure of Lehman found “materially misleading” accounting and “actionable balance sheet manipulation.” (here) But just as Arthur Andersen had signed off on Enron’s scams, Ernst & Young found no problem with Lehman. (here)
In short, this was an Enron-style, go directly to jail and do not pass go, sort of fraud. Lehman’s had been using this trick since 2001. (here) It looked fine to Timmy’s Fed, which extended loans allowing Lehman to flip bad assets onto the Fed’s balance sheet to keep the fraud going.
More generally, this revelation drives home three related points. First, the scandal is on-going and it is huge. President Obama must hold Geithner accountable. He must determine what did Geithner know, and when did he know it. All internal documents and emails related to the AIG bailout and the attempt to keep Lehman afloat need to be released. Further, Obama must ask what has Geithner done to favor his clients on Wall Street? It now looks like even the Fed BOG, not just the NYFed, is involved in the cover-up. It is in the interest of the Obama administration to come clean. It is hard to believe that it does not already have sufficient cause to fire Geithner. In terms of dollar costs to the government, this is surely the biggest scandal in US history. It terms of sheer sleaze does it rank with Watergate? I suppose that depends on whether you believe that political hit lists and spying that had no real impact on the outcome of an election is as bad as a wholesale handing-over of government and the economy to Wall Street.
What did Timmy know, and when did he know it?
Point number two. Lehman used an innovation, “Repo 105” to hide debt. The whole Greek debt fiasco was caused by Goldman, et. al., who helped hide government debt. (here and here) Whether legal or illegal, Wall Street has for many years been producing financial instruments designed to mislead shareholders, creditors, and regulators about the true financial position of its clients. Note that Lehman’s counterparties in this fraud included JP Morgan and Citigroup (who actually precipitated Lehman’s final failure when they finally called in their loans). It always takes at least three to tango: the firm that wants to hide debt, the counterparty that temporarily takes it off their books, and the accounting firm that provides the kiss of approval.
Worse, after aiding and abetting such deception, Goldman and other Wall Street institutions then place bets (using another nefarious innovation, credit default swaps) against their clients, wagering that they will not be able to service the debts—which are greater than the market believes them to be. Does that sound something like insider trading? How can regulators permit such actions?
What did Timmy know, and when did he know it?
Third point. To the extent that debt is hidden, financial institution balance sheets present an overly rosy picture—of course, that is the purpose of the financial “innovations”. Enron did it; AIG did it; Lehman did it. What about Bank of America, Citi, JP Morgan, Wells Fargo and Goldman? We now know that the New York Fed subjected Lehman to three wimpy “stress tests”, all of which it failed. Timmy’s Fed then allowed Lehman to construct its own sure-to-pass “stress” test. (We know, of course, that the test was absolutely meaningless because, well, Lehman passed the test and then immediately failed spectacularly. Timmy then let the biggest banks run their own stress tests, which they (surprise, surprise) managed to pass.
What did Timmy know, and when did he know it?
As our all-time favorite Fed Chairman Alan Greenspan liked to put it, “history shows” that when financial institutions pass their own stress tests, they are actually massively insolvent. There is no reason to believe that this time will be different. Mike Konczal reports that there is every reason to believe the biggest banks are hiding huge losses on second liens. (here) These are second mortgages or home equity loans that amount to about $1 trillion of which almost half are held by the top four banks. Since the first principal of a mortgage is paid first, it is likely that much of the second liens are worthless. Yet banks are carrying these on their books at 86 to 87 percent of face value—which was necessary to allow them to pass the stress tests. Konczal shows that at a more reasonable loss rate of 40% to 60%, the four largest banks would have “an extra $150 billion hole in the balance sheet”. I won’t go into the policy conundrum implied for President Obama’s plan for principal reduction to help homeowners (the banks will not allow renegotiation of underwater mortgages because that would force them to recognize losses on the second liens).
Of greater importance is the recognition that all of the big banks are probably insolvent. Another financial crisis is nearly certain to hit in coming months—probably before summer. The belief that together Geithner and Bernanke have resolved the crisis and that they have put the economy on a path to recovery will be exposed as wishful thinking. In the bigger scheme of things, this is only 1931. We have a long way to go before bank assets (and nonbank debts) are written down sufficiently to allow a real recovery. In other words, a Minsky-Fisher debt deflation is still in the cards.

7 responses to “Timmy-Gate: Did Geithner Help Hide Lehman’s Fraud?

  1. Sure, Geithner should be held accountable for his actions but won't. But, this report implies even bigger questions such as what new schemes by investment banks replaced financing via the repo market? And what was the impact and possible future impact of the 2004 SEC decision re: Net cap rules?

  2. How can there be a debt deflation when the Fed and Treasury will simply invent some new "money-printing" scheme to liquify the system? When TARP gave them problems they created the AIG shell, and what that gig was up the Fed bought $1 trillion in mortgages. What's next? I don't see how you can be bearish in a sovereign fiat money system. There is no end to how much money the Fed can print as has been pointed out many times on this blog.

  3. With due respect, when it comes to Lehman in 2008, I think the regulators were so focused on "net capital" that they didn't even consider the possibility of fraud.You're writing after-the-fact. But in early 2008, the focus would have been on Lehman's firm equity position as analyzed against what assets would realistically have to take deep haircuts. I worked in Lehman Japan through one of these amorphous "professional service firms", on a project to study their bond trading. The product control group there didn't realize they were doing a yen-carry trade, using repos to fund a yen borrowing by the European affiliate. Did "Repo 105"-designated transactions pass through the Lehman Japan trading desk? Yes, I remember seeing the designation. But I'm not sure that anyone outside of the conspiracy knew what that meant. They looked like all the other repo transactions the firm did at a systems level.If anything, I think the evidence shows that the regional senior people in the Repo 105 scandal (like Enrico Corsalini), were much more worried about the effect of the heavy repo volume on their minimum net capital position (since absent the fraudulent number, it would dilute capital), than being "in on" the scandal.The people who are at a professional in those Wall Street firms, they neither know as much as what they act like, nor what people give them credit for. Once the prosecutors start pumping the lower ranks for information, I think they're going to find the scheme continued for so very long only because a very few people were really in on it. Just like Madoff.

  4. This is by far and away the best account of this chicanery on the web today. Others have attempted to summarize it but only clumsily by comparison. Very helpful.Sad to say, nothing will be done to deal with Geithner or anyone else involved here. The ruling class protects its own. Has anything been done by the Justice Department to bring known torturers to justice and that after we executed Japanese war criminals for employing the self-same practices during the Second World War? Only massive demonstrations and economy paralysing strikes – not parliamentary means – will bring an end to the causative factors that slowly have robbed us of our democracy. Reliance on congressional or special investigations to remedy the corruption and criminality of those that govern us is to look upon Washington's realities with rose-colored glasses. There must be an authentic "peoples' moment" for there to be an enduring solution to what we face. Andrei Vyshinsky

  5. Dr Wray, here is an interesting counter-argument to Mike Konczal's article you cited. Copied it from the comments section:Posted by Dave in NYC | March 16th, 2010 at 10:19 am Looking at Total 2nd Lien/Junior Lien mortgages in one bucket is not a productive way to analyze things. Closed-end 2nd liens have performed very differently from home equity lines of credit (HELOCs) and your analysis does not reflect that.There are $762 billion of junior lien loans in U.S. commercial banks, but 79% of those, or $604 billion, are actually HELOCs, while only 21% are closed-end 2nds.Closed-end 2nds are performing generally how you would expect — 11% net charge-offs (i.e., losses) in 2009, with 8.6% delinquent at the end of the year.HELOCs, on the other hand, have performed much better — only 3% losses in 2009, and only 2.6% delinquent at the end of the year (a number which actually declined from year-end 2008).There are a number of possible reasons for this discrepancy — I believe HELOCs are generally issued to higher quality borrowers, customers who do other business with the bank, and don’t always have a first lien in front of them. Comparing bank-underwritten HELOCs to the securitized product out there is an erroneous comparison, as the stuff on bank balance sheets has performed much better.You can criticize the SCAP for taking too short-term a view of things, but 1 year into their 2-year horizon, the actual realized losses on this overall pool of loans is 5%, and the percentage that are behind on their payments is only 3.8%. You should consider the possibility that your 40-60% projection is not going to materialize, and perhaps update your assumptions just as you ask the Fed to update its tests.

  6. Thanks for comments. Anon 1: Govt is not financially constrained. Absolutely agree. The consequences of Govt taking all bad debt–trillions–off all private balance sheets and substituting govt debt is certainly feasible. But a) it will not be done; b) it sets up unimaginably bad incentives. That would truly be the end of capitalism as we know it. The implications are simply too far reaching to even imagine. And horrible. What we need to do instead is to impose lossses, downsize finance.Hoofin: What did timmy know and when did he know it. What stinks most is the coverup. Coverups bring down administrations. You could be right that they originally had good intentions (I seriously doubt it–I think this is all about Timmy protecting his future employers), but if so they should come clean now.Bubble: No, I expect we will have to revise upward the losses. the logic makes no sense. the whole system is a Ponzi/Madoff pyramid scheme. The 40-60% loss ratio used in the calculations will prove to be a vast underestimate. The "first" losses on bad mortgages is 90%. There is nothing left for seconds. However the Konczal piece does talk about possibility that seconds are paid off first. Could happen in some cases. Real estate prices will continue to fall–for years. Losses will mount. This is 1931. Another decade to go….

  7. @anonymous 3/16/10 4:59pmHey, I'd like to see Geithner go, simply because he didn't pay his taxes. Some schmuck gets a $500 bad credit remark on his report and it haunts him for the next 7 years. Others, like mentioned, stiff the public for much much more and get called "sir".Obama's not going to do it because that's not his style. But the sense I have is Volcker has more say in that circle than Geithner or Summers ever will going forward. Ann Dunham did not raise any dummy.