By: Elliot Turner

“The triggering device in financial instability may be the financial distress of a particular unit. In such a case, the initiating unit, after the event, will be adjudged guilty of poor management. However, the poor management of this unit…may not be the cause of system instability.”
–Hyman Minsky

The blogosphere is abuzz over the U.S. Bankruptcy Court’s dissection of the October 2008 demise of Lehman Brothers. The area of particular intrigue pertains to Lehman’s hiding real risk outside the scope of their balance sheet:

Lehman did not disclose…that it had been using an accounting device (known within Lehman as “Repo 105”) to manage its balance sheet – by temporarily removing approximately $50 billion of assets from the balance sheet at the end of the first and second quarters of 2008….

In a Repo 105 transaction, Lehman did exactly the same thing, but because the assets were 105% or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financings, so that the assets could be removed from the balance sheet.

Regardless of the perceived impropriety in using such tactics, this deception seems consistent with legal and regulatory interpretations of accounting laws, while sitting in stark contrast to the spirit and principle behind the regulations themselves. This is an important distinction. When regulators see that market participants are evading the spirit of their regulations, while acting within the framework of the law, steps must be taken to tighten up the language of the law itself to limit improper behavior. Yves Smith at Naked Capitalism points out that not only are Lehman and their accountants–Ernst and Young–culpable in using evasive maneuvers, so too are the New York Fed, and our Treasury Secretary, Mr. Geithner:

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.

The implications of this development are significant; however, this significance expands far beyond the scope of the Lehman bankruptcy itself. Not only were the private institutions engaging regulatory arbitrage, so too were the regulators themselves. This is incredibly alarming. The N.Y. Fed ultimately was complicit in Lehman’s attempt to shift its risk to non-traditional accounting vehicles and leaving shareholders and taxpayers with naked exposure in the process. Yet further, the stress tests conducted by the NY Fed and the SEC assessing the systemic risk of a Lehman failure in the end “were a sham. Only one outcome was permissible: that Lehman pass. So after the Fed was unable to come up with an objective-looking stress test that Lehman could satisfy, they permitted Lehman to devise a test with low enough standards to give itself a clean bill of health” (quoting Yves Smith at Naked Capitalism).

As Hyman Minsky wisely observed decades ago, after the fact, people will focus on the failure of the “triggering unit” rather than on the systemic problems. What is important to learn about these events is not unique to Lehman. We need to discover how widespread and deep these problems were in the past, and continue to be in the present. Although Lehman is the one that our government allowed to fail, we all know that Citigroup (C) and AIG (AIG), among others suffered massive losses triggered by off balance sheet risk. In the end, U.S. taxpayers are footing the bill, while management at these institutions remains in tact and is profiting handsomely.

We need a wholesale examination into how widespread these “Repo 105” practices were in the financial arena. Further, we need to learn whether our regulatory bodies truly serve to enforce the principles that our regulations seek to uphold; or whether they are so beholden to the institutions they regulate as to be rendered utterly useless in the process. In focusing the scrutiny too closely on Lehman Brothers itself, I believe the larger, more important questions risk being swept under the rug. Many want to forget about the past and focus on the present and the future; however, that is impossible without an understanding of the events leading up to the crisis. Without such an analysis and forward progress in improving our financial sector regulatory landscape it is nearly impossible for investors, shareholders and depositors alike to have complete confidence in our financial system.

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