New York Sues Accounting Giant Ernst & Young for Fraud in Connection with Lehman’s Repo 105, But the ENTIRE American Economy is a Ponzi Scheme

New York attorney general Andrew Cuomo is about to charge Lehman’s accountants, Ernst & Young, with fraud for allowing Lehman to cook its books using the infamous “Repo 105″ shell game. This comes only weeks after a Lehman retirement fund sued Lehman CEO Dick Fuld over the same scam.

Tyler Durden has documented that Ernst & Young did, in fact, knowingly commit fraud with regard to Lehman’s Repo 105s. See this and this.

I applaud Cuomo’s move, as the economy cannot recover until fraud is prosecuted.

But it wasn’t just Lehman.

As Durden has repeatedly pointed out, all of the big banks have used Repo 105s or similar schemes to hide their debts. See this, this, this, this and this. As I noted in September, the ongoing use of Repo 105 like debt-hiding games by the big banks will render Basil III capitl requirements meaningless.

And – despite protestations to the contrary – the government knowingly allowed the shell game.

As I wrote in April:

Regulators like the Fed and SEC have said they didn’t know about Lehman’s use of Repo 105s to hide its mountain of debt.

But in a must-read New York Times Op-Ed, law school professors Susan P. Koniak, George M. Cohen, David A. Dana, and Thomas Ross point out:

Our bank regulators were not, as they would like us to believe, outside the disco, deaf and blind to the revelry going on within. They were bouncing to the same beat. In 2006, the agencies jointly published something called the “Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities.” It became official policy the following year.

What are “complex structured finance” transactions? As defined by the regulators, these include deals that “lack economic or business purpose” and are “designed or used primarily for questionable accounting, regulatory or tax objectives, particularly when the transactions are executed at year end or at the end of a reporting period.”

How does one propose “sound practices” for practices that are inherently unsound? Yet that is what our regulatory guardians did. The statement is powerful evidence of the permissive approach bank regulators took toward the debt-dissolving financial products that our banks had been developing, hawking and using themselves for years. And it’s good reason for Americans to be outraged by the “who me, what, where?” reaction of Mr. Bernanke and the S.E.C. to the revelation of Lehman’s Repo 105 scam.

***

The interagency statement on “sound practices” of 2006 … was greeted with effusive praise from bankers, their lawyers and accountants. Gone was the requirement [proposed by the law professors and others] to ensure that customers understood these instruments and that the banks document that they would not be used to phony-up a company’s books.

The focus on complexity was also gone, as was the concern over transactions “with significant leverage” — that is, deals with little real cash underneath, another unfortunate deletion because attending to excessive leverage would have served us well.

Instead, the only products that the banks were asked to handle with special care were so narrowly defined and so obviously fraudulent that suggesting that they could be sold at all was outrageous. These included “circular transfers of risk … that lack economic substance” and transactions that “involve oral or undocumented agreements that … would have a material impact on regulatory, tax or accounting treatment.” [and these weren’t banned, but apparently only required special disclosures by the banks]

Just as troubling, at least in retrospect, the new statement specifically exempted C.D.O.’s from the need for any special care ..

Only two years later, these same regulators were explaining that the complexity and opaqueness of instruments like C.D.O.’s had contributed significantly to the economic collapse…

Moreover, the collapse was characterized by institutions supposedly healthy one day and on the verge of collapse the next, due in no small part to their extraordinary debt burdens — debt burdens that complex instruments magically removed from the books.

To this day, that final interagency statement (which was adopted in 2007) has not been repealed or replaced. It can still be found on the S.E.C. Web site, along with the letters from industry representatives praising the 2006 draft.

And as I noted in March in an essay entitled Lehman Fraudulently Cooked Its Books, Accounting Giant Ernst & Young Helped, Geithner and Bernanke Winked and Slapped Them on the Back:

Geithner and Bernanke have been busted letting Lehman cook its books to try to hide its problems.

***

Tyler Durden slams the New York Fed, in a must-read essay:

There should be an immediate investigation into how many other banks are currently taking advantage of this artificial scheme to manipulate and misrepresent their cap ratio, and just why the New York Fed can claim it had no idea of this very critical component of the Shadow Economy.

As does Karl Denninger:

Remember, The Feral Reserve is supposed to by the “uber-regulator” and the “safety and soundness” manager for the financial system.

They did a great job, right? Well…

For example, when

the Examiner questioned Lehman executives and other witnesses about Lehman’s financial health and reporting, a recurrent theme in their responses was that Lehman 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.

True? Let’s see what the Examiner had to say:

Although various Government agencies had information that raised serious questions about Lehman’s reported liquidity and about the sufficiency of its capital and liquidity to withstand stress scenarios, the agencies generally limited their activities to collecting data and monitoring.

Oh. They looked but didn’t act. I see.

Indeed, they looked pretty closely….

After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress-testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank.5753 The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.”5754 Lehman failed both tests.5755 The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed.However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed.5757 It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

So let’s see what we got here. They ran two sets of stress tests and the firm failed both. Not satisfied with the results they then designed a third set, which the firm also failed (we can reasonably presume the third had less stringent requirements than the other two!)

Instead of applying any of these three, FRBNY, which was run by one MR. TIMOTHY GEITHNER, NOW OUR TREASURY SECRETARY WHO REPORTED TO ONE BEN BERNANKE, instead took Lehman’s word that all was ok and did nothing.

Wait a minute. In the spring of 2009 we were told that all the big banks ran “Stress Tests” of Geithner’s design. But Treasury didn’t actually run them and didn’t actually get and process the data – they told the banks to do so.

Uh, that’s exactly what Lehman did, right? And Lehman passed its own “internally computed” stress test but failed all three of the externally-computed ones.

Do you still accept that all these other banks are solvent? What about the facts we do know – such as the inconvenient fact that between them the “big banks” have something like $150 billion of Home Equity lines behind an underwater and delinquent first mortgage, which is, by the way, worth zero yet being carried at or near full value……

Nor did it end there.

The SEC inspection revealed significant problems at Lehman. The SEC found that Lehman’s Price Valuation Group was understaffed; and it found that Lehman’s asset pricing function was overly “process driven.”5761 But the SEC did not release its findings or formally present them to Lehman prior to Lehman’s demise.

So The SEC knew, and they too did nothing.

It’s worse. While Geithner is implicated as being “concerned” about Lehman in the paper, the most-troubling part the narrative is here:

The challenge for the Government, and for troubled firms like Lehman, was to reduce risk exposure, and the act of reducing risk by selling assets could result in “collateral damage” by demonstrating weakness and exposing “air” in the marks.5823

Air?

Uh, that’s an apparent admission that FRBNY and Tim Geithner specifically knew that the marks that these banks were taking on their assets was materially and intentionally false.

Where have we seen this of late? Oh yeah – in all those banks that have failed of late, with 25-40% discounts to their claimed balance sheet values when the marks are actually reduced to losses to the deposit fund by the FDIC!

So let’s see here. We now have:

  1. Geithner, and presumably everyone under him, knew the marks on these assets were fictions months before Lehman failed, yet they intentionally concealed this fact from the market and took no action (nor did the SEC) to disclose this intentional misdirection.

  2. The misdirection and false claims in this regard are almost certainly continuing today, as evidenced by the FDIC seizures literally on an every-week basis.

How about Bernanke? While he maintains (as did Geithner) that primary responsibility lay with the SEC, he also said:

Our concern was about the financial system, and we knew the implications for the greater financial system would be catastrophic, and it was.”

Now What?

Now what?

Well, as I’ve noted time and again, Geithner and Bernanke’s strategies of covering up how bad things are, trying to paper over the severity of the problems of the financial giants by artificially inflating asset prices and allowing accounting tricks are doomed to failure.

Yves Smith points out that Geithner must be fired and that a full audit of the Fed – especially the New York Fed – must be conducted:

The key revelation is that Lehman as of late 2007 was routinely using repo transactions at the end of the quarter to mask how levered it truly was:

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.2850 Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851 Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.

Yves here. The stunning bit is these “repos” were actually a conventional type of repo, despite the name ….

Denninger raises one question: were other banks engaging in this type of accounting chicanery? But there is another question: did some of Lehman’s counterparties must have suspected what was going on, given that this took place on a large scale basis at the end of every quarter? How many had an idea that Lehman was engaging in massive window dressing and chose to play along?

But here is the part of the report that discussed how the Fed aided and abetted Lehman misconduct:

the Examiner questioned Lehman executives and other witnesses about Lehman’s financial health and reporting, a recurrent theme in their responses was that Lehman 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.

Yves here. So get this: even though Lehman dressed up its accounts for the great unwashed public, it did not try to fool the authorities. Its games playing was in full view to those charted with protecting investors and the financial system.

So what transpired? The SEC (which in all fairness, has never had much expertise in credit markets, this is a major regulatory problem) handed assessing Lehman over to the Fed, which bent over backwards to give it a clean bill of health:

After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress‐testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank.5753 The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.”5754 Lehman failed both tests.5755 The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed.5756 However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed.5757 It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

Yves here. So get this: the stress tests 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.

So why should we trust ANY government designed stress test, particularly when the same permissive grader, Timothy Geithner, was the moving force behind the ones dreamed up last year, which have been widely decried by banking experts, including Bill Black, Chris Whalen, and Josh Rosner? We linked to a simple analysis by Mike Konczal that demonstrates that for the biggest four banks alone, merely on their second mortgage portfolios, the stress tests of 2009 were too permissive to the tune of at least $150 billion.

Lehman type accounting, in other words, is being institutionalized, with the active support from senior government officials.

It is time for Geithner to go. He is not fit to serve as Treasury secretary.

And the time is overdue for a full audit of the Fed, and in particular the New York Fed, from the start of the Bear crisis through and including all the retrades of the AIG bailout.

Of course, the entire U.S. economy is itself a giant Ponzi scheme, according to Bill Gross, Nouriel Roubini, Laurence Kotlikoff, Steve Keen, Michel Chossudovsky and the Wall Street Journal. In that light, the government’s knowing complicity with the banks’ Repo 105 and similar schemes isn’t all that surprising.

And since Wall Street finance has been exported globally, much of the world economy is also a giant Repo 105. See this, for example.

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