Ted Kaufman, United States Senator for Delaware, one of the most business friendly states, has attacked Wall Street claiming that fraud and potential criminal conduct were at the heart of the financial crisis.
In a speech he was preparing to give to the Senate floor, Sen. Kaufman called for those responsible for the recent Lehman Brothers accounting scandal to be pursued through civil and criminal investigations.
The recent furore surrounding Lehman arose last week after the publication of a 2,200 page report concerning the fall of the 158 year old bank. Although much has already been discussed regarding the collapse, the report contained a revealing history of Lehmans accounting practices.
Using Repo 105 agreements, Lehman exchanged 105% of collateral for 100% cash in short-term loans. Repos, or repurchase agreements, are extremely common in day-to-day banking. Even the United States Federal Reserve uses repos to smooth temporary or cyclical changes in monetary supply.
However by using Repo 105s, Lehman could hide debt from investors and regulators. The key was for Lehman to disclose the Repo 105s as sales, rather than loans. One method would be to show that the collateral being exchanged far exceeded the cash being received. In the case of Repo 105s, the theory was that Lehman couldnt buy back the collateral, and therefore the transaction is deemed a sale, rather than a loan. This change in asset status allowed Lehman to shift $50 billion off its balance sheet.
However, such a transaction also needs a legal stamp of approval, something that no U.S. firm wished to give Lehman. Instead, British law firm Linklaters provided the approval under British law, and Lehman ran the repo transactions through its London office.
Ernst & Young, Lehmans auditor, has also been dragged into the mire by failing to alert regulators to Lehmans intent, despite a Lehman employee raising concerns about the accounting practices. The Wall Street Journal has recently reported that the whistleblower, Mathew Lee (a 14 year veteran of the firm), was fired weeks after notifying Ernst & Young.
Unlike other market failures, auditors have so far escaped the regulatory spotlight. The collapse of Enron led directly to the breakup of the energy firms auditor Arthur Andersen. In the U.K., Tory shadow chancellor George Osborne has also called for accounting reform, but Sen. Kaufman has made the most public call to date for auditors to be held accountable.
So far, with the exception of individual fraudsters like Madoff and Stanford, there have been no high profile sentences against those responsible for some of the biggest corporate losses in financial history. In 2009 Sen. Kaufman introduced the Fraud Enforcement and Recovery Act, with the aim of restoring rule of law to Wall Street. So far, Sen. Kaufman has failed to reap any scalps.
In his recent speech, Sen. Kaufman said: Many have said we should not seek to “punish” anyone, as all of Wall Street was in a delirium of profit-making and almost no one foresaw the sub-prime crisis caused by the dramatic decline in housing values. But this is not about retribution. This is about addressing the continuum of behaviour that took place some of it fraudulent and illegal, and in the process addressing what Wall Street and the legal and regulatory system underlying its behaviour have become.
Sen. Kaufman is also keen to tie-up the numerous loop holes that Wall Street is so adept at exploiting, highlighting the recent unorthodox transactions facilitated by Goldman Sachs on behalf of the Greek government.
Similar to Lehman Brothers, the aims of the deals were to create an apparent reduction in Greek debt by pricing transactions off-market. Although Goldman did not do anything illegal, the level of opaqueness in the deal caused Gerald Corrigan, a former President of the Federal Reserve Bank of New York and Chairman of Goldman Sachs Bank USA, to explain to a UK parliamentary committee that with the benefit of hindsight … the standards of transparency could have been and probably should have been higher. The fact that Goldman is now profiting from the deals it created as Greeces financial woes continue has only stoked Sen. Kaufmans desire to hold Wall Street to account.
Where Goldman may have broken the law is selling Greek bonds to American investors. At least some of these bonds, however, were likely sold to American investors, so they may therefore still be subject to applicable U.S. securities law explains Sen. Kaufman. While qualified institutional buyers (QIBs) in the U.S. are able to purchase bonds (like the ones issued by Greece) and other securities not registered with the SEC under Securities Act of 1933, the sale of these bonds would still be governed by other requirements of U.S. law. Specifically, they presumably would be subject to the prohibition against the sale of securities to U.S. investors while deliberately withholding material adverse information.
If we uncover bad behaviour that was nonetheless lawful, continued Sen. Kaufman, or that we cannot prove to be unlawful (as may be exemplified by the recent reports of actions by Goldman Sachs with respect to the debt of Greece), then we should review our legal rules in the US and perhaps change them so that certain misleading behaviour cannot go unpunished again.
Sen. Kaufman is a member of the Senate Judiciary Committee, and has the power to push for some of the biggest figures in the recent economic crisis to be prosecuted. Yet the 1,336-page financial regulation bill put forward by Senate Democrats on 15 March may overshadow Sen. Kaufmans attempts returning rule of law to Wall Street. The bill, which aims to push forward a ban on banks engaging in proprietary trading, and create a Consumer Financial Protection Bureau within the Fed, which could ban various financial instruments, has yet to receive Republican support, and even if agreement was reached, then the chances of a bill passing in election year are slim.
It has also come to light that government officials were working with Lehman while the bank was conducting Repo 105 transactions. After the collapse of Bear Stearns, the S.E.C. and the Fed took up residency in Lehman. If executives at Lehman were criminally prosecuted, they could claim that regulators knew what was going on. Both the auditors and the regulators will be used as human shields by ex-Lehman executives, making successful criminal prosecution an unlikely occurrence.