Lehman Scandal: Where’s the Follow Up?

This is a post which originally appeared at New Deal 2.0 by Eliot Spitzer and Joshua Rosner. Eliot Spitzer is former governor of New York. He blogs for Slate.com.  Joshua Rosner is managing director of an independent financial services research firm.

It doesn’t take a rocket scientist — and certainly not an accountant — to deduce one thing from the Lehman scandal. The misleading of regulators, investors and the public did not happen in isolation. Like Enron, WorldCom, Tyco, Wachovia, Washington Mutual, Fannie/Freddie, CDOs, Bear, AIG, bond insurers, GM, Chrysler, CIT, California, Greece and the countless others wrapped up in this crisis, Lehman is symptomatic of a banking system bent on finding ways to hide risk from the investing public and regulatory community. Every time the truth was uncovered, investors fled and new investors demanded returns that compensated them for the new understanding of the known risks and for those that might remain hidden. In some cases, the cost of that new capital broke the firms.

Traditionally, banks and investment banks acted as principals or agents, matching capital in search of economic return with borrowers needing capital to earn a real return on economic activity. Today, they have turned to manufacturing artificial demand for financial products on false pretense. We have seen them act in such a manner on behalf of their debt-issuing clients. And in the case of Lehman, they have done so on their own behalf. We can expect that other firms used this and similar tactics to hide their true financial condition – firms that are still in business and, to varying degrees, massaging or manipulating their numbers.

It should be clear to all that a deeper examination of the relationship between all the audit firms and their clients on the issue of risk-obfuscation is needed. Limiting any inquiry to Lehman alone is inadequate. To start, here are a few simple questions:

1. To the Fed: Where were you? Did you know what Repo 105 was? You claim that you were not the regulator but acknowledge that you were on site for 6 months before Lehman’s failure to make sure you would be repaid on your exposures, so wouldn’t deceptive accounting have reduced your faith in your ability to collect on your exposures?

2. To the SEC: What are you doing to ensure that other banks and investment banks are not using similar techniques to manipulate their books?

3. To federal investigators: Where are the subpoenas?

4. To the remaining post-Arthur Anderson audit firms: Have you signed off on any client transactions whose primary purpose was not driven by economic business decisions but rather to change the appearance of assets or liabilities? Are you aware of any of your client firms using any mechanism to optically reduce the appearance of leverage while actually retaining the risk?

5. To the investment banks and banks: Did you use Repo 105 or any other accounting practices, such as the end-of-quarter parking of assets at unconsolidated but related hedge funds or total return swaps for the primary purpose of shifting income?

6. To shareholders: Shouldn’t you demand to know if the firms in which you have invested have used deceptive accounting practices?

7. To Congress: You have authority to demand answers from virtually all of these entities, and especially the Fed, the SEC and the auditors. What are you waiting for? Why have you not already sought all the email traffic between the FED and Treasury and Lehman, and, as we have argued elsewhere, AIG and the Fed?

In the banking world, there are generally four types of risk; liquidity risk, credit risk, operational risk and reputational risk. Of these, only reputational risk failures threaten the entire value of the business and its goodwill. If our questions remain unanswered, the entire financial system will remain dangerously exposed.