On Friday, the Wall Street Journal revealed details of a cover up by the nation’s largest banks that have been engaged in potentially-criminal accounting activities to conceal the amount of debt on their balance sheets. The SEC has been notified of the allegations and has launched a probe to determine whether further action is needed. Among the banks implicated, are Goldman Sachs, JP Morgan, Bank of America, and Citigroup. According to the WSJ:
"Major banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York. A group of 18 banks....understated the debt levels used to fund securities trades by lowering them an average of 42 per cent at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters." ("Big Banks Mask Risk Levels", Kate Kelly, Tom McGinty, Dan Fitzpatrick, Wall Street Journal)
The article has set off alarm bells on Wall Street because of the similarity between Lehman Bros. "repo 105" transactions and these new signs of obfuscation by other large banks. "Repo 105" is an accounting device that Lehman used to hide $50 billion in debt off its balance sheet in an attempt to mislead investors about the true state of its financial health. The WSJ story suggests that the practice may be more widespread than originally thought. The "repo 105" scandal is further complicated by suspicions that Lehman was assisted in its effort by the Federal Reserve Bank of New York which, at the time, was headed by the present Secretary of the Treasury, Timothy Geithner. Here is a short recap of what transpired between the Geithner's NY Fed and Lehman according to ex-regulator William Black and former NY governor Eliot Spitzer from an article on Huffington Post:
"The FRBNY [i.e., New York Fed] knew that Lehman was engaged in smoke and mirrors designed to overstate its liquidity and, therefore, was unwilling to lend as much money to Lehman. The FRBNY did not, however, inform the SEC, the public, or the Office of Thrift Supervision (which regulated an S&L that Lehman owned) of what should have been viewed by all as ongoing misrepresentations.
The Fed's behavior made it clear that officials didn't believe they needed to do more with this information. The FRBNY remained willing to lend to an institution with misleading accounting and neither remedied the accounting nor notified other regulators who may have had the opportunity to do so...... We now know from Valukas and from former Treasury Secretary Paulson that the Treasury and the Fed knew that Lehman was massively overstating its on-book asset values." (Time for the Truth" William Black and Eliot Spitzer, Huffington Post)
So the question is whether the NY Fed helped other banks conceal important financial information from investors, too. And--if that's the case--then how can the public be confident that the biggest banks in the country are truly solvent?
According to the WSJ: "An official at the Federal Reserve Board noted that the Fed continuously monitors asset levels at the large bank-holding companies, but the financing activities captured in the New York Fed's data fall under the purview of the Securities and Exchange Commission, which regulates brokerage firms."
The Fed's explanation is a tacit denial of its responsibility to regulate or report suspicious accounting practices to the appropriate agencies. The response is not just "buck passing", but also suggests collusion. So far, there's no clear link between the Fed and the shady bookeeping at the banks. But many now believe that -- in the case of Lehman -- the Fed acted as an "enabler", either by serving as a counterparty in repo 105 deals or by looking the other way while the transactions were executed. Either way, the situation demands an independent investigation.