Madoff vs. Lehman
By now, everyone is at least somewhat familiar with the extent of the SEC’s failure in not detecting the Bernie Madoff ponzi scheme, even after being handed damning evidence on a silver platter by whistleblower Harry Markopolos.
Probably just like any other present or past Wall Streeter, I find two aspects of the Madoff case particularly striking:
–Markopolos’ account of how little the SEC knows (basically, nothing, in his view) about how the finance industry works, and how disinterested it was in either learning about the industry it is mandated to regulate or in doing its job of enforcing the rules
–Madoff’s comments on how easy it was to fool the SEC. Auditors came in, asked a few questions and left without bothering to actually audit–that is, to verify the truth of Madoff’s answers.
From hearing Markopolos on Bloomberg radio during his book (No One Would Listen) tour, I came away with the impression that Markopolos is a very obsessive, prickly man with a more-than-healthy respect for his own intelligence. Whether he was that way before his pursuit of Madoff, or because of it, is an open question. But, if you wanted to be extra-generous to the SEC, you might think that he gave off a weirdness vibe when he (repeatedly) visited them, that worked against the case he was making.
Now comes Lehman, which is shaping up to be a carbon copy of the Madoff case.
I’ve already written about the bare bones of the Lehman case a few days ago. Basically, SEC examiners were sent into the offices of the major investment banks, including Lehman, as the financial crisis was unfolding. Their job was to monitor trading activities and identify liquidity or leverage problems. According the the just-released report of the Lehman bankruptcy court, however, Lehman was, in effect, falsifying its financial accounts right under the SEC’s noses.
See my earlier post for more details, but in the simplest terms what Lehman did during the last year of its existence was to:
— borrow tens of billions of dollars right before its quarter ended,
–use the money to repay other debt,
—but not show the new borrowings anywhere in its financials.
The result was that the company substantially understated its financial leverage in its reporting to shareholders and the SEC.
1. Initial reports indicated this accounting sleight of hand was being accomplished by shunting highly questionable transactions through Lehman’s London office. This activity, and the associated “funny” accounting, was presumed to have the blessing of the British Financial Services Authority, the UK equivalent of the SEC.
To me at least, this seemed like another bad consequence of the UK’s “regulation lite” policies, which were aimed at building up the country’s financial services industry by supervising companies’ activities less rigorously than was customary elsewhere.
It turns out, however, that this isn’t right. The Financial Times reports that Lehman rendered a full and accurate account of these transactions to the FSA, using conventional accounting standards. It reported both the cash received and the new borrowings. It was only when Lehman gave its worldwide financials to shareholders and the SEC that it eliminated the new debt.
This sounds just like the Madoff ponzi scheme, where Madoff told the SEC one thing and foreign regulators another, in the hope no one would make a simple phone call to compare notes. And, of course, no one did.
2. It also turns out that Lehman used its dubious financials to bad-mouth other brokers, including Merrill Lynch, to the commercial banks who were lenders to both. Merrill believed itself at a disadvantage. It briefly considered mimicking the Lehman accounting technique but rejected the idea. So Merrill called up the SEC–and the Federal Reserve–and reported what Lehman was doing. Apparently, both the Fed and the SEC–again, a lá Madoff–ignored what Merrill was saying.
3. In what appears to me to be twisting the knife a little bit, JP Morgan Chase announced that it had at one time used an accounting treatment similar to Lehman’s for a small number of low-dollar-value transactions.
Morgan makes two points, in an implicit criticism of Lehman, the SEC and the auditors, Ernst & Young:
(1) it stopped doing so when Jamie Dimon, one of the few heroes of the financial meltdown, took over (read: this was at best a dubious way to do business); and
(2) it disclosed the new borrowings in footnotes, as it believed accounting rules required it to do (read: JPM thinks Lehman should have disclosed the new borrowings someplace, even with the accounting dodge it was using).
Where is the SEC? When did it stop regulating the markets?
The SEC response
The SEC response to the newspaper accounts is reportedly that all the senior people assigned to Lehman have since left the agency–and, I guess, by implication they have nothing that they can investigate.
I don’t think this is a good enough answer. Although the investigatory wheels are grinding extremely slowly, they do seem to be moving. The Lehman bankruptcy report could easily, I imagine, lead to prosecution of Lehman’s top management. This is something that I think the American public wants, given the enormity of the damage to the economy the financial crisis has done.
Given instances like Madoff and Lehman, investigation of the regulators can’t be far behind. If the press depiction of the SEC inaction turns out to be substantially accurate–and the evidence seems very strong that it is–the most benign finding I can imagine is one of incompetence and negligence on a level that defies belief.
Of course, logically speaking, it may turn out that the situation with the SEC is not so benign–and is in fact far worse than that. There’s no evidence of a darker side to the SEC as yet, however. And in any event, the strength of Wall Street lies less in the SEC than in the basic honesty of the very large majority of market participants.