Just when you thought that nothing could stink more than Timothy Geithner’s handling of the AIG bailout, a new report details how Geithner’s New York Fed allowed Lehman Brothers to use an accounting
gimmick to hide debt. The report, which runs to 2200 pages, was
released by Anton Valukas, the court-appointed examiner. It actually
makes the AIG bailout look tame by comparison. It is now crystal clear
why Geithner’s Treasury as well as Bernanke’s Fed refuse to allow any
light to shine on the massive cover-up underway.

Recall that the New York Fed arranged for AIG to pay one hundred cents on the dollar on bad debts to its counterparties—benefiting Goldman Sachs and a handful of other favored Wall Street firms. The purported reason is that
Geithner so feared any negative repercussions resulting from debt
write-downs that he wanted Uncle Sam to make sure that Wall Street
banks could not lose on bad bets. Now we find that Geithner’s NYFed supported Lehman’s efforts to conceal the extent of its problems.
Not only did the NYFed fail to blow the whistle on flagrant accounting
tricks, it also helped to hide Lehman’s illiquid assets on the Fed’s
balance sheet to make its position look better. Note that the NY Fed
had increased its supervision to the point that it was going over
Lehman’s books daily; further, it continued to take trash off the books
of Lehman right up to the bitter end, helping to perpetuate the fraud
that was designed to maintain the pretense that Lehman was not massively insolvent.

Geithner told Congress that he has never been a regulator. That is a quite honest assessment of his job performance, although it is completely inaccurate as a description of his duties as President of
the NYFed. Apparently, Geithner has never met an accounting gimmick
that he does not like, if it appears to improve the reported finances
of a Wall Street firm. We will leave to the side his own checkered past
as a taxpayer, although one might question the wisdom of appointing
someone who is apparently insufficiently skilled to file accurate tax
returns to a position as our nation’s chief tax collector. What is far
more troubling is that he now heads the Treasury—which means that he is
not only responsible for managing two regulatory units (the FDIC and
OCC), but also that he has got hold of the government’s purse strings.
How many more billions or trillions will he commit to a futile effort
to help Wall Street avoid its losses?

Geithner has denied that he played any direct role in the AIG bail-out—a somewhat implausible claim given that he was the President of the NYFed and given that this was a monumental and unprecedented
action to funnel government funds to AIG’s counterparties. He may try
to deny involvement in the Lehman deals. (Again, this is implausible.
Lehman executives claimed they “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. In fairness, the SEC also overlooked
any problems at Lehman. But here is what is so astounding about the
gimmicks: Lehman used “Repo 105” to temporarily move liabilities off
its balance sheet—essentially pretending to sell them although it
promised to immediately buy them back. The abuse was so flagrant that no US law firm
would sign off on the practice, fearing that creditors and stockholders
would have grounds for lawsuits on the basis that this caused a
“material misrepresentation” of Lehman’s financial statements. The
court-appointed examiner hired to look into the failure of Lehman found
“materially misleading” accounting and “actionable balance sheet
manipulation.” (here) But just as Arthur Andersen had signed off on
Enron’s scams, Ernst & Young found no problem with Lehman.

In short, this was an Enron-style, go directly to jail and do not pass go, sort of fraud. Lehman’s had been using this trick since 2001. It looked fine to Timmy’s Fed, which extended loans allowing Lehman to flip bad assets onto the Fed’s balance sheet to keep the fraud going.

More generally, this revelation drives home three related points. First, the scandal is on-going and it is huge. President Obama must hold Geithner accountable. He must determine what did Geithner know,
and when did he know it. All internal documents and emails related to
the AIG bailout and the attempt to keep Lehman afloat need to be
released. Further, Obama must ask what has Geithner done to favor his
clients on Wall Street? It now looks like even the Fed BOG, not just
the NYFed, is involved in the cover-up. It is in the interest of the
Obama administration to come clean. It is hard to believe that it does
not already have sufficient cause to fire Geithner. In terms of dollar
costs to the government, this is surely the biggest scandal in US
history. It terms of sheer sleaze does it rank with Watergate? I
suppose that depends on whether you believe that political hit lists
and spying that had no real impact on the outcome of an election is as
bad as a wholesale handing-over of government and the economy to Wall
Street.

What did Timmy know, and when did he know it?

Point number two. Lehman used an innovation, “Repo 105” to hide debt. The whole Greek debt fiasco was caused by Goldman, et. al., who helped hide government debt. Whether legal or illegal, Wall Street has for many years been producing
financial instruments designed to mislead shareholders, creditors, and
regulators about the true financial position of its clients. Note that
Lehman’s counterparties in this fraud included JP Morgan and Citigroup
(who actually precipitated Lehman’s final failure when they finally
called in their loans). It always takes at least three to tango: the
firm that wants to hide debt, the counterparty that temporarily takes
it off their books, and the accounting firm that provides the kiss of
approval.

Worse, after aiding and abetting such deception, Goldman and other Wall Street institutions then place bets (using another nefarious innovation, credit default swaps) against their clients, wagering that
they will not be able to service the debts—which are greater than the
market believes them to be. Does that sound something like insider
trading? How can regulators permit such actions?

What did Timmy know, and when did he know it?

Third point. To the extent that debt is hidden, financial institution balance sheets present an overly rosy picture—of course, that is the purpose of the financial “innovations”. Enron did it; AIG
did it; Lehman did it. What about Bank of America, Citi, JP Morgan,
Wells Fargo and Goldman? We now know that the New York Fed subjected
Lehman to three wimpy “stress tests”, all of which it failed. Timmy’s
Fed then allowed Lehman to construct its own sure-to-pass “stress”
test. (We know, of course, that the test was absolutely meaningless
because, well, Lehman passed the test and then immediately failed
spectacularly. Timmy then let the biggest banks run their own stress
tests, which they (surprise, surprise) managed to pass.

What did Timmy know, and when did he know it?

As our all-time favorite Fed Chairman Alan Greenspan liked to put it, “history shows” that when financial institutions pass their own stress tests, they are actually massively insolvent. There is no reason
to believe that this time will be different. Mike Konczal reports that
there is every reason to believe the biggest banks are hiding huge losses on second liens.
These are second mortgages or home equity loans that amount to about $1
trillion of which almost half are held by the top four banks. Since the
first principal of a mortgage is paid first, it is likely that much of
the second liens are worthless. Yet banks are carrying these on their
books at 86 to 87 percent of face value—which was necessary to allow
them to pass the stress tests. Konczal shows that at a more reasonable
loss rate of 40% to 60%, the four largest banks would have “an extra
$150 billion hole in the balance sheet”. I won’t go into the policy
conundrum implied for President Obama’s plan for principal reduction to
help homeowners (the banks will not allow renegotiation of underwater
mortgages because that would force them to recognize losses on the
second liens).

Of greater importance is the recognition that all of the big banks are probably insolvent. Another financial crisis is nearly certain to hit in coming months—probably before summer. The belief that together
Geithner and Bernanke have resolved the crisis and that they have put
the economy on a path to recovery will be exposed as wishful thinking.
In the bigger scheme of things, this is only 1931. We have a long way
to go before bank assets (and nonbank debts) are written down
sufficiently to allow a real recovery. In other words, a Minsky-Fisher
debt deflation is still in the cards.