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In 2010, Richard Fuld, the former CEO of Lehman Brothers, told a congressional committee that he had "absolutely no recollection whatsoever of hearing anything" about Repo 105 at the time of the transactions. Lehman's demise, he claimed, was caused by "uncontrollable market forces" and the U.S. government's unwillingness to rescue the firm. Of course, Henry Paulson, the U.S. Treasury Secretary in 2008, had tried in vain to get Fuld to accept a buyer offering a reasonable price; Fuld had been holding out for more in spite of the financial condition of Lehman. It is stunning that a man who had been allowed to reach such a pristine and lofty office in the business world would not even permit himself to acknowledge any contributory role in the downfall of the organization he had run. Such an attitude alone seems worthy of a prison sentence (and the return of his salary and bonuses); how he and his "team" had manipulated the books to make the bank look wealthier than it was would seem to make such a sentence inevitable.

However, as of March 15, 2011, no high-profile executives involved in the finacial crisis of 2008 had been successfully prosecuted. In Feburary of the same year, for example, a federal criminal investigation of former Countrywide Financial Corp. Chief Executive Angelo Mozilo had been, according to The New York Times, "closed without charges." Regarding "the battered real-estate portfolio and an accounting move known as Repo 105," the paper reported that SEC officials were growing more worried in the early months of 2011 that "they could lose a court battle if they bring civil charges that allege Lehman investors were duped by company executives. The key stumbling block: The accounting move, while controversial, isn't necessarily illegal." This is an extremely important point, for it means that FASB, the non-profit quasi-regulatory body that promulgates generally accepted accounting principles (GAAP) in the United States, is too permissive--too accommodating of how executives of publicly-held corporations want to value assets and liabilities.

Punctum saliens, the means by which accounting standards are determined is too susceptible to influence from CPA firms and their clients, the public corporations being audited.  The structural conflict of interest existing between the "independent" auditors and their clients is magnified to the extent that either of the two parties have inordinate influence on FASB.  Even if a government agency such as the SEC were to set the regulations, there would still be the risk that the accounting firms and/or public corporations could gain leverage over the regulators, in what is called regulatory capture. The root problem behind both allowing the conflict of interest and being too accommodating in terms of GAAP is that Americans, and thus the values in American culture, are too conducive to business--meaning not sufficiently realistic concerning the possibility of greed and any resulting harm. An examination of why the Lehman executives could manipulate their books unfairly and yet legally points to this proclivity manifested through a too-flawed and friendly accounting regulatory system.

The New York Times reports that in March of the same year in which Richard Fuld testified before Congress to disavow any responsibility in the failure of the bank he had run, "the Repo 105 transactions were condemned by court-appointed examiner Anton R. Valukas, who said in a report that they enabled Lehman to 'paint a misleading picture of its financial condition.' . . . In the transactions, Lehman swapped fixed-income assets for cash shortly before the securities firm reported quarterly results, promising to buy back the securities later. The cash was used to pay down the company's debts. Emails sent by executives at the company referred to Repo 105 as a 'drug' and 'basically window dressing.'" Valukas concluded there were "colorable," or credible, legal claims against Ernst & Young, Fuld and former Lehman finance chiefs Ian Lowitt, Erin Callan and Christopher O'Meara. Indeed, when he was the Attorney General of New York, Andrew Cuomo criticized the Repo 105 transactions as a "house-of-cards business model, designed to hide billions in liabilities in the years before Lehman collapsed."  The implication is that Fuld and his subordinate managers had committed fraud.

Even so, Ernst & Young "had concluded that the accounting in the Repo 105 transactions was acceptable."  In a statement, Ernst & Young "said," we stand "behind our work on the Lehman audit and our opinion that Lehman's financial statements were fairly stated in accordance with the U.S. accounting standards that existed at the time." (italics added) Fairness, in other words, depends solely on whether the books of a company are in line with the accounting standards, rather than on whether the values recorded on the books reflect the values of the underlying assets and liabilities. In terms of the repos at Lehman, The New York Times reports that SEC officials generally concluded that "the transactions were consistent with accounting standards." Successfully prosecuting former Lehman execcutives for making misleading statements about the bank's financial condition is an uphill battle, according to the paper, because the executives relied on legal and accounting opinions. Furthermore, in his report, Valukas wrote that he didn't find "sufficient evidence to support a colorable claim for breach of fiduciary duty in connection with any of Lehman's valuations." Also, SEC officials were not "convinced that Lehman shareholders suffered material harm, since executives were trading one type of highly liquid asset for another." However, the apparently lower debt levels might have influenced existing and potential investors in their decision-making regarding their level of exposure from investing in Lehman. In other words, their risk was being deliberately understated by Lehman's management. Even if particular investors were not actually harmed, showing an apparent lower risk than would be the case without the repos (and cost valuations on the real estate investments) was not in the investors' interest. Moreover, it just isn't fair, even if it is legal because it is allowed by GAAP. The problem, in other words, extends from Fuld and his sycophants at Lehman to the FASB.

The wrench in the works with my thesis is the fact that there are indeed different ways in which an asset or liability can be valued fairly. There are different viable assumptions, for example, regarding whether an asset should be valued at cost or market. Each assumption has a downside. Showing a real estate investment at cost, for instance, has the downside that the market-value of the asset, if significantly lower, is not shown. That is, the transactions-value of the asset at the time is ignored. Even if the firm intends to hold the asset, the lower market value would determine what the firm could do with that asset in covering for any needed debt payments. On the other hand, if market values fluctuate substantially, changes in an asset's value may not make much difference to the underlying value of the asset, and thus to the firm, especially if the firm intends to hold the asset long term.  To the extent that speculators can artificially push up or short an asset's market price, the latter does not reflect the underlying, or fundamental, value of the asset or even the real supply and demand (e.g., oil price hikes in the wake of the Libyan disruptions in 2011). Unfortunately, the companies being regulated and the accounting firms they hire can use such authentic debates to open GAAP up wider than a sloppy whore so they can have their way with her in order to look better than they are. That such selfishness, deceitfulness and greed can be accommodated by GAAP, and thus the FASB, and ultimately the American electorates, is the real problem, and unfortunately there is not an easy solution because the basic problem lies in values and assumptions held by a population.

As useful as flexibility is in accommodating different assumptions and plans regarding assets and liabilities, the refusal of FASB to fortify its sanctioned accounting methods with conditions so investors are not misled--a refusal that I contend is from inordinate influence from the regulated and their public accountants--means that managers running publicly-held companies like Lehman Brothers are enabled to do practically-speaking whatever they want to show the public (and the owners) only the asset values and debt levels that they want. Allowing only cost to value real estate, for instance, could be conditioned not on whether the firm intends to hold the asset (a subjective matter that a manager could manipulate and even falsify), but rather on the extent of difference in percentage terms between the market value and cost. An accounting breed of relativism unchecked allows for and enables greed. Lest we want to succumb to such decadence, fairly stated ought not be tied to conforms to GAAP if the latter is too tolerant. The regulated will always prefer relativism in regulation.  Even if GAAP is tightened, fairly stated ought not to be determined solely in terms of those standards. Additionally, CPA firms ought to be on the look out for fraud or misleading practices even if they are allowed by the FASB's standards.  The latter are means rather than ends in themselves. According to Kant, beings of a rational nature must be treated as ends in themselves (as well as means). GAAP are not rational beings.

Beyond changes in GAAP and what CPA firms are charged to look at, the friendliness of the FASB to the business world, or at the very least the extent of the organization's accommodation, should convince the American people and government officials that more government regulatory involvement is warranted. While some government regulators could come from industry to contribute their technical knowledge, they should be checked by superiors who have a healthy skepticism of business and a salient regard, or value, for the public interest. Ultimately, it is up to the American people, operating through our elected officials and the related governmental agencies, to stand up to the temptation to have regulation esssentially by the regulatees. However, this requires esteeming values that are sufficiently realistic concerning the role that greed and selfishness can play in those of us who run the world of business. Power as well as money can be intoxicating, especially in high doses. Lest the value of economic liberty blind us to this subterranean all-too-human propensity, we as a society could pay more attention to the societal blind spot of structural or institutional conflicts of interest implicit in the very design of some of our most important regulatory systems.
Source: http://online.wsj.com/article/SB10001424052748703597804576194871565429108.html

Click to add a Comment or Question (or View Posted Comments) on business ethics at Lehman Brothers.


On greed, see related essay, "Godliness and Greed": http://thewordenreport.blogspot.com/2011/02/godliness-greed-how-effective-is.html

On Lehman's corporate governance, see: http://thewordenreport.blogspot.com/2011/02/godliness-greed-how-effective-is.html

For years, banks and other issuers have paid rating agencies to rate their securities. This is a bit like restaurants paying food critics to write on their food.  In the wake of the SEC’s charge that  people at Goldman Sachs built the Abacus investment to fall apart so a hedge fund manager, John A. Paulson, could bet against it, the Senate’s Permanent Subcommittee on Investigations questioned representatives from Moody’s and Standard & Poor’s about how they rate risky securities. Carl M. Levin, the Michigan Democrat who heads the Senate panel, said in a statement: “A conveyor belt of high-risk securities, backed by toxic mortgages, got AAA ratings that turned out not to be worth the paper they were printed on.” Throughout the testimony, the institutional conflict of interest was salient whereby credit-rating agencies put market-share considerations foremost in rating securities presented by the banks that are paying the agencies. Someone at one bank, J. P. Morgan, went so far as to communicate to one of the agencies that the agency’s ratings should reflect market-share considerations.  Essentially, the bank was reminding the agency that the bank was a client. To be fair, the agency replied that such considerations are not part of the ratings process.  However, the testimony before the committee suggested that the reality has often been quite otherwise. The upper managements of the agencies in particular regularly pressure their ratings analysts to rate in such a way that the agency’s market share does not suffer.  In other words, the message is: “Rate so we don’t lose any clients.”

In fact, the agencies even shared their models with the banks.  As a result, the banks could game the models so the securities would get high ratings.  To be sure, there was also fraud involved, such as making it seem like the mortgages in a CDO came from different servicers or different regions of the US.  Some bankers relabeled parts of collateralized debt obligations in two ways so they would not be recognized by the computer models as being the same. Others were also able to get more favorable ratings by adding a small amount of commercial real estate loans to a mix of home loans, thus making the entire pool appear safer. “If you dug into it, if you had the time, you would see errors that magically favored the banker,” said one former ratings executive.  The assymetry was no accident, for there is an underlying structural conflict of interest at the core of the ratings system. The actual clients–the general public that relies on the ratings–are not the parties paying the agencies.  Also, the agencies get more when their ratings are higher because more of the underlying securities are sold.   To demand that an agency be independent of the “client” paying it is to place the agency in a structural or institutional conflict of interest that cannot be effectively remedied by simplying subjecting the agency to higher regulatory standards. Worse still, often times the underlying structure is ignored.

Although not made transparent in the Senate hearing, I want to point to the assumption that the agencies would be able to handle their conflict of interest, even in the face of rising pressure for profits as increasing attention was directed to their stock prices. There seems to be a belief in American society that businesses can rise to the occasion when a structural conflict of interest is involved.  In other words, we tend to mitigate the force of such ethical dilemmas, essentially assuming that human nature can be relied upon to surmount them.  Even in the committee testimony, former employees from the rating agencies suggested that common regulatory standards for rating, similar to the FASB standards in accounting, would suffice. This is actually a rather poor choice of comparison, for the public accounting profession is rife with its own conflict of interest that has thus far been shoved under the rug.  One need only look to Arthur Andersen in giving the go-ahead to Enron’s use of “unrelated” partnerships to hide debt or to Arthur Young knowing of the Repo 105s at Goldman Sachs to question whether using regulatory standards goes far enough.

Institutional conflicts of interest are not solved by common regulatory standards because they too can be gamed. The incentives have not been changed, so we can expect the pent-up water to eventually make its way through the muddy dams we construct.  In both public accounting and securities rating, the “independent” assessors cannot be paid by the institutions whose books or products are being assessed.  The unwarranted assumption that turning these functions over the government is the only alternative adds to the easy decision that simply creating or tweeking regulatory standards must suffice.

As an alternative to having the government rate securities, the financial industry as a whole could be required to contribute to a pool that would fund the rating agencies. The SEC would assess the agencies periodically and decide how much each would receive.  Essentially, the government would be the umpire rather than perform the rating function itself.  As long as the banks do not capture the SEC (which is another problem in need of a solution), they would not be able to pressure the rating agencies.  It might be suggested that industry self-regulation could work. That is, the banks altogether would assess the rating agencies.  However, this alternative would simply allow the banks to collude to pressure the agencies.  We ought not replace the government with one of the teams in performing the role of umpire.

It is unlikely that Congress will go beyond mandating stricter disclosure statements and allowing plaintiffs to sue the agencies. Within the fecklessness of Congress in extracting the structural conflicts of interest from the rating function is a fear that tampering with it might risk the salubrity of the credit markets.   Under this logic, riding the ratings function of a structural bias would somehow compromise the function because the public might get a true look at the lack of credit-worthiness of some of the securities currently deemed credit-worthy. An illusion is thought better, or more expedient, than a solid economy. Besides the dubiousness of such reasoning, there is the argument more generally that we can’t afford to tamper with our financial system as long as it is still at risk.  However, before assuming power, Barak Obama argued that the only time when real change can happen is during a crisis–while the forces of the status quo are temporarily marginalized.   So it would seem that we are in a catch 22–or, more accurately, we have put ourselves in one.   In actuality, riding our financial system of institutional conflicts of interest would strengthen rather than risk our economy.
I suspect that the true reason why neither the ratings nor the public accounting structural conflicts of interest have been removed goes beyond our collective ignorance of the nature of an institutional conflict of interest.  As Dick Durbin said after the  banking industry scuttled foreclosure reform, “the banking industry owns Congress.”  Apparently it owns the credit-rating agencies too, as well as the public accounting firms. The wolves are paying the guards of the chicken coop.  Regulating the pay does not go far enough; we need to address the question of the payor.  Until we do so, we are bound to keep scratching our heads as chickens continue to come up missing.

Sources:
http://www.nytimes.com/2010/04/24/business/24rating.html?hp=&adxnnl=1&adxnnlx=1272117625-MtgpixNdFNobkGOTVoD0NA ; http://www.nytimes.com/2009/12/08/business/08ratings.html?_r=1&ref=business