Proof that Regulators Knew of and Allowed Debt-Hiding Accounting Tricks Like Lehman's Repo 105

Regulators like the Fed and SEC have said they didn't know about Lehman's use of Repo 105s to hide its mountain of debt.

But in a must-read New York Times Op-Ed, law school professors Susan P. Koniak, George M. Cohen, David A. Dana, and Thomas Ross point out:

Our bank regulators were not, as they would like us to believe, outside the disco, deaf and blind to the revelry going on within. They were bouncing to the same beat. In 2006, the agencies jointly published something called the “Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities.” It became official policy the following year.

What are “complex structured finance” transactions? As defined by the regulators, these include deals that “lack economic or business purpose” and are “designed or used primarily for questionable accounting, regulatory or tax objectives, particularly when the transactions are executed at year end or at the end of a reporting period.”

How does one propose “sound practices” for practices that are inherently unsound? Yet that is what our regulatory guardians did. The statement is powerful evidence of the permissive approach bank regulators took toward the debt-dissolving financial products that our banks had been developing, hawking and using themselves for years. And it’s good reason for Americans to be outraged by the “who me, what, where?” reaction of Mr. Bernanke and the S.E.C. to the revelation of Lehman’s Repo 105 scam.

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The interagency statement on “sound practices” of 2006 ... was greeted with effusive praise from bankers, their lawyers and accountants. Gone was the requirement [proposed by the law professors and others] to ensure that customers understood these instruments and that the banks document that they would not be used to phony-up a company’s books.

The focus on complexity was also gone, as was the concern over transactions “with significant leverage” — that is, deals with little real cash underneath, another unfortunate deletion because attending to excessive leverage would have served us well.

Instead, the only products that the banks were asked to handle with special care were so narrowly defined and so obviously fraudulent that suggesting that they could be sold at all was outrageous. These included “circular transfers of risk ... that lack economic substance” and transactions that “involve oral or undocumented agreements that ... would have a material impact on regulatory, tax or accounting treatment.” [and these weren't banned, but apparently only required special disclosures by the banks]

Just as troubling, at least in retrospect, the new statement specifically exempted C.D.O.’s from the need for any special care ..

Only two years later, these same regulators were explaining that the complexity and opaqueness of instruments like C.D.O.’s had contributed significantly to the economic collapse...

Moreover, the collapse was characterized by institutions supposedly healthy one day and on the verge of collapse the next, due in no small part to their extraordinary debt burdens — debt burdens that complex instruments magically removed from the books.

To this day, that final interagency statement (which was adopted in 2007) has not been repealed or replaced. It can still be found on the S.E.C. Web site, along with the letters from industry representatives praising the 2006 draft.

As the law professors point out, you can have all sorts of laws on the books, but if regulators aren't enforcing them, they are not worth the paper they are written on.