Global Trends by Martin Khor

Monday 15 March 2010

Wall Street firms attacked for manipulation

The financial crisis in the United States and Greece were caused by the massive building up of debt.  Recent reports show how manipulative accounting and devious devices were used by Wall Street banks to enable Lehman Brothers and the Greek government to “window dress” their debts to acceptable levels.


The use of “innovative” financial instruments to hide a company’s or a country’s bad and deteriorating financial situation has been highlighted in recent cases that illuminate how manipulative accounting contributed to the global financial crisis.

Last week a US government-directed report on the collapse of Lehman Brothers found that the investment bank that used a device known as Repo 105 to hide up to US$50 billion of troubling securities that it held, in order to give a good portrayal of its financial health, just months before it collapsed.

The Lehman failure in September 2008 almost triggered a domino effect of bank failures that could have caused a global financial collapse. This was averted by a desperate move of the US financial authorities to get Congress to agree to massive bail-outs of financial institutions.

A fortnight ago it was also revealed that the investment bank Goldman Sachs had made use of another device, the derivative known as currency swap, to assist the Greek government in hiding its fiscal deficit which had ballooned above the level permitted by the European Union’s disciplines of being within the eurozone.

Greece is now facing an enormous economic crisis that has threatened the status of the euro, and a bailout of the country is being worked out by European leaders.  Goldman Sachs was criticized by the German chancellor Angela Merkel for its role in the Greek tragedy and is under investigation by the US authorities.

It is important for developing countries like Malaysia to monitor such cases and learn the lessons.  We should be on guard not to allow such manipulative and misleading devices to be introduced or misused either by international or domestic financial firms, so as to avoid similar devastating consequences.

The two recently revealed cases show how the giant financial firms of Wall Street have been operating with freedom in inventing and using financial instruments that are euphemistically termed “innovative” but which in fact are speculative and earn thumping profits for the firms or

manipulative in hiding bad assets or deficits and produce a cheerful front for an unsustainable financial position.

Attempts by the Democrats in the US Congress to pass a bill to tighten regulation of such financial activities have been stalled by Republican resistance.  This week the key Democrat Congressman, Christopher Dodd, is expected to get his bill through an important Senate committee without the support of any Republican.

Meanwhile the German and French political leaders are trying once again to get the G20 to discipline financial speculation through controls over institutions like hedge funds and instruments like derivatives and credit default swaps, but they face opposition from the US and the United Kingdom which are the centres of hedge funds and speculative activities.

The 2000 page report on Lehman, by lawyer Anton Valukas, which a US bankruptcy court had commissioned, found evidence against the bank’s chief executive and financial managers for breaching fiduciary duties and its auditor Ernst and Young for malpractice.

The bank had used “Repo 105” transactions, which the report called an “accounting gimmick”, to keep US$50 billion of assets off its balance sheet and thus paint a misleading picture that it had less leverage or debt when it was time to publish its quarterly financial reports during the height of the crisis in 2008.

The report said that this avoided costly downgrades of the firm’s status by rating agencies but it misled investors as to the true state of its finances.

The Financial Times has explained the Repo 105 trade as compared to a normal repo trade as follows. In a normal “repo” transaction, a bank transfers assets to a counter-party as collateral in exchange for cash.  The bank agrees to repay the cash plus interest and take the collateral back after a specified period. The assets remain on the bank’s balance sheet and it incurs a liability for the cash it is to repay. 

In the Repo 105, used to reduce the bank’s portrayed leverage, the transaction is quite similar to a normal repo, except that the bank pledges assets worth 105 percent of the cash received from the counterparty.  The transaction is also described as a “sale” and the assets are removed from the balance sheet while the cash received is used to pay off liabilities, thus reducing leverage at critical moments such as when a financial report is being prepared.

Lehman took enormous risks and had raised its maximum risk limit from $2.3 bil to $4 bil by the end of 2007.  Its risk-management practices were weak, and it excluded its most risky assets such as its investments in real estate and private equity from calculations of the required stress tests of its trading positions and investments.

Using the “Repo 105” device, Lehman moved $50 bil in assets off its balance sheet for a period to show a reduction in its leverage ratio (a measure of its debt level). The report concluded that Lehman’s use of Repo 105 was done to manipulate the balance sheet for deceptive appearance, affected its net leverage ratio and rendered its financial statements “deceptive and misleading.”

The revelations of manipulation have caused disgust even in Wall Street, according to the Financial Times which concluded that the report “sheds a damning light on the inner workings of Wall Street, or at least a part of Wall Street that was hell bent on juicing profits and hiding losses during the boom that led to the crisis.”

As to the Goldman-Greece affair, the New York Times reported on 24 February that US Federal Reserve is examining the financial stratagems devised by Goldman Sachs and other big banks to help Greece mask its ballooning debt over the last decade.

The Fed chairman Ben Bernanke, told a Congress hearing that the Fed was “looking into a number of questions relating to Goldman Sachs and other companies related to their derivatives arrangements with Greece.”  He said the securities commission was also concerned about how derivatives have contributed to Greece’s problems, adding it is counterproductive to use “these instruments in a way that potentially destabilizes a company or a country.”

As explained by New York Times, in 2001, Goldman Sachs helped the Greek government to quietly borrow billions of dollars by creating a derivative (a currency swap) that essentially transformed a loan into a currency trade that did not have to be disclosed under European rules. The deal helped Greece stay within the limits on deficit spending that were crucial to Greece joining the euro.

Goldman earned $300 million in fees from the transaction.  In 2005, Goldman sold the
currency swap, to the National Bank of Greece, before reorganizing it into a British legal entity called Titlos in 2008.

“Such deals – including similar financial transactions employed by other European countries –  have created an uproar on the Continent, drawing sharp criticism from Angela Merkel, the German chancellor, and other leaders.”

Greece built up massive budget deficits and is now struggling to raise billions of euros in loans to refinance its existing debts and avoid default.  Its problems have shaken the euro and the stock markets.

Goldman, however, defends Greece debt swaps.  Mr Gerald Corrigan, chairman of Goldman Sachs Bank USA, the bank’s holding company, said it was “consistent” with the regulations of the time.

Greece’s Finance Minister George Papaconstantinou also insisted last week that his country was not the only one using such financial arrangements back in 2001.  He added that such deals had now “been made illegal, and Greece has not used them since”.