Global Trends by Martin Khor
Monday 15 March 2010
Wall Street firms attacked for manipulation
The financial crisis in the
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
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.
It is important for developing countries like
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.
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
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