Wednesday, April 21, 2010

How did he know?

Today's WSJ includes "Debt 'Masking' Under Fire ... SEC Considers New Rules to Deter Banks From Dressing Up Books ..." and "Senators Seek Cash as They Mull Rules ... Both Parties Have Held Dozens of Fund Raisers on Wall Street While Fashioning New Regulations for Financial Markets."

But yesterday, this WSJ op-ed by Gerald O'Driscoll noted:

Why has this happened? Financial services regulators failed to enforce laws and regulations against fraud. Bernie Madoff is the paradigmatic case and the Securities and Exchange Commission the paradigmatic failed regulator. Fraud is famously difficult to uncover, but as we now know, not Madoff's. The SEC chose to ignore the evidence brought to its attention. Banking regulators allowed a kind of mortgage dubbed "liar loans" to flourish. And so on.

We have now learned of the creative way Lehman Brothers hid its leverage (how much money it was borrowing) by the use of a Repo 105. The Repo 105 meant Lehman temporarily swapped assets (such as bonds) for cash. A Repo, or repurchasing agreement, is a way to borrow money. But an accounting rule allowed Lehman to book the transaction as a sale and reduce its reported borrowings, according to a report by the court-appointed Lehman bankruptcy examiner, a former federal prosecutor, last month.

Are we to believe that regulators were unaware? Last week Goldman Sachs was accused in a civil fraud suit of deceiving many clients for the benefit of another, hedge-fund operator John Paulson.

The idea that multiplying rules and statutes can protect consumers and investors is surely one of the great intellectual failures of the 20th century. Any static rule will be circumvented or manipulated to evade its application. Better than multiplying rules, financial accounting should be governed by the traditional principle that one has an affirmative duty to present the true condition fairly and accurately—not withstanding what any rule might otherwise allow. And financial institutions should have a duty of care to their customers. Lawyers tell me that would get us closer to the common law approach to fraud and bad dealing.
How did he know?


I could not ignore this report on what the regulators were actually doing.  Yes, and if we only had more of these guys, things will get much better.