Ad by The Cutting Edge News

The Cutting Edge

Wednesday July 18 2018 reaching 1.4 million monthly
Ad by The Cutting Edge News

Lehman on the Edge

Back to Page One

Lehman Brothers and Government Regulation: It Was the Least they Could Do

September 27th 2010

Crime Topics - Richard Fuld
Former Lehman CEO Richard Fuld

On September 1, former Lehman Brothers CEO Richard Fuld Jr. testified about the failure of his Wall Street firm, painting himself and his company as victims of “uncontrollable market forces” and unsympathetic government banking officials.

Afterward, The New York Times said the seemingly “tragic and solitary figure” had gained a “fairly sympathetic hearing” from the federal Financial Crisis Inquiry Commission as he gave his version of the chaotic days before Lehman’s massive bankruptcy filing on Sept. 15, 2008 — two years ago.

No Wall Street player did more than Lehman to bring the subprime mortgage boom to life. It began its push into subprime in the mid-1990s, helping what was then a niche business begin its dramatic expansion. Ten times over a span of 11 years, Lehman ranked first or second on the list of Wall Street’s top packagers of subprime mortgage-backed securities. In 2005, at the height of the subprime boom, the firm put together $54 billion in subprime mortgage-backed bonds — more than any investment bank had ever packaged.

Three years of investigation in Lehman's methods have yielded my book The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America—and Spawned a Global Crisis,which delves into the rise and fall of the subprime industry. It revealed many highlights and lowlights that illustrate how Lehman helped fuel the growth of subprime — and how it enabled the questionable practices that came to dominate the market.


■One of the subprime lenders Lehman financed in the 1990s was First Alliance Mortgage Company, known as FAMCO for short. Lehman got involved with FAMCO even though one of Lehman’s own vice presidents warned that the lender was the kind of place where you “leave your ethics at the door,” and that it specialized in “high-pressure sales to people in a weak state.” The lender frequently charged borrowers as many as 20 upfront points on their loans — $20,000 in initial fees on a $100,000 loan.

Lehman helped steer hundreds of millions of dollars in funding FAMCO’s way. In 1999 and 2000, it kept FAMCO afloat after other investment banks, spooked by a series of government investigations of the lender, refused to provide it financing.

Lehman denied wrongdoing. A federal jury later concluded that FAMCO had engaged in fraud, and that Lehman had knowingly “aided and abetted” the fraud. An appeals-court panel upheld the jury’s conclusion, writing: “Lehman admits that it knowingly provided ‘significant assistance’ to First Alliance’s business, but distinguishes that from providing substantial assistance to fraud. In a situation where a company’s whole business is built like a house of cards on a fraudulent enterprise, this is a distinction without a difference.”

■Along with raising money to support independent lenders, Lehman also owned two subprime lenders outright, BNC Mortgage and Finance America. In 2007, I interviewed 25 former employees of these two companies who said that workers and managers at the lenders engaged in a variety of shady practices to put borrowers into deals they couldn’t afford; in some instances, several former employees alleged, workers used scissors, tape and Wite-Out to create fake tax forms and pay stubs and make loan applicants’ financial profiles look better. One ex-employee told me staffers who tried to “take a stand” against such practices “were reprimanded for not being cooperative — not wanting to be creative about making deals work.”

Lehman officials said that any such instances were not representative of the company’s practices. They said the firm had tough antifraud controls and it went to great lengths to screen out dicey loans.

■Another Lehman subsidiary that funded significant numbers of questionable loans during the boom years was Aurora Loan Services. Aurora focused on “Alt-A” loans, which fit somewhere between subprime and A-credit loans. An in-house special investigations team reviewed a sample of mortgages packaged into securitizations by Lehman’s structured finance experts, and found that 40 to 50 percent of them had misrepresentations in the loan documents, according to a witness in a securities fraud lawsuit later filed by Lehman investors. Another sample, the witness said, showed even worse numbers — more than 70 percent of those loan files showed signs of fraud, such as inflated property appraisals.

According to the securities suit, however, top Lehman managers were more concerned with pushing Aurora’s loans through the firm’s securitization pipeline than with screening out bad loans. One of the Lehman-installed managers, the suit alleged, “stormed out of a meeting and yelled at the vice president for special investigations, loud enough for everyone in the vicinity to hear: ‘Your people find too much fraud!’”

Profit and Loss

Lehman Brothers’ high-wire business strategy in subprime and other markets helped it post records profits of $3.2 billion in 2005, then eclipse that mark with profits of $4 billion in 2006 and nearly $4.2 billion in 2007. But by the middle of 2008, Lehman’s risky bets began to catch up with the investment bank. It reported losses of nearly $7 billion over just six months, setting the stage for the firm’s Sept. 15, 2008, failure.

By Fuld’s reckoning, the largest corporate bankruptcy in U.S. history was simply the result of a misunderstanding. A swirl of incorrect perceptions and rumors, he told the financial crisis commission earlier this month, produced a loss of market confidence. Then, he said, federal officials operating on “flawed information” refused to provide a bailout that could have saved one of the nation’s most powerful financial institutions.

What Dick Fuld and his top lieutenants know, and when did they know it?

One morning in June 2005, Michael Gelband, a Lehman Brothers managing director and the firm’s head of global fixed income, gave a presentation to his colleagues about the dark side of the real estate market.
The meeting began just after 6:45 a.m. Each attendee was handed a dossier of about 30 pages. One former executive who was at the meeting, Lawrence G. McDonald, says that it was “as close to a special forces military briefing as any I’d ever attended.”

In his 2009 book, A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers, McDonald recalls that Gelband described the stunning proliferation of “no-doc” mortgages and other toxic loans, sold by commission-driven salesmen and then purchased by Lehman and other Wall Street banks:

He cited the shadow banks, the vast complex network of mortgage brokers that were not really banks at all but managed somehow to insert themselves into the lending process, making an enormous number of mortgages possible while having to borrow the money themselves to do so. He cited outfits such as Countrywide, New Century, HBOS, and NovaStar, among others, and he accused them of creating well over $1 trillion in economic activity that was comprehensively false money and would never be converted into genuine economic power.

Gelband, McDonald writes, predicted that the house of cards could soon collapse — perhaps in 2007 or 2008 — producing serious consequences for the U.S. economy.

After the meeting, Gelband didn’t stop pressing the issue. He used his position on Lehman’s executive committee to try to persuade the firm to pull back from its massive bets on the real estate market.

But warnings from Gelband and others with similar concerns were largely ignored by CEO Richard Fuld and his inner circle, according to McDonald and news accounts citing other former Lehman insiders.

Lehman Packaged $52 Billion

Through much of 2006, for example, Lehman continued pushing hard on subprime lending, packaging nearly $52 billion in subprime mortgage-backed securities for the year and maintaining its spot as Wall Street’s No. 1 patron of subprime, according to industry tracker Inside Mortgage Finance.

It’s worth noting, too, though, that McDonald isn’t the only source who claims that higher ups at Lehman had fair warning that they were taking unreasonable risks with the firm’s all-in gamble on commercial and residential real estate.

New York magazine says that in late 2006, as the first cracks in the real estate market began appearing, Gelband met with Fuld and told him: “The world is changing. We have to rethink our business model.” Fuld brushed Gelband off, told The Observer of London that Lehman execs pushed aside risk managers in a headlong effort to catch up to rival Goldman Sachs. “It was quite hard to stand in the way,” Gowers said. Lehman had good risk managers, “but the prevailing atmosphere was for fast growth and special fast-track treatment for what we now know were toxic deals.”

Fuld’s Foot on Accelerator, Not Brake Pedal

Larry McCarthy, former head of distressed debt trading at Lehman, told Reuters that he quit the firm after repeatedly warning that the firm was too leveraged on borrowed money and that the real-estate market couldn’t keep going up forever. When Lehman’s risk committee was urging the company to “hit the brake pedal,” McCarthy claimed, Fuld was “hitting the accelerator.”

“Other than six or seven people, no one really knew him,” McCarthy said. “It was like he was in his own world on the 31st floor. He was never in touch with the troops. In my four years there, he never came down to the trading floor. Not once.”
In an interview with a Reuters reporter who tracked him down last year at his vacation home in Idaho, Fuld denied that he’d ignored warnings about Lehman’s risks: “What, do people think I’m an idiot, that suddenly I woke up two months before and suddenly things were a problem? No. No, the signs were there.” As for the suggestion that he isolated himself, Fuld said: “I left my office, I left my office plenty.” (I tried to arrange an interview with Fuld in late 2009 through his attorney, Patricia Hynes. In an e-mail reply, she told me, “Mr. Fuld is not doing any interviews.”)

In testimony and in unscripted moments, Fuld has continued to maintain that he is a scapegoat and victim of events that were beyond his control.

Around the time of the first anniversary of Lehman’s collapse, Fuld told Reuters: “They’re looking for someone to dump on right now, and that’s me.” Later, he added: “I do believe at the end of the day that the good guys do win. I do believe that.”
In February of 2009, Anton Valukas, a former U.S. attorney in Chicago, was appointed by the bankruptcy court to examine the failure of Lehman Brothers. Fourteen months later, after an exhaustive — and expensive — effort by his law firm, Jenner & Block, Valukas made public his findings in a 2,200-page report.

The report did what journalists and federal investigators had so far failed to do: produce convincing, prosecutable evidence that senior Lehman executives were culpable in the bank’s downfall. In the months before Lehman collapsed like a Jenga tower at a preschool, the investment bank used a dodgy accounting maneuver called Repo 105 to hide as much as $50 billion from its balance sheet in an attempt to look less leveraged than it actually was.

According to a recent Wall Street Journal report, Repo 105 is now at the center of the Securities and Exchange Commission’s investigation. Former Lehman chief executive Richard Fuld Jr., and two former Lehman chief financial officers are in the agency’s crosshairs, the paper said.

In September, Valukas and his team of investigators spoke for the first time publically about the investigation. They shared new details about their discovery of Repo 105 and what it might mean for prosecutors seeking to hold Lehman executives accountable.

Valukas and his team first learned about Repo 105 from a Lehman whistleblower named Matthew Lee. In the spring of 2008, Lee wrote a letter to senior Lehman executives spelling out his concerns. He later met with several Lehman officials and with representatives from Lehman’s outside auditor, Ernst & Young. Nothing was done.

It wasn’t the last time that Lee told his story and was ignored. Before the examiner’s lawyers interviewed Lee, Robert Byman, who served as Valukas’s chief of staff for the investigation, called an assistant U.S. attorney who was investigating Lehman. It was standard protocol at that point to clear interviews with the office.  Go ahead if you want, Byman said he was told, but the U.S. attorney’s office added that it viewed Lee as a “kook.”

Inside Repo 105

Repurchase agreements are common, but typically an entity must keep the underlying asset on its balance sheet. Repos act as secured loans, a way for a bank to raise quick cash, with the underlying security as collateral. For example, someone might use a bicycle worth $120 to serve as collateral for $100 in cash. That cash might be used to pay off — again, just for example — a very angry bookie. When the borrowed received his paycheck, he  would return the $100 plus interest and receive his bicycle in return. (Everyone is happy, and keeps their knee caps).

Lehman, though, booked the repo transactions as a sale. Near the end of a financial quarter, Lehman’s European unit would “sell” securities to a counter-party and would use the money to pay down other short-term liabilities, so it could report quarterly leverage numbers low enough to satisfy the ratings agencies, and thus investors. A few days after the quarter end, Lehman would repay the cash, plus a hefty interest, and get its securities back.

This trick gave the illusion that Lehman was less leveraged than it actually was. Dozens of rank-and-file employees told the examiner that they were under tremendous pressure to make the Repo 105 deals, especially as Lehman’s financial position got increasingly shaky. Lehman’s own executives described the maneuver as a “gimmick” and, in an email, as “another drug we r on.”

In the end, the numbers were huge. As Lehman was forced to announce a quarterly loss of $2.8 billion at the end of the second quarter of 2008, it sought to cushion the bad news by trumpeting that it had significantly reduced its net leverage ratio to less than 12.5 and that it had reduced the net assets on its balance sheet by more than $50 billion. Lehman did not disclose, however, that it had used Repo 105 to temporarily remove the assets.

Valukas also says that there are “colorable claims” against Ernst & Young for its role in allowing the transactions. Fuld, the Lehman executives, and Ernst & Young have denied any wrongdoing.

A Fuld prosecution may provide the SEC — and the Justice Department, if it follows on — the best chance to hold an architect of the financial crisis personally responsible. But the case isn’t a slam dunk.

What happened at Lehman with Repo 105 is simply not comparable to the fraud at places like Enron and HealthSouth. There was no cover up. It was used for nearly a decade, supported by the opinion of counsel at a law firm in London, and either ignored or tacitly approved by accountants at Ernst & Young. “This was not a secret,” one of the Jenner & Block investigators told me. “It was widely discussed at all levels.”

Lehman Not Alone

Some senior Lehman employees vigorously defended the practice to the investigators. One executive, Kaushik Amin, the former head of liquid markets in Lehman’s fixed income division, got agitated when the investigators questioned him about Repo 105. “If the examiner thinks we were using Repo 105 to manipulate the balance sheet, he is smoking dope,” Amin said, according to the lawyers present at the interview.

Lehman executives also claimed that it wasn’t alone in classifying assets in this way, and the intervening months have proved them right. A few months ago, Bank of America said it wrongly classified $10.7 billion in repo agreements as sales, Citigroup said it misclassified $9.2 billion, and American International Group said it misclassified $2.3 billion.

Ultimately, the bankruptcy examiner opted not to inveigh on whether Repo 105 was itself a violation of accounting rules, a decision that likely saved executives like Amin from being fingered as individuals whose actions leave them vulnerable to civil prosecution. Instead, he focused on the sole issue of disclosure. Whatever the purpose of the transactions, Lehman had an obligation to tell investors what it was doing, Valukas said.

Accountability and Lehman

What government investigators might do with the evidence that the examiner turned up is anyone’s guess. The SEC, and, especially, the Justice Department, have struggled mightily thus far to win financial crisis-related cases. The highest profile case to go to trial involved two Bear Stearns hedge fund managers, who had had exchanged emails that suggested they thought what they were peddling was junk. Last November, a federal jury quickly acquitted both of criminal fraud charges.
The SEC has succeeded in wringing out some hefty fines from institutions — most notably $500 million from Goldman Sachs — but individuals have mostly gone unpunished. The SEC has a big one queued up, though: Angelo Mozilo and two other former Countrywide executives are set to go to trial on civil fraud charges beginning Oct. 19 in Los Angeles federal district court.

Accountability is a curious thing. Will Americans feel better about the government’s response to the financial crisis if the former chief executive of one bank is forced to pay a big fine? Add Mozilo and a handful of former chief financial officers to the mix. What if they have to surrender some of their fortune, too?

Put in a historical context, it doesn’t seem like much. Consider: in the wake of the savings and loan crisis 20 years ago, more than a thousand S&L insiders were convicted of felonies, including big names such as Lincoln Savings’ Charles Keating. Financial titans who served time behind bars as a result of the Wall Street scandals of the same era included junk bond king Michael Milken.

Another curious thing about accountability. A few years ago, the thought that a handful, at best, of the architects of the financial crisis would be punished would have seemed like the absolute least the government could do. Now, it is the most.

Michael Hudson is a staff writer with the Center for Public Integrity and author of The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America—and Spawned a Global Crisis, forthcoming from Times Books. Ben Hallman is a staff writer at the center.

Back to Page One
Copyright © 2007-2018The Cutting Edge News About Us