Zero Hedge

In the aftermath of the Zachery Kouwe plagiarism fiasco, the last thing Andrew Ross Sorkin’s Dealbook needs is another scandal. Yet this is precisely what may come out of a recent column by the TBTF author, in which ARS insinuated that Lehman whistleblower Matthew Lee came forth with incriminating Repo 105 evidence only after he was made aware he was about to be “downsized.” The Columbia Journalism Review’s Ryan Chittum debunks this story, after pointing out some potentially gross misrepresentations in the Sorkin column, which go to directly to motive and to the integrity behind Lee’s actions. “The Times’s DealBook editor Andrew Ross Sorkin, who wrote the
column, quotes the sources saying the whistle blower came forward only
after “it became clear” he was to be replaced in his job. We’ll get to
that peculiar phrasing in a minute, but the main problem is the Times story gives no indication that Lee was called for comment. In fact, he wasn’t called, according to Lee’s lawyer, Erwin Shustak, whom I talked to yesterday. “I’ve never spoken to the man (Sorkin) in my life,” Shustak says. “Nobody’s spoken to Matthew.” That doesn’t meet a basic fairness test. As it happens, Shustak tells us that Lee had no idea his job was in danger.” If indeed Sorkin misstated facts, a retraction is the only recourse as the potential for legal escalation on all sides of the story is huge. We are confident that while to Lehman managing directors $50 billion may have been a drop in the ocean, legal prosecution going after either ARS (or Lee) to reclaim it in part (or in whole) will surely make the Dealbook editor’s head spin, even after accounting for Paulson and Geithner’s 10,000 purchases of TBTF each (exaggeration ours… we hope).

Chittum writes:

There are some real journalistic lapses in a New York Times column Tuesday
that quoted anonymous sources about a Lehman Brothers whistleblower who
tried to warn about the failing bank’s questionable accounting
maneuvers, including one known as Repo 105.

The problematic passage is here:

Lehman’s shell game didn’t come to light until June 2008,
when a lower-level executive named Matthew Lee sent a letter to
management raising a host of questions about the firm’s practices. (By
the way, the S.E.C. and Fed were still working inside the building at
this point.)
What the examiner didn’t report, however, was that
Mr. Lee started raising questions about Repo 105 only when it became
clear that he was being replaced in his role, according to people
briefed on the matter. Indeed, Mr. Lee’s original letter to management
did not mention the use of Repo 105.

Chittum then proceeds to note the abovementioned discussion with Lee’s lawyer Shustak in which he makes it clear that Sorkin never spoke to his client.

That doesn’t meet a basic fairness test. As it happens, Shustak tells us that Lee had no idea his job was in danger.

“That comment was made not based on any reality or fact that I’m
aware of,” Shustak says. “He couldn’t possibly be accurate because I
know that until Mr. Lee wrote these letters, he had not been notified
that he was part of any layoffs.”

This is useful information that blunts, if not debunks, the
anonymous sources’ innuendo that Lee was motivated to come forward
because he was about to lose his job. Indeed, an on-the-record denial
carries far more weight than an off-the-record or on-background attack,
which this assertion clearly was. Sorkin declined to comment.

The slip occurs near the bottom of a column on the failures of
regulators to discover the Lehman scandal that was right in front of
them, and is a jarring end to an otherwise fine piece.

Chittum continues:

Also, as noted, the Times’s phrasing poses problems, reporting Lee blew the whistle only after “when it became clear” he was being replaced.

Clear to whom? If Lee didn’t know he was being replaced the fact that
he was on his way out is irrelevant. The phrase itself is blurry. Why?

Lee’s lawyer, Shustak, says Lee never sought the limelight:

“Matthew is a very private person,” he says. “His life has been
devastated when he was let go. He has not worked since then and is
living off his 401k. He just doesn’t want to get into the middle of
whatever lawsuits are going to be coming out of this whole report.”

It is a pity that the NYT, which recently let go hundreds of press room staffers, in the latest round of layoffs, has been resorting to such devices as attributing reality where there is none. In the old days, journalists would be forced to issue a retraction (or much worse) if indeed their reporting was not based on facts, as this particular piece so far appears to be. To be sure, this is not the first time the Columbia Journalism Review has discussed ARS – a week ago Dean Starkman wrote the most scathing review of Too Big To Fail we have yet read. Could this be just a case of some bad blood? Or, as Starkman insinuates, is this merely yet another case of Wall Street media capture? the truth will be made apparent over the next several months by the tone of Sorkin’s pieces. Nonetheless, having already attempted to exonerate Fuld once, one wonders just where Sorkin’s allegiance lies.

By the way, doesn’t it seem increasingly hard to vilify Richard S. Fuld Jr., the former chief executive of Lehman Brothers,
given what’s happened since that firm filed for bankruptcy? 

No Andrew, it doesn’t. Yet we understand. After all, a sequel to TBTF has to be in the works at some point. And should Andrew lose his contacts, he may have to rely on his extensive understanding of finance to piece things together as an impartial outsider for once. Ironically, the Lehman examiner’s report is precisely what Too Big To Fail should have been, had ARS actually dug in underneath the surface of all the primary material he had been presented with. We are surprised Doubleday or Penguin has not yet offered Valukas an advance for his next much more relevant Wall Street thriller.

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By Karl Denninger, The Market Ticker

See, I told you so…..

March 18 (Bloomberg) — Greek Prime Minister George Papandreou set a one-week deadline for the European Union to craft a financial aid mechanism for Greece, challenging Germany to give up its doubts about a rescue package.

Papandreou said he may turn to the International Monetary Fund to overcome its debt crisis unless leaders agree to set up a lending facility at a summit March 25-26.

How about this?

Your nation made the mess, now clean it up!

“It’s an opportunity to make a decision next week at the summit,” Papandreou told reporters in Brussels today. “This is an opportunity we should not miss. When you have that instrument in place, that could be enough to tell the markets hands off, no speculation, let this country do what it’s doing.”

What’s wrong with speculation when you give people reason to speculate?  More to the point, is it speculation if you get caught lying on your financials and taking intentional actions designed to cover up your true debt position?

I’d call that an educated guess, and it’s very different than “speculation.”

Greece pinned its hopes on the Brussels summit as German officials voiced qualms about an EU-led rescue, potentially backtracking on a commitment hammered out by finance ministers just three days ago. Greek bonds and the euro fell.

There was no commitment.  There was an attempt to jawbone – that is, lie – by politicians who find it easy to lie.

The market, however, calls all bets. It always has and always will.  If Greece learned anything from our little market collapse in 2008 it should have been this – remember, Hank (I’m gonna roll the tanks!) Paulson tried this very same game – repeatedly.  It didn’t work – not with Bear Stearns, not with Fannie, not with Freddie, and not with Lehman. 

It didn’t take long for the market to decide that he was full of the dark side and press the bet, and as soon as that happened we found out that the “Bazooka” was really nothing more than a fancy form of bankruptcy. 

Oops.

If Greece doesn’t like the consequences of getting caught cooking the books, one solution would be to stop doing that and come clean with the people – even if it results in your government being sacked.

The “reaction” in Greece to reality poking its head in the tent is instructive, and something that all developed nations that have decided to go down this sort of road with lying about fiscal and banking matters (cough-United States-cough-Britain-cough-Spain-cough-Germany-cough-Portugal-cough-take-your-pick) should pay attention to. 

I wonder if it has sunk into the consciousness of Obama and Geithner, along with Congress, that having “replaced” 10% of consumer final demand in the economy in a ridiculous (and doomed) attempt to prevent bad debt from being defaulted, not to mention the lies told about our actual fiscal situation (holding retirement “promises” off book anyone?), we (along with a bunch of other nations that have done the same) are headed down the same road that Greece is.

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Zero Hedge

Going through today’s pertinent Q&A with Bernanke, initially we focus on Fed nemesis #1, Ron Paul. First question of relevance: “Do you Mr. Bernanke think that rates were hold too low for too long?” The degree of Fed delusion is easily seen by the response: “the bottom line is nobody really knows for sure, but the evidence is quite mixed.” Obviously the bald one has never attempted to sell a home in the Inland Empire. The evidence sure would be a little less mixed in that case. But at least Bubble Ben has given a speech on it (which incidentally caused John Taylor to almost have a conniption against the stupidity of the Fed’s chairman). Yet just in case you thought the man may have at least one screw unloose in his voluminous cranial hollow, Bernanke opens his mouth and says “Even if rates were too low for too long, the magnitude of the error was not big enough to account for the huge crisis we had. I think what caused the crisis was a failure in regulation.”…..And this is the man who determines monetary policy….Only now do we find out he has never actually ever opened an Econ 101 textbook, instead opting to go straight to writing them. Luckily Ron Paul proceeds to give the Princeton “expert” a much needed lesson in monetarism, and what happens when rates are zero for far too long.

To be expected, Bernanke certainly did not appreciate being schooled in Econ 101. After Paul rips Bernanke’s face off with the Chairman’s constant excuse that regulation is the answer to everything, arguing instead that artificially low rates merely send constantly flawed price signals, Bernanke retorts “Well you need some system to set the money supply. I guess you are a gold standard supporter.” At this point Paul gives the most priceless response ever: “I am for the constitution.” (4:50 into the clip)… A flabbergasted Bernanke again proceeds to cast the blame… This time everywhere but the Fed: “Every major country in the world uses a Central bank to make some decision about the money supply.” We ask the philosophy experts among our readers to tell us just what type of fallacy this is. Ron Paul once again has a brilliant response: “Then there is no good information for the investor unfortunately.” What are you talking about Ron – there is Cramer. At least until such time as his particular regulators wake up… Which they seem to have done so today finally.

Next up, California’s Brad Sherman asks the current-former Fed Chief duo the following runner up to the most critical question of the day: “Bureaucracies hate bad headlines, they’ll often do desperate things behind the scenes to avoid that big headline from breaking. Prudential regulators are going to get bad headlines if a big institution fails, particularly under some circumstances, and if they can prevent that failure, if they can just put it off for six months, their reputations and careers can be saved. Monetary policy, just cutting the interest rate by quarter point can save a troubled institution. So how can we be sure that monetary policy is not influenced by the natural human desire of bank supervisors, to save one or two institutions, for at least long enough for them to move over to another department. How do we make sure that monetary policy does not meet the career needs of bank supervisors?” And the token bullshit response from the follicularly confused one: “I don’t think that’s a very realistic scenario.” Oh really? We think it is, and in fact we think that the probability of influence on monetary policy arising from this line of thinking is much, much greater than all that other BS we have been hearing about how an audit will make the Fed become an engine of hyperinflation, the argument that Barney Frank, Chris Dodd, Mel Watt and all the other bought and paid for Wall Street cronies are using to prevent Ron Paul’s audit the Fed initiative from ever passing. Bernanke elaborates on what one day will be an amusing case study: “I suspect the Central Bank Chairman will be around and concerned about his or her reputation when the economy has excessive inflation or whatever problem might arise from bad interest rate policy. I don’t think there is much evidence for that particular issue.” How about the issue that every reputation can be bought and paid for by someone with a big suitcase full of brand new $100 trillion bills, with a portrait of Supreme Chancellor Blankfein on the front? This is post the hyperinflation – certainly the Central Bank chairman will not be dumb enough to want to be paid in Pre-Petition money.

Yet of all questioners, Rep. Scott Garrett asks the truly most relevant questions of the day. First among them: “Are the GSE obligations sovereign debt?” Bernanke’s response: “We stand behind it, but whether it is legally sovereign debt or not, I am not equipped to tell you.” Same thing from Volcker, who adds that it is a “bad arrangement where you have this quasi private organization and the government stands behind it.” So not even the wannabe uber regulator knows how to account for an amount equal to half of the total US Federal Debt. Swell.

On Lehman Garrett asks “The Fed was there on scene, your folks were there at Lehman’s. Was the Fed aware of the Repo 105 and the accounting irregularities going on?” Bernanke answers “No – they were hidden. We are currently, for example, the principal regulator of Goldman Sachs, and we have about a dozen people on site, and another dozen who are looking at the company. We had in this case two people assigned to Lehman. And their main obligation was to make sure we get paid back our loans…. Our objective on the discount window loan was to make sure it was safe and they were safe.“

Now parse the last few sentences carefully. Not only does the Fed admit that it is and was in the Fed’s interest to delegate manpower to make sure that Goldman is fine (in an agent ratio of 6-to-1 “scouring” over Goldman’s books), but Bernanke blatantly contradicts himself when claiming the reason for the presence of the Fed’s entourage. If the Fed was indeed so focused on recouping its discount window borrowings, then how on earth did Geithner green light that Lehman would be allowed to deposit a nearly $3 billion  CDO, which contained loans by CFC, which after a cursory look Citigroup determined was “Bottom of the barrel” and “junk”? What is the basis of this dual standard – why does the Fed pretend to be concerned with safeguarding taxpayer money (with which Bernanke justifies its minimalist presence at Lehman) when it comes from the Discount Window yet is happy to collateralize “junk” paper in the Primary Dealer Credit Facility? Is whoever was in charge of the Lehman account at the FRBNY some schizophrenic (and please let it not be discovered that the person in charge was, just like in AIG’s case, again Steven Manzari)? And why does the Fed believe it has any credibility as an uber-regulator when it constantly fails a less than uber-one?

In earlier questioning by Spencer Bacchus, Bernanke answered that the only reason why the Fed had a “couple” of people in the company, was to make sure that Lehman “repaid the money lent by the Fed’s Primary Dealer Credit Facility.” Yet the Fed had lent out money, as noted above, collateralized by, well, excrement. Once again that is a truly “brilliant” overture by a wannabe regulator of all that has a dollar sign in front of it. 

Bernanke digs himself even deeper. When explaining why the FRBNY got paid back, BB says “we took collateral and we took extra large haircuts to make sure it was safe.” Oh… so now you care about getting paid back. Was it, perhaps, under the guidance of one Goldman Sachs, who may have at this point decided it was time to rid the world of the pesky Lehman Brothers that made you start enforcing legitimate collateral controls?

Then Garrett asks the key question: “In light of these reports is this something that we should be concerned about? Is activity at these other [banks such as Goldman] is that something that (a) we should be concerned about and (b) something the Fed should be concerned about and are you looking into it.” Bernanke’s retort “[the banks] are now under our consolidated supervision, so we are now paying attention to these issues.” That’s the non-answer. As to the answer of whether the Fed is looking at whether shady accounting is going on or was going on in the past, Bernanke’s version of the Fifth is as follows: “I don’t know. This report just came out this week.” In other words if Peck had not agreed to declassify Valukas’ report, if there was no pressure to put the Examiner’s report in the public domain the Fed would never have expressed any interest into just what kind of shady accounting goes on to mask the Tier 1 and Risk Based Capital of the banks under its supervision, and that leverage ratios by most of the banks it supervises are likely complete shams?

A relentless Garrett keep probing: to the NJ representative’s question whether the Fed demanded that Lehman’s regulator (whoever it may be since it was not the Fed, even though the Fed had implemented three separate liquidity stress tests, of which Lehman failed every single one) require that Lehman raise its liquidity, Bernanke once again gets an acute case of amnesia: “I don’t have the exact information that you are asking.” So once again the Fed proves that the only thing it can regulate is the bribery sinking fund at Goldman et al with direct recipient Federal Reserve governors. Everything else will just fall into place once yet more of Goldman’s competitors are done away with, and Goldman (and JPM, of course, can’t forget Fed, Jr), are left standing as the only two financial firms in the known universe. And this is the Fed that lame duck and financially supremely challenged Chris Dodd wants to put in charge of regulating everything in this country? If that really ends up happening, we are so #&$*ed… but not before Goldman funnels all of Americas’ money into its Middle-Class Irredeemable Negative Interest Rate All-market Fund SIV.

More articles from Zero Hedge….

By Michael Pettis, China Financial Markets

The Chinese new year has only just started, and already trade tensions are ratcheting up. This is perhaps appropriate — astrologers tell us that the year of the Tiger is often a year of instability and conflict — and I suspect things will almost certainly get worse. The timing of various domestic political events in the US, China and Europe will make it harder than ever for any of these countries to back down before 2012 (by which time, presumably, the world will have ended anyway).

Last Thursday President Obama made a fairly strong speech in which he urged China to adopt a “more market-oriented exchange rate”. The timing of the speech was important. On April 15 the US Treasury department will release its report stating whether or not China is a “currency manipulator”, and it is hard to believe that the Treasury department is not facing some pretty stiff pressure.

China’s response to Obama’s speech was pretty rapid and pretty angry. According to an article in the Saturday issue of the Financial Times

What it means to “politicise” the currency policy wasn’t made clear, but on Sunday Premier Wen also jumped into the fray. He denied that the RMB was undervalued and, in the words of an article in Monday’s Wall Street Journal, added the following:

Wen is absolutely right. Undervaluing or depreciating a currency certainly is a form of trade protectionism, but that, I think, is exactly the point. In a world of sluggish growth and rising unemployment, everyone’s currency policies are legitimately going to be scrutinized over whether they constitute trade protection.

An article in the People’s Daily has Wen also warning that “China opposes accusations and even forceful measures that press for yuan appreciation, which will not benefit the exchange rate reform.” The claim that external pressure will never advance reforms in China is now much debated in Europe and the US, and may be less widely believed abroad than it has been in recent years.  We’ll see.

These are murky political waters into which I do not want to dip, but it is hard to escape the politics of the debate.  The same issue of the People’s Daily had another article pointing out that US debate on the currency was driven mainly by domestic considerations and that the only reason Obama brought up the subject of the RMB was to address domestic polls.

There is, as always, a certain amount of nonsense in these articles. For example the exchange rate itself affects the ratio between savings and investment, so while the first part of Zhao’s statement is more or less right — although not as a “fundamental reason” but rather as part of an accounting identity — the second part is certainly wrong and probably meaningless.  More interestingly, it seems a little weird to argue that one of the benefits that China has provided the world with its undervalued exchange rate is low consumer prices that allow countries like the US “to consume excessively”. Aside from the fact that this pretty explicitly acknowledges that the currency is undervalued, since excess consumption is exactly the problem in the US, and since Chinese per capita consumption is much less than 10% of that of the US, it seems that China should be more approving of US attempts to return the favor and allow Chinese consumers the benefit of subsidized US prices.

Everything is politicized

Still, I do think the People Daily’s article is right to say that the RMB is becoming an important domestic issue for Obama, and that it is domestic US politics that is driving much of the recent noise and the rancor. Obama’s popularity has dropped considerably, and ahead of the upcoming elections he needs to show that he is addressing fundamental economic problems. And of course it is also always easy to get votes by bashing foreigners — this is one of the many attitudes that the US and China share.

But even though the People Daily’s criticism is correct, perhaps that doesn’t change anything meaningful. The concern over the effect of the RMB on US employment may still be a perfectly valid one, and the fact that Obama is under domestic pressure to address the currency is not an especially good reason to dismiss his concerns. On the contrary. Obama has little wiggle room, and as Paul Krugman pointed out in a fiery, and probably influential, speech last Sunday, the US may hold the stronger cards in any showdown. According to the relevant article in Business Week,

Krugman elaborated further Monday in the New York Times in an article, and then in a follow up article Wednesday, both of which are likely to be much quoted and widely read. Although Premier Wen noted again in his speech Sunday that China is “worried” about the value of its US dollar reserves, perhaps as a warning that China would counteract any US trade move by selling off USG bonds, Krugman doesn’t seem especially worried about this threat.

He may be right. Aside from the fact that it is not clear how China can dump Treasury bonds, he claims that it would only help the Fed in its quantitative easing, and would probably do far more damage to Europe (since China would presumably have to buy euros) than to the US.

The latter point is almost certainly correct. China’s Selling dollars and buying something else would allow the US to get even more bang for its protectionist buck, probably at poor Europe’s expense.  I would also add that the main long-term impact of dumping USG bonds might be no more than to cause a liquidation of Chinese assets at very low prices, and an equivalent transfer of wealth from China to the US (or to others likely at some point to buy cheap dollar assets).

Remember that at the beginning of WW1 something similar happened. In an urgent attempt to raise gold reserves to pay for the war, in the late summer of 1914 European belligerents dumped onto US markets what amounted to a far greater share of US assets than China currently holds. This caused about six months of havoc, and many sleepless nights in New York and Washington. But the US responded by putting into place temporary capital and stock market controls, and when the dust settled, the net effect was one of the most massive short-term transfers of wealth ever recorded from one group of countries, the European belligerents, to another, the US.  European dumping caused a collapse in prices, and US investors ultimately scooped up the assets up very cheaply.

That doesn’t mean that there will be no cost for the US if China dumps, but rather that the cost might be absorbed fairly comfortably over a reasonable time period. I suppose I will be very unpopular for pointing this out — especially with people in the US Treasury department and among Chinese cold warriors — but please don’t blame the messenger.  I am just trying to use the limited historical precedents to figure out what is likely to happen.  We have seen asset dumping before, and on an even larger scale, and the US capital market is deep enough that it might easily absorb it.

Where I disagree with Krugman is with his claim that the chance of triggering a trade war is small. In fact, the day Krugman published his article, 130 US Congressmen sent an open letter to secretaries Timothy Geithner (Treasury) and Gary Locke (Commerce) demanding that China be designated a currency manipulator.  They called for duties to be imposed on Chinese imports to counter the effect of the undervalued RMB.  This raises pressure significantly, and I am sure in the next week or two there will be a lot more.  There are also strong rumors of some high-powered and relevant Congressional session next week.  Stay tuned.

Of course regular readers of my blog won’t be surprised by any of this.  The logic behind a prediction of trade war is almost unchallengeable, and the two countries are simply the two most visible in a world in which trade tensions must inexorably rise.  Just ask the Germans and their European partners.  Trade relationships will continue to get much worse, largely because the cost of trade war for high-deficit countries is so much lower than for high-surplus countries, and there seems to be no real attempt on either side to tone down aggressive actions or rhetoric. We seem to be caught in a downward spiral, and the longer it goes on the harder it is for anyone not to participate.

But while I think the economic effect of a tariff war on the US is likely to be smaller than many expect (and much smaller than that indicated by some of the outraged yelping I saw on a CNBC show dedicated to the subject today), and maybe even employment-positive in the short term, I do not think it is in the longer term interest of the US.  I think trade war would be very painful for China, and forcing them into such a difficult position will poison the relationship for many years.  This is likely to be the most important global relationship of the next few decades, and we really need a better way to resolve these very thorny issues, but that almost certainly isn’t going to happen.

To return to the People’s Daily article, I think many in China have argued that a revaluation of the RMB may have a significant effect on China’s trade surplus without having an equivalent effect on the US trade deficit. The same would be true of tariffs on Chinese goods.  In either case, say many in Beijing, China loses, but the US doesn’t gain, so why is the US so determined to force this outcome?

I think this claim is probably correct. An RMB revaluation in itself might not have as big an impact on the US deficit as many think. To see why, I thought I would try to outline what the impact of an RMB revaluation would be for China and the world by asking a few basic questions and coming up with my best possible answers. Here goes:

What will the balance sheet effect of an RMB revaluation be on China?

There are broadly speaking two different classes of revaluation effects, the economic effect and the balance sheet effect. By the former I just mean the impact a revaluation will have on the future development of China’s economy, and by the latter I mean the immediate balance sheet losses and gains for China. Obviously these two are related.

Let me begin with balance sheet impacts. Two weeks ago I posted a rather long entry on that very subject. For those who can’t bear reading or re-reading such a long post, the quick answer is that, contrary to common perception, a revaluation of the RMB is likely to have a very small, and probably positive, overall balance sheet impact on total Chinese wealth.

That is, however, not the end of the story. There is a significant transfer within China of wealth, which will create clear winners and losers. Basically any economic entity that is explicitly or implicitly long dollars (by which I mean any foreign currency not pegged to the RMB) and short RMB, will lose in a revaluation. Conversely, any entity that is explicitly or implicitly long RMB, and short dollars, will win. In my earlier entry I pointed out that the PBoC is the single biggest loser. It is long, if correctly counted, roughly $3 trillion in dollars, against which it is short an equivalent amount of RMB.

Exporters and manufacturers in the tradable goods sector will also lose. Their expected revenues (which can be conceptually capitalized as an asset) are mainly in dollars whereas their expected costs are partly or mainly in RMB. This means that the value of future revenues will drop relative to the value of future expenses, and so they will take a loss.

Finally in that entry I pointed out that any wealthy Chinese individual with a substantial amount of honest or ill-gotten gains stuffed in bank accounts abroad will also lose. But I forgot to mention another big group of losers — anyone in China who has stockpiled inventories of goods or commodities whose prices are set in international markets. Those prices will immediately drop in RMB terms upon a revaluation, and if the asset purchases were financed by RMB borrowing or assets, there will be a loss. So to the extent that companies or individuals are stockpiling iron, copper, chemicals, or anything similar, they will also take an immediate loss.

So who wins in a revaluation? Nearly everyone in China who has at least part of his consumption basket consisting of imported goods, which basically means every one in China except pure subsistence farmers. Because the rise in the value of the RMB causes the price of all imports automatically to fall, a revaluation increases the wealth of Chinese households by increasing the real value of their current and future assets and income.

This is the key point. A revaluation shifts wealth from the Chinese government and the manufacturing sectors (and some wealthy Chinese) to Chinese households — which, by the way, is pretty much what is meant by “rebalancing” in the Chinese context. There are many other ways besides revaluation to shift income this way. The PBoC can raise deposit rates, wages can rise faster than productivity, companies can be privatized by giving away shares to the pubic, and so on. They all have the same effect. They shift resources to households and away from producers, infrastructure investment, and real estate developers. This allows household income to grow relative to national income, which ultimately increases the consumption share of GDP.

What will the economic effect of an RMB revaluation be on China?

So as things stand currently, the reason an undervalued RMB distorts international trade is because it transfers income from Chinese households (they have to pay more for imports) and subsidizes Chinese manufacturers in the tradable goods sector. This is one of the many mechanisms by which households are forced to subsidize production and investment.

A revaluation, then, is part of the rebalancing mechanism. It helps to reduce subsidies to manufacturers and returns the income to Chinese households, who can then increase their relative consumption. But there is a cost to this rebalancing. China’s current industrial policies sacrificed household income in order to spur manufacturing growth, and this had the obvious secondary effect of speeding up employment and, with it, household income. So in a way by repressing household income growth China was paradoxically able to achieve rapid growth in household income. Neat trick, eh?

But of course this growth wasn’t unencumbered. Much Chinese growth was based on concealing the true costs behind hidden subsidies, so that real economic growth was likely to be lower than recorded economic growth. More importantly, because everything in the world must balance, the imbalances within China required the opposite imbalances outside of China — which mostly meant in the US.  Just as this global system implicitly taxed Chinese household consumption to subsidize Chinese manufacturing and employment growth, it also implicitly taxed US manufacturers in order to subsidize US consumers. American consumers got cheaper (foreign) goods, American manufacturers had to compete against lower (foreign) prices.

So Americans over-consumed and Chinese over-saved. The system worked well for quite a while, until, as with Japan in the late 1980s, US debt levels and employment rose to economically and politically unacceptable levels.

For China and the US to adjust means both of them unwinding this trade-off. Beijing will have to enact policies that reduce the subsidies to manufacturers and return the income to Chinese households. But this automatically means depressing economic growth and, more importantly, depressing employment growth.

This shouldn’t be a serious problem if it happens slowly. As Chinese manufactures gradually lose their subsidies, they will rely more than ever on the consequent rising Chinese consumption, and so domestic consumption will replace subsidized foreign demand as the source of growth. Not only will China have a safer and more balanced economy, but it will be more innovative (consumption tends to drive innovation, not production) and much more efficient.

But China cannot adjust too quickly. If Beijing removes the implicit subsidies, including those caused by the undervalued exchange rate, too rapidly, that could force large-scale bankruptcies as Chinese manufacturers found themselves unable to compete globally or at home. If these bankruptcies forced up unemployment, then paradoxically even as the transfers from households to businesses are being reversed, household income would nonetheless decline as unemployment soared. In that case Chinese manufacturers would find themselves becoming uncompetitive in international markets just as domestic markets are collapsing.

The conclusion? A rebalancing is necessary for China, as nearly everyone in the leadership knows. This will involve, among other things, a significant revaluing of the currency. But rebalancing cannot happen too quickly without risking throwing the economy into a tailspin.  That cannot and should not be a part of the US or Chinese policy objective.  By the way if China is forced to revalue the currency too quickly, it will have to enact countervailing policies — lower interest rates, suppress wages, increase credit and subsidies — to protect the economy from falling apart, and these will exacerbate other imbalances that may be even worse than the currency misalignment.  Currency revaluation, then, should be part of a broader adjustment process.

So how can the global system adjust?

If we abstract for a moment, and call all trade-deficit countries the United States, and all trade-surplus countries China, there are broadly speaking two ways the system can adjust. Remember that each domestic imbalance requires the other, so that if China adjusts, the US must adjust too, and if the US adjusts, China must adjust too.  (For those more technically inclined, by the way, this is one of the points that Krugman makes in his second article, although using different terms: China’s exporting of capital must create capital imports somewhere else, and these capital imports are the obverse of the trade deficit.)

One way in which the system can adjust is for China to take the lead and reverse the policies that cause households to transfer resources to its manufacturers. As a consequence consumption will no longer be taxed to subsidize production. This will cause household consumption to rise as share of GDP — the good way by a surge in consumption, the bad way by a collapse in economic growth.

Either way, the rebalancing in China will force an equivalent rebalancing in the US. As the price of Chinese goods rise, the net impact will be to transfer resources from US consumers, who have to pay more for their imports, to US producers (US producers become more globally competitive). The rise in Chinese consumption relative to Chinese production would be necessarily matched by a rise in US production relative to US consumption. (Some readers will notice that I am ignoring the role of investment in economic growth, and of course changes in investment matter, but over the medium to long term the basic argument is unchanged.)

The second way in which the system adjusts is if the US drives it. The US can put into place policies that favor manufacturers at the expense of consumers. These include consumption taxes, manufacturing subsidies, penalties for consumer borrowing, subsidies for investment, or, more ominously, import tariffs. These can all have the same aggregate effect on the US trade account by shifting the relationship between how much Americans produce domestically and how much they consume. And of course as the US adjusts, China must also automatically adjust.  Tariffs just on Chinese goods, by the way, will have a minimal impact on the US adjustment since trade may very well just shift to other countries.

Note that in either case both countries will rebalance, but rebalancing says nothing about how rapid economic growth must be. I addressed this in a blog entry last week when I discussed Japan’s dismal post-1990 rebalancing. In this context rebalancing just means that in China economic growth will be less than consumption growth, and in the US consumption growth will be less than economic growth. The problem is that China will try to adjust by pushing the cost of the adjustment onto the US, and the US will try to adjust by pushing the cost onto China. Each country can strive towards the good outcome (rapid economic growth) or find itself facing the bad outcome (declining consumption). This is why policy coordination and gradualism is so important.

Will a revaluation cause China’s trade surplus to decline?

Yes, all other things being equal, but of course all other things are not equal. Within China there are several things that will affect the trade surplus. Remember that the trade surplus exists because of the imbalance between Chinese domestic production and Chinese domestic consumption (technically the surplus is the difference between savings and investment), and so anything that affects the subsidies to manufacturers, or that affects household income, will also affect the trade surplus.

I have already argued that interest rates and wage growth that is lower than productivity growth can affect the trade surplus as much as the undervalued currency. In that case, if the RMB revalues, and at the same time real interest rates are forced down by a sufficient amount, or wage growth is restrained, the net result can easily be a rise, not a decline, in the trade surplus. It depends on the relative magnitude of the different factors.

The external environment also matters. If US interest rates decline for example, unlike in China where declining deposit rates is likely to spur savings, US consumption may rise even as the cost of Chinese imports rises because of a surge in the RMB.

Quite a lot of defenders of RMB stability have made the point that the rise of the yen after 1985 and the rise of the RMB after 2005 were most emphatically not associated with declining trade surpluses. According to their arguments, this clearly proves that the currency doesn’t matter.

This is nonsense, and even if it were true it seems more an argument in favor of revaluing than an argument in favor of not revaluing. But it isn’t true because in both cases there were countervailing changes.  Perhaps most importantly, local interest rates in Japan and China declined in real terms, thus reducing local consumption, and US interest rates also declined, spurring US consumption (I know, I know, this sounds strange, but the wealth effect of interest-rate changes in the US is the opposite of that in Japan and China because of the differing structures of household balance sheets). All that happened in both cases was that the rebalancing effect of the currency revaluation was swamped by the exacerbating effect of other factors. The only thing that Japan after 1985 and China after 2005 prove is that the currency is not the only thing that matters.

Will a decline in China’s trade surplus cause the US trade deficit to decline?

Not necessarily. Beijing has pointed out many times that a contraction in the Chinese trade surplus does not necessarily mean an equivalent contraction in the US trade deficit. All it requires is an equivalent contraction in the rest of the world’s net trade deficit. This could easily happen with an improvement in the trade balances of Vietnam, Mexico, Korea or anyone else, enough fully to absorb the reduction in China’s trade surplus. In that case, the US trade balance does not improve, and the US gets none of the employment benefit of the RMB revaluation. China will simply import fewer jobs from abroad and some other countries will import more, or export fewer, jobs.

Remember that if the RMB revalues, this is the same as if all the currencies of the rest of the world depreciate. This will cause a shift in the rest of the world so that households will see a small reduction in their real income, and non-Chinese producers in the tradable goods sector will see a small increase in their competitiveness vis a vis the rest of the world (largely because Chinese producers becomes less competitive). This will reduce non-Chinese consumption and increase non-Chinese production, and the distribution of these changes among different countries, including the US, will depend on a vast array of factors.

So Beijing is absolutely correct in arguing that an RMB revaluation might not have a major impact on the US trade balance, although there is one important caveat. A number of other developing countries, especially in Asia, are concerned about excessively loose domestic monetary policy and inflation, and would like to raise the values of their own currencies. They cannot do so, however, until China does. During the crisis China has expanded its share of global net demand at their expense. If an RMB revaluation causes revaluation in other countries with large trade surpluses, the net impact on the much smaller “rest of the world” will be much bigger, and so simply as a function of arithmetic the US is bound to benefit.

This fact again argues in favor of globally coordinated action rather than an excessive focus on RMB bashing. If China is forced to revalue the RMB, in order to gain the optimal global rebalancing it should be done as part of a general realignment of currencies (although of course cynics will point out that surest way to ensure that something doesn’t get done is to coordinate it globally).

Is it only China that must act?

China will rebalance, but it cannot do so quickly. If it does, as I discussed above, it may easily fall into a spiral of declining competitiveness leading to rising unemployment leading to declining domestic consumption leading to more unemployment. Clearly this is not in China’s interest.

There is another problem. There are several countries with structurally low consumption and high production — Germany, Japan and China being the most important (and I leave out the OPEC countries for obvious reasons). Simply forcing China to adjust, in that case, might cause damage to Chinese growth prospects without helping the US rebalancing effort.

For example, a sharp rise in the RMB, especially if accompanied by a rise in other Asian currencies, will take depreciation pressure off the dollar. Since currently most of that depreciation pressure is borne by the euro, a revaluation of the RMB could easily also result in a decline in the euro, whose economies will then see a sharp improvement in their net trade balance. This means that a significant part of the benefits of Chinese revaluation may accrue to Germany, a country that has yet to resolve its own internal imbalances.

So limiting the whole rebalancing discussion just to China and the RMB may end up not helping much. It is true that the US could force through a rapid domestic rebalancing of its own, including by raising import tariffs generally (and not just on Chinese goods), if it really wanted to, and the benefits to the US would be a surge in employment and manufacturing at probably little real long-term economic cost. But unilateral action on the part of the US risks creating at least some problems for the rest of the world, especially China, Japan, and parts of Europe.

So what must be done? Clearly there is a problem with the undervaluation of the RMB and with Chinese domestic imbalances. But just as clearly there are also problems with a number of other major over-consuming and over-producing countries. In addition Chinese producers have become so addicted to a wide variety of implicit subsidies, besides the currency, that they cannot possibly adjust very quickly. It will take years of continuous adjustment to wean them away from an undervalued currency, too-low interest rates, excessive credit aimed at SOEs, and sluggish wage growth.

That suggests that if we want to resolve the global imbalances in an optimal way that maximizes global growth and equity, we would need all the major problem countries to work out a program, perhaps over 8 to 10 years, in which China, Japan and Germany take concrete measures to shift subsidies away from manufacturers and return the income to households, and the US, the UK and other deficit countries shift income from households to investment.

Of course the cynic in me says getting a global solution will prove impossible. Each country that benefits in the short term from stonewalling on any aspect of the complex adjustment process will do so. So I guess that just leaves trade war. This is the year of the Tiger, after all.

More articles from China Financial Markets….

By Karl Denninger, The Market Ticker

You know it’s going to get good when LIESman says something like “there is a point in time when ignorance goes from being amusing to being dangerous” to a grizzled trader like Santelli.

Well, Liesman did, and…. (we’ll do facts after the video)

Now for the facts:

Any government can pump stock prices of insolvent institutions for a while by allowing them to lie on their balance sheets.  The poster child for this is, of course, Lehman brothers.  I reproduce for your edification a chart showing two quarterly reports during which Lehman was arguably insolvent (light gray) and then (in pink) a further period of time spanning more than a month when their counterparties knew they had no cash, yet FRBNY and The Fed, including but not limited to FRBNY, Paulson, Geithner and every other bank they dealt with knew they had no money.  Yet their stock continued to trade, the company continued along, and Dick Fuld was on CNBS saying he was going to “burn the shorts.”

What was the outcome Steve?  Was it “all ok in the end” even though for a period of more than six months the stock continued to trade and in fact after that first report went up significantly?

What caused the collapse?  They ran out of cash flow.

Now about those other large banks and their balance sheets….

As a corollary to the above governments can also pump markets generally by replacing private demand in GDP with borrowing and spending, just as you can by using your credit card even though your income has been cut off.  This can and does lead to huge market rallies – for a while.  However, unless you can manage to increase credit in the system generally, meaning that private parties “come back” and take over from government, eventually the government becomes unable to sustain such a practice, just as you become unable to sustain such a practice.  In point of fact the government has borrowed and spent ten percent of GDP (in addition to all that it was spending before) for the last two years.  This has prevented the recognition of an economic depression in the “statistics” put forward by government, but that replacement of private demand is not, in fact, private demand!  Thus you have unemployment and underemployment, even under the government’s statistics (among those who want jobs), hovering near one person in five in the economy, and only 60% of the labor force is actually working.  The other 40% of working-age, non-institutionalized people, are not working – which means they’re drawing on social programs of some sort.  This, of course, exacerbates the demand for the government to continue borrowing and spending that additional 10% of GDP.

What will cause this to collapse?  The same thing – recognition that the banks are in fact broke (and there are a bunch of them that are), inability to sell or roll over enough debt to satisfy the leaches in society, one of the rating agencies growing a pair of balls and downgrading the United States and more.  Indeed, a lockup in the credit markets could easily occur just as it did in 2008, and for the same reasons – a recognition that “heh that jackass over there has no good collateral!”

Can the government keep this from happening forever?  No.  

Can it do so for “an extended period of time”?  Sure, but for exactly how long?

That’s the key, isn’t it?  We’re not running an 89% debt-to-GDP ratio, it’s in fact over 500%.  We’re lying just as Lehman was lying, but on a grader scale.  Yet when Rick Santelli brings this up, the pump monkeys go nuts.

Why?

Well gee, if you want to sell something to someone that is based on a fraudulent premise, how much luck will you have if the truth is exposed?

‘Nuff said.

More articles from the Market Ticker….

What do Enron, Greece and Lehman Brothers have in common?

The world is about to find out.

The latest disturbing news to crawl out from under a rock this weekend was that Lehman’s used offshore accounting gimmicks to mislead the world about its financial problems. This was the conclusion reached by Anton Valukas, a Chicago prosecutor and fraud expert and contained in his 2,200-page report. He was commissioned by the bankruptcy court to pore over millions of documents to get to the bottom of the biggest bankruptcy in U.S. history involving US$613 billion in debts.

Among his findings and opinions:

• Valukas believes that Lehman executives were involved in “balance sheet manipulation” in order to shift tens of billions of dollars of bad assets off its books.

• The shift was done, as was the case with Greece, using the repo market or an eyebrow-raising buy-sell arrangement.

• Valukas said Ernst & Young, Lehman’s auditors, did not “question and challenge improper or inadequate disclosures” in the firm’s professed results.

• Lehman could not get their offshore gimmick “papered” (which means a legal opinion approving the maneuver) by any credible American law firm so they shopped around and used Linklaters, a legal shop in London, he alleged.

• The New York Federal Reserve Bank, run at the time by Timothy Geithner (now U.S. Treasury Secretary), imposed no restraints on Lehman even though the firm failed to pass several smell tests conducted by Fed staff, alleged Valukas.

• Valukas said he questioned Lehman executives in the past few months and they said full and complete information was disclosed to government agencies (stock markets, SEC, the Fed) about the repo transactions and the governments never raised objections nor did they demand corrective action.

The report raises questions. Were the market’s “cops” then the same people who are still in charge and advising Obama and Congress? Did they have any inkling of trouble or not?
If regulators knew, why didn’t they do something? If they knew, why didn’t they force disclosure to the investing public?

Conversely, if they were not told the truth, then why haven’t charges been laid?

The revelations may take down some very prominent people, send a few others to jail and explain why the former administration refused to bail out Lehman Brothers.

Read more….

After a year-long investigation, court-appointed bank examiner Anton Valukas has produced a deadly 2,200 page report which details the activities that led to the Lehman Brothers bankruptcy. The report is a keg of dynamite. The question now is whether anyone in government has the nerve to light the fuse. Valukas provides powerful evidence that Lehman executives were involved in “balance sheet manipulation” by implementing an arcane accounting procedure called “Repo 105” which masked the bank’s true financial condition from investors and regulators.

Read more….

Zero Hedge

This week in The IRA we feature a
conversation with Bill
King, who along with his wife and business partner Mary works in the
world of
derivatives broadly defined via their Chicago-based firm, M. Ramsey King

Securities. We first started taking with Bill in the 1980s, during the
political wrangle – we won’t call it a battle – over free trade with and

democracy in Mexico. That was about the time of the first
appearance of “Too Big to Fail” for the large banks following the
Mexican peso
meltdown. Un fuerte abrazo a nuestros amigos en Mexico!

But before we go to our feature, a few
comments on current
events. First and foremost we remind one and all about the impending
start
of the FDIC’s rule make effort regarding the reform of bank
securitizations.
Last week, the FDIC approved an extension through September 30, 2010 of
the Safe Harbor Protection for Treatment by the FDIC as
Conservator or
Receiver of Financial Assets Transferred by an Insured Depository
Institution in
Connection With a Securitization or Participation.

We hear that the FDIC rule making
process could start as soon
as next month, but more likely will wait till the FDIC’s board meeting
in May.
We also hear that the President’s Working Group (PWG) on Financial
Services is
preparing a “white paper,” in cooperation with the Federal Reserve Board
and the
Office of the Comptroller, to block the FDIC reform effort. This
campaign, which
apparently was orchestrated by the largest dealer banks, is intended to
derail
the new rules proposed by the FDIC mandating greater transparency and
disclosure
for bank sponsored residential mortgage securitization deals.

The PWG, in case you don’t know, is an
informal group created
in 1988 by President Ronald Reagan that allows the executives of the
biggest
banks to influence public policy in Washington, but without going
through the
trouble of registering as lobbyists or other public disclosure.
Sometimes
referred to the “plunge protection team,” the PWG is part of the
invisible
government of Washington,” an agency which operates within the
government, but
at the behest of private interests.

Barry Ritholtz has a nice summary on
the PWG in his book,
Bailout Nation, and also in his Blog, “The Big Picture.” As Barry
notes,
the PWG is every bit as incompetent as most other people in Washington,
but they
do have one special skill: pushing the banking industry’s agenda in
Washington via informal “guidance” and white papers that are written by
and for
compliant regulators. The PWG essentially acts as a super-lobbying
channel
for the largest banks focused right at regulators. Only “team players”
need apply.

The Federal Reserve Bank of New York
and the OCC in Washington
are reportedly drafting the “guidance” on reform of bank securitizations
and at
the request of the PWG. No clue whether the White House is involved
directly yet
or if this is merely a Tim Geithner operation. These PWG white papers
are
never released to the public even though the Treasury acts as the de

facto public affairs organ for this corporate influence group.

We

called out former Wachovia Bank CEO and Goldman Sachs (GS)
banker Robert Steel on the subject of the PWG last year at the Chicago
Fed’s international banking conference. He was unapologetic and more
than
a little offended, or so he claimed. The PWG acts with impunity in
Washington, in part because the members of Congress understand their
subordinate
role. We hear that Senator John Warner (D-VA) is now competing with
Judd Gregg (R-NH) to be the next “Senator from Wall Street” and
specifically
seems to be angling to join a private equity firm. Gregg’s tastes seem
to
run more along the lines of a large OTC derivative dealer
bank.

The fact that the PWG is in league
with the Fed and Treasury
against the FDIC board is all you need to know about the politics of
reforming
private label mortgage securitization. If Barack Obama were really
interested in
reforming Washington, he would rescind President Reagan’s executive
order and
disband the PWG for good. Allowing the big banks which participate in
the PWG to
lobby financial regulators and members of Congress without any public
disclosure
is a national scandal and makes a mockery of any claim by Barrack Obama
to be
changing the business of Washington.

We noted in our comment last Tuesday
in American
Banker, “Viewpoint: Stop Blocking FDIC Securitization Effort,”

that “the practical policy issue is the losses observed in failed banks
over the
past two years, averaging over 30% of total assets, versus just 11% on
average
in the S&L crisis. The common factor in failed banks with high loss
rates is
unsafe and unsound securitizations practices, thus the FDIC initiative
on
securitization.”

It is very telling to us that the FDIC
is advocating greater
openness and transparency in bank sales of mortgage loans to
securitizations,
but the Fed and OCC are standing with the larger dealer banks that
arguably
caused the financial crisis in complex structured assets. Hopefully
these
federal agencies and the industry groups they seem to be allied with
will
realize that the FDIC’s rule making process holds the potential to
revive
private label mortgage finance and that they can influence the outcome -
but
only if they participate constructively.

One mortgage market veteran who ran
risk for one of the largest
private conduits in the business put the situation succinctly last week:
“You
can argue against the FDIC securitization proposals, looking at them in a

bundle, as perhaps being overkill, but each piece of their proposal,
taken
separately, is pretty compelling. The other bank regulators and industry
groups
could easily negotiate a better, more streamlined deal that would help
the
market if they bothered to push back and participate constructively,
instead of
simply attacking the FDIC.”

To read the rest of our rant on the possibility of zombie bank love between Barclays and Citigroup, and the interview with Bill King, click the link below:

http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

– Chris

More articles from Zero Hedge….

Zero Hedge

Ultimately the biggest loser from the whole Repo 105 scandal may not be the perpetrators, i.e., Fuld, the firm’s numerous CFOs, Tim Geithner and Mary Schapiro, but the alleged “fact-checkers” – auditors Ernst & Young. Just like Enron’s Star Wars-based off balance sheet accounting gimmicks brought down Arthur Anderson, so “Repo 105″ may likely be responsible for the downfall of E&Y. Although while in Enron’s case, it was just the accounting that brought the firm down, in Lehman’s case the confluence of numerous factors will render each individual one relatively less critical, potentially to the point of irrelevance. And while book cooking was just as big of an issue for Lehman as it was for Enron, the fact that the bank did pretty much every other borderline illegal thing possible, will take away focus from just the Repo 105 fiasco, or just the liquidity misrepresentations, or just the commercial real estate book mismarking, and so forth. So to facilitate a decision on E&Y culpability, we present a candid look at Ernst & Young’s Financial Services Office, the company’s presentation on Paragraph 10 of IAS 39 overseeing Repo agreements, E&Ys analysis of FAS 140 “Accounting for Financial Transfers and Repurchase Financial Transactions”, the Examiner’s conclusions on the firm’s breach of conduct, the firm’s soon to be dwindling banking client base, and last, and most certainly least, a snapshot of E&Y’s Lehman co-lead partner, Hillary Hansen, against whose negligent actions, as part of the Lehman E&Y practice, the Examiner concludes “that sufficient evidence exists to support a colorable claim for malpractice.”

Follows a presentation of E&Y’s Financial Services Office.

In the United States, Ernst & Young LLP is the only public accounting firm with a separate business unit dedicated to the financial services marketplace. Created in 2000, the New York–based Financial Services Office today includes more than 3,300 professionals in more than 30 locations across the US, as well as in Bermuda, the Bahamas and the Cayman  Islands. Key offices throughout the US include Boston, Charlotte, Chicago, Dallas, Los Angeles, McLean, Minneapolis, New York, Philadelphia, San Francisco and Stamford. Our financial services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, risk and technology, to our asset management, banking, capital markets and insurance clients.

In addition, Ernst & Young professionals in our financial services practices worldwide align with key global industry groups, including Ernst & Young’s Global Asset Management Center, Global Banking & Capital Markets Center and Global Insurance Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and  regulations in order to help our clients address key issues.

The group’s key contacts are listed in the attached presentation. Note the name of Bill Schlich, one of the two E&Y people named by the Examiner as responsible for the negligence colorable claim against the firm in the Lehman case.

E&Y was quite aware of the concept of traditional Repos, as can be ascertained by the following company presentation:

Furthermore, E&Y was certainly quite aware of the nuances of SFAS 140, the accounting board’s green light of what would, with Linklaters’ blessing shortly, become known as Repo 105. In essence, SFAS 140 is what allowed the accounting of repos as true sales. Some complications, as E&Y itself notes, arising from SFAS, are that “in saome cases it may not be possible for attorneys to provide true sale opinions under U.S. bankruptcy law when the transactions are combined and integrated.” The full E&Y SFAS 140-associated education session is presented below.

EY SFAS 140 Repo Alert

A brief tangent here, which goes toward disclosure. Surely the use of SFAS 140 in Lehman’s operations should have merited some mention in the firm’s public filings, which after all would need E&Y’s blessing. Yes and no. As the examiner points out, Lehman did not follow through on full disclosure requirements:

In a few of its financial statements, Lehman stated that “The Company accounts for transfers of financial assets in accordance with SFAS 140” and followed this statement with a summary of SFAS 140’s three criteria for recognizing the transfer of financial assets as sales (LBHI 10?Q, filed July 15, 2002), at p. 8; see also id. at p. 42 (discussing SFAS 140 in the context of securitizations and special purpose entities). In these instances where Lehman made the general disclosure regarding SFAS 140: (1) the SFAS 140 disclosure was listed under “Consolidation Accounting Policies” along with a disclosure regarding Special Purpose Entities or was part of a “Securitization activities” disclosure; (2) Lehman did not state that it treated some repo transactions as sales under SFAS 140; and (3) the financial statement contained other disclosure(s) stating that Lehman treats repo transactions as secured financings (i.e., not as sales) and/or regarding securities owned and pledged as collateral (as described above) (LBHI 10?Q (filed July 15, 2002), at pp. 8, 14; LBHI 10?Q (filed Oct. 15, 2002), at pp. 9?10, 17; LBHI 2002 10?K, at pp. 69, 71, 91; LBHI 10?Q (filed Oct. 15, 2003), at pp. 10?11, 12?13, 20; Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 28, 2007 (Form 10?Q) (filed on Apr. 9, 2007), at pp. 11?12 (“LBHI 10?Q (filed Apr. 9, 2007)”); LBHI 10?Q (filed July 10, 2007), at pp. 11?12; LBHI 10?Q (filed Oct. 10, 2007), at pp. 11?12).

Back to E&Y – where things get really bleak for Ernst & Young is the following disclosure of a whistleblower arising from Lehman’s soon to be ashes, and E&Y’s treatment of his brand new information.

On May 16, 2008, Matthew Lee, then?Senior Vice President in the Finance Division responsible for Lehman’s Global Balance Sheet and Legal Entity Accounting, sent a letter to certain members of Lehman’s senior management identifying possible violations of Lehman’s Ethics Code related to accounting/balance sheet issues. Lehman involved Ernst & Young in its investigation of the concerns raised in Lee’s May 16, 2008 letter.

Subsequently, less than a month later, on June 12, 2008, Ernst & Young – Schlich and Hillary Hansen – interviewed Lee. Hansen’s notes of the interview reveal that Lee made certain statements to Ernst & Young about Lehman’s Repo 105 practice, including, most notably, the volume of Repo 105 activity that Lehman engaged in at quarter?end (May 31, 2008). Hansen’s notes specifically recount Lee’s allegation that Lehman moved $50 billion of inventory off its balance sheet at quarter?end through Repo 105 transactions and that these assets returned to the balance sheet approximately a week later.

To wit:

Hansen’s notes indicate that Lehman’s “Rates [and] Liquid Markets” businesses engaged in “Repo 105/Repo 108 [to] reduce[] assets by 50B [by] moving off B/S [i.e., balance sheet] in Europe & back in 5 days later.” Hillary Hansen, Ernst & Young, Handwritten Notes (June 12, 2008), at p. 1 [EY?LE?LBHIKEYPERS 5826869]. This is consistent with the Examiner’s conclusions that at quarter?end in second quarter 2008, Lehman reduced its balance sheet by slightly more than $50 billion through Repo 105 transactions.

Amusingly, while yesterday we discussed the interorganizational scapegoating, today we arrive at the intra-version. Bill Schlich, the partner named above, is quick to make thing Hansen’s fault.

When interviewed by the Examiner, Schlich did not recall Lee saying anything about Repo 105 transactions during that interview, although he did not dispute the authenticity of Hansen’s notes from the Lee interview. In spite of Hansen’s notes, Schlich maintained that Ernst & Young did not know that Lehman engaged in the following Repo 105 activity during the listed time periods: $49.1 billion at first quarter 2008 (Feb. 29, 2008); and $50.38 billion at second quarter 2008 (May 31, 2008).

Now Hillary Hansen, unwilling to be thrown under the bus without some token defense, also comes out with a scapegoating excuse. Left with little recourse, she blames incompetence.

During the Examiner’s interview of Hansen, Hansen recalled that while Ernst & Young questioned Lee about his May 16, 2008 letter, Lee “rattled off” a list of additional issues and concerns he held, one of which was Lehman’s use of Repo 105 transactions. Ernst & Young had no further conversations with Lee about Repo 105 transactions. Prior to her interview of Lee in June 2008, Hansen had heard the term Repo 105 “thrown around” but she did not know its meaning; according to Hansen, Schlich described Repo 105 transactions to her shortly after they met with Lee.

It is good to know that a head auditor on a top 5 investment bank was unfamiliar with its business practices, and the implications of SFAS 140, even though the firm, as presented above, was edumacating its partners about such things.

We are not sure, however, who Schlich and Hansen will be able to scapegoat this on. Full summary of key events follows:

On June 13, 2008 – the day after Lee informed Ernst & Young of the $50 billion in Repo 105 transactions that Lehman undertook at the end of the second quarter 2008 – Ernst & Young spoke to Lehman’s Audit Committee but did not inform the committee of Lee’s allegation, even though the Chairman of the Audit Committee had clearly stated that he wanted every allegation made by Lee – whether in Lee’s May 16 letter or during the course of the investigation – to be investigated. Ernst & Young met with the Audit Committee on July 8, 2008, to review the second quarter financial  statements and again did not mention Lee’s allegations regarding Repo 105. On July 22, 2008, Ernst & Young was also present when Beth Rudofker, Head of Corporate Audit, gave a presentation to the Audit Committee on the results of the investigation into Lee’s allegations.

 

Ernst & Young did not disclose to the Audit Committee – either during the meetings or in private executive sessions after – that Lee made an allegation related to Repo 105 transactions being used to move assets off Lehman’s balance sheet at quarter-end. Cruikshank told the Examiner that he would have expected to be told about Lee’s Repo 105 allegations. Similarly, Sir Gent told the Examiner that the alleged volume of Lehman’s Repo 105 transactions mandated disclosure to the Audit Committee as well as further investigation...Ernst & Young did not follow?up on either Lee’s allegations regarding Lehman’s Repo 105 activity or Reilly’s claim that he had no knowledge of Lehman’s alleged $50 billion Repo 105 usage figure. Ernst & Young signed a Report of Independent Registered Public Accounting Firm for Lehman’s second quarter 2008 Form 10?Q on July 10, 2008, less than four weeks after Schlich and Hansen interviewed Lee.

Not to beat a dead horse, but E&Y was at fault: as the Examiner points out:

Disclosure of the agreement to repurchase component of Repo 105 transactions was required in the MD&A. Lehman’s repurchase of the securities was a known event that was reasonably likely to occur and would have had a material effect on the company’s financial condition or results of operations. Lehman’s disclosure in the Liquidity and Capital Resources section should have included a discussion of what was known with respect to the timing and/or amounts of the cash flow created by the repayment of the Repo 105 cash borrowing in the first seven to ten days after quarter-end, specifically: (1) the availability of cash as a result of the repayment of the Repo 105 cash borrowing; (2) the ability to borrow more capital because of a reduction in debt rating or deterioration in leverage ratio due to the repayment of the Repo 105 cash borrowing; (3) the effect of the repayment of the Repo 105 cash borrowing on the cost of capital/credit rating; and (4) the economic substance and business purpose of the Repo 105 arrangements.

Indeed, there was a “duty to report”:

SEC Rule 12b?20 requires that all filings contain such additional information necessary to make the information contained in the filing not misleading. Moreover, “Once defendants choose to speak about their company, they undertake a duty to ‘speak truthfully and to make such additional disclosures as…necessary to avoid rendering the statements misleading.’”

And here is why the plaintiff bar is really hung over today. The lawsuits are coming:

An investor reviewing Lehman’s 2007 Form 10?K and two 2008 Forms 10?Q would not have been able to discern that Lehman was engaged in Repo 105 transactions. Indeed, Lehman made no disclosures in its Statement of Income, Statement of Financial Condition, Statement of Cash Flows, or MD&A sections (including its section on liquidity) from which an investor could infer that Lehman treated a certain volume of repo transactions as sales under SFAS 140, thereby decreasing its net assets and its net leverage ratio…In addition, even a sophisticated reader of Lehman’s financial statements would not have been able to ascertain from Lehman’s 2007 Form 10?K or its first and second quarter 2008 Forms 10?Q the amount of Lehman’s Repo 105 usage, nor even ascertain the fact that Lehman was engaged in these transactions, by attempting to quantify the amount of liquid securities temporarily removed from the balance sheet, as reported in Lehman’s public financial statements.

We sure hope that Fuld, O’Meara, Callan, Lowitt and all of E&Y are promtly depositing money in their legal representation singking fund:

The Examiner finds that sufficient evidence exists to support the finding of colorable claims against Richard Fuld, Christopher O’Meara, Erin Callan, and Ian Lowitt in connection with their actions in causing or allowing Lehman to file periodic reports that did not disclose Lehman’s use of Repo 105 transactions and against Ernst & Young for its failure to meet professional standards in connection with that lack of disclosure… While there were credible facts and arguments presented by each that may form the basis for a successful defense, the Examiner concluded that these possible defenses do not change the now final conclusion that there is sufficient evidence to support a finding that claims of breach of fiduciary duty exist against Fuld, O’Meara, Callan, and Lowitt and a colorable claim of professional malpractice exists against Ernst & Young.

And focusing again purely on E&Y:

The Examiner concludes that sufficient evidence exists to support colorable claims against Ernst & Young LLP (“Ernst & Young”) for professional malpractice arising from Ernst & Young’s failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman’s public filings.

This surely can not be good news to E&Ys current batch of existing banking clients, which are US Bancorp, SunTrust, CapitalOne, Regions Financial, KeyCorp, Comerica, Cullen/Frost Bankers, and Zions Bancorp, among the largest ones. In fact, we anticipate that the termination letters are already in the mail.

Meet Hillary Hansen.

The weakest link in the above presentation is surely E&Y partner, and co-head of the Lehman account, Hillary Hansen. For all of you who would like to get a glimpse of this presumably tireless workhorse which was supposed to be working 24/7 figuring out what the hell was going on with Lehman’s books, you may be in for a disappointment. In this Fora TV presentation on the topic of “Women’s Networks Help Level the Playing Field” from January, 2009, we get a glimpse into Ms. Hansen’s busy lifestyle “I am a woman raising three small children, I commute from far away, I work home two days, usually I am not in on Fridays (laughter), I telecommute and often times I get asked how I fit it all together.” Oh yes, Ms. Hansen we are confident you will be getting that question and many others very soon. What we found hilarious is Ms. Hansen’s sentiment vis-a-vis her audit client Lehman Brothers. Fast forward to 17:15, where Hansen discloses that “We audit Lehman Brothers, UNFORTUNATELY.” Once again prophetic. However in the wrong direction. Something tells us that Lehman’s shareholders, despite knowing how great of a woman networker and a terrific partially-stay at home mom M.s Hansen may be, coupled with just how horrendous of an auditor, the lawsuits that are sure to follow will focus on the latter.

Full link of Hansen’s brief unspired monologue after the jump.

With all this information, we are confident that (again, with the assumption that we live in some semblance of a sane/ration world), E&Y’s Financial Services Office is done (even despite such ironically apropos warnings on the firm’s website as “Top six liquidity risk management challenges for global banks “), and quite possibly the entire firm. Integrity is the number one currency for an auditor, and just like Anderson, E&Y’s just went out in a puff of green-colored smoke. Then again, with America’s population broadly distracted by the healthcare debate, by the phantasmagorical market, and by mass scapegoating campaigns in which nobody seems intent on getting to the bottom of the responsibility chain, we will be very much unsurprised if nothing ends up happening, and the well-greased machine of endless corruption keeps chugging along as per usual.

And here, due to popular demand, is E&Y’s Global Code Of Conduct.

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