A FEW weeks ago, two Republican House members asked Ben Bernanke, the chairman of the Federal Reserve, whether the Fed knew — before Lehman’s bankruptcy examiner revealed it — about the bookkeeping scam at Lehman known as “Repo 105.??? This scam allowed Lehman to disguise how much debt it was carrying, right up until it collapsed. Lehman got new loans to pay off old loans, pretended the new loans were “sales,??? and through a complicated series of steps made both the old and new loans disappear just in time for its quarterly reports.
Well, the truth is this: The collapse of Enron back in 2001 revealed that the biggest financial institutions, here and abroad, were busy creating products whose sole purpose was to help companies magically transform their debt into capital or revenue. At the time, there were news reports about Merrill Lynch pretending to buy Nigerian barges from Enron, JPMorgan Chase dressing up its loans to Enron as commodity trades and Citigroup disguising Enron debt as profits from Treasury-bill swaps.
Ideas like the proposal by Paul Volcker, the former Fed chairman, to prohibit traditional banks from trading on their own accounts, will do little to improve the situation so long as enforcement is left up to regulators’ discretion. Passing piecemeal fixes to outlaw each fraud-inviting instrument — like the provision slipped into the recent jobs bill that outlaws a derivative that had been designed by the industry to allow individuals to evade paying taxes on their stock dividends — will never be a substitute for restoring civil liability for abetting securities fraud. Innovation can too easily outstrip specific rules.
Yes, we can lay Lehman’s Repo 105 and the proliferation of dangerously complex instruments at the feet of the Fed, the S.E.C. and the other signatories to the watered-down interagency statement. Years earlier, after Enron collapsed, they learned all they needed to know about the bogus structures banks developed to conceal financial instability. Yet by backing down and giving in, the regulators encouraged them. We are paying for those mistakes today.
