Tue | Jan 31, 2023

Unravelling Lehman's creative destruction

Published:Friday | April 16, 2010 | 12:00 AM
Wilberne Persaud, Financial Gleaner Columnist

Intermittent revelations about Lehman Brothers' operations immediately prior to its collapse provide an interested public with a rare keyhole view into a once scenic, beautiful cave, the attraction and envy of all the world's wannabe financial centres. Historically, Wall Street has been responsible for, rather, enabled and facilitated, tremendous US innovation and development impacting the international economy.

It garnered funds, made smooth, seamless links among passive savers, risk-loving investors, innovative dreamers.

All of this resulted from its capacity to continuously craft appropriate financial instruments to fuel the creative destruction so fundamentally important to expanding US industrial development, output as well as business organisational innovation.

Alas, beginning with the 1999 repeal of the Glass-Steagall regulatory mechanisms, it has entirely lost its way.

As the Lehman-crafted veil, described as potential cause for colorable action by the bankruptcy examiner, unfurls, we become aware of the toxicity spread at Wall Street's core by greed expressing itself through perverse and pervasive short-run objectives: quarterly profit numbers and potential dividends, shady efforts to achieve projected and announced share price and a focus on bonuses guaranteed to be harvested by creative accounting, among other shenanigans.

The latest revelatory drip, like acid rain on the Wall Street roof, comes from a piece by Louise Story and Eric Dash in The New York Times of April 12. Lehman strategically bought into a firm called Hudson Castle. While Castle operated in the public sphere as an independent entity, it was, the newspaper reported, actually "deeply entwined with Lehman. For years its board was controlled by Lehman, which owned a quarter of the firm".

I positively love their turn of phrase in this comment: Hudson Castle was "stocked with former Lehman employees".

The effect of this arrangement was to create a "hidden passage on Wall Street, a secret channel that enabled billions of dollars to flow through Lehman Brothers". The architect of this arrangement and procedure was a Lehman staffer, Kyle Miller.

His memorandum explored how an investment in Hudson Castle would allow Lehman and its clients access to financing without the risk of having to undergo public scrutiny should anything go south. Miller refers to this possibility as "headline risk" - bad publicity.

He also emphasised the reduced "moral obligation" it would create for its off-balance sheet accounting treatment of the interlocking non-autonomous transactions - transactions entered into not for independent reasons but merely for the look and feel of the accounts.

Miller went on to become president of Castle.

There's much more to discuss but the implications are clear and easily identified. Without enabling lawyers, accountants and auditors whose decisions are allowed by regulators, these kinds of arrangements could never by implemented. We had a huge glimpse of this already from the Enron debacle of late 2000.

Jamaica had its fair share of these kinds of activities in the 1990s as former governor of the Bank of Jamaica, Jacques Bussières, pointed out in an Observer article of March 18, 1996.

At that time, Bussières pointed out that "no matter how much effort is made to improve the legislative framework, and how much human and financial resources are devoted to strengthening the supervisory process, there will always be one essential element that is required, if the people of Jamaica are to have confidence in their financial system.

"This element is integrity. ... Not everyone in the financial system shares the same philosophy. ... Some have a confused view of what is meant by fiduciary responsibility. They have exhibited a tendency to believe that depositors' money is their money and have in the process lent to themselves large sums of money to purchase real estate or other assets in pursuit of their own self-ambition. They have repeatedly violated the law in full cognisance of it and quite often they have been supported in their endeavours by some members of the legal and accounting profession."

Since Lehman was trading bothfor clients and its own account, this comment is entirely apposite. Ethics in business, 'good' corporate governance, is a prerequisite for fiduciary responsibility.

The US$700-billion Troubled Asset Relief Program meant to deal with the subprime mortgage crisis and much larger assistance provided by the US Treasury and the Federal Reserve's low-interest rate policy has bailed out Wall Street.

The rebound is so rapid that the New York stock market is bubbly. Bonuses are back to pre-meltdown numbers. Some argue that the federal government will make a profit on the deal.

Yet, many are unconvinced that the economy is truly out of intensive care. They are correct.

The foreclosure rate leaving millions of Americans still in over their head with mortgage debt, unemployed and too uncertain of the future to spend normally means recovery is weak. The problem is that foreclosures drive down market value of all residential real estate. The impact of this is a weak construction industry with more than 25 per cent unemployment compared to the overall rate of around nine per cent. Interconnectivity of this industry to growth is uncontested.

Apart from the clear need to bring equity to the response - a matter of days to bail out Wall Street but almost two years with no real effort of the banks to live up to the arrangement for mortgage modification - the real economic recovery remains in jeopardy.

Financial Gleaner letter writer of April 9, Duane Barrett, CPA, informs us of regulatory responses to inappropriate behaviours on Wall Street thought to be cause for colorable action.

I am sure readers are aware "that members of the US analyst and accounting community have always taken the issue of accounting shenanigans very seriously", even if not the fact that "several aspects of the exam syllabus detail how to uncover accounting schemes that attempt distort the financial picture of an entity and the warning signs to be on the lookout for".

My only comment: This is demonstrably an inadequate response.