Don't Wait for Reform

Former Treasury Secretary Hank Paulson admitted in his recent memoir that Lehman Brothers' balance sheet was bogus before the bank collapsed in 2008. Nonetheless, Lehman paid out $5.2 billion in bonuses in 2006 and $5.7 billion in 2007. Lehman's investors lost a fortune, of course. But Paulson doesn't extend his logic to its natural conclusion. Lehman's practices weren't all that different from those of every other big bank on Wall Street. Lehman was just the first to go under, causing a financial run that led George W. Bush to warn "this sucker could go down" unless the federal government came up with hundreds of billions to bail out the remaining banks. It should be obvious that the bailouts concealed the other banks' bogus balance sheets -- thereby covering their assets and their asses.

We now know, for example, that Goldman Sachs along with a few other banks helped Greece hide its public debt and then placed financial bets that Greece would default, using "credit-default swaps" to avoid risking its own capital. It's the same tactic Goldman used for (and against) American International Group (AIG): Hide the ball, and then bet against the ball and fob off the risk to investors and taxpayers -- using derivatives such as credit-default swaps to make sure no evidence of the risky tactics appears on the balance sheets. Even today, no one knows the fair value of the complex derivatives underlying these and related maneuvers, which is exactly the point. One can only wonder how many other countries, and companies, may blow up in the future.

Now that bonuses are flowing again, the Street is awash in apologies. Morgan Stanley's John Mack says he regrets his firm's role in the credit crisis and is "especially sorry for what's happened to shareholders." Goldman Sachs' Lloyd Blankfein admits the firm "participated in things that were clearly wrong and we have reason to regret." John Reed, former co-chief executive officer of Citigroup, apologizes to "people I love and care about" who lost everything as a result of the creation of the financial behemoth a decade ago.

Apologies are cheap. But the banks fear genuine financial reform would cost them a bundle if it stopped the use of off-balance-sheet derivatives that have allowed the banks to place big bets with little capital. So even as Wall Street sheds crocodile tears about the terrible things it's done, it is throwing money at Capitol Hill to thwart reforms that would prevent it from continuing to do terrible things.

The political payoffs seem to be working. Proposed legislation from Treasury and the House (at this writing, the Senate Banking Committee hasn't reported out) has loopholes big enough to allow bankers to drive their Ferraris through them. Specifically, they permit secret derivative trading in foreign-exchange swaps (similar to what Goldman used to help Greece hide its debt) and in transactions between big banks and many of their corporate clients (as with AIG).

Before you wallow in hopeless cynicism, though, it's worth noting that we already have a law against this. It's called the Sarbanes Oxley Act of 2002. It just needs to be enforced.

Think back to the corporate looting scandals that came to light almost a decade ago when the balance sheets of Enron, WorldCom, and others were shown to be fake, causing their investors to lose their shirts. Nearly every major investment bank played a part in the fraud -- not only advising the companies but also urging investors to buy their stocks when the banks' own analysts privately described them as junk.

Sarbox, as it's come to be known, was designed to stop this. It requires CEOs and other senior executives to take personal responsibility for the accuracy and completeness of their companies' financial reports and to set up internal controls to assure the accuracy and completeness of the reports. If they don't, they're subject to fines and criminal penalties.

Sarbox is directly relevant to the off-the-balance-sheet derivative games Wall Street has been playing. No bank CEO can faithfully attest to the accuracy and completeness of its financial reports when derivatives guarantee that the reports are incomplete and deceptive.

I was on a panel recently with a former chair of the Securities and Exchange Commission who was asked why the commission wasn't enforcing Sarbox against Wall Street. He had no response except to mumble that legislation is meaningless unless adequately enforced. Exactly. So while financial reform is needed, there's no reason to wait for it. The SEC should immediately go after the big banks' top executives using the tools it was given after the last scandal.

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