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At Lehman, Watchdogs Saw It All

Almost two years ago to the day, a team of officials from the Securities and Exchange Commission and the Federal Reserve Bank of New York quietly moved into the headquarters of Lehman Brothers. They were provided desks, phones, computers — and access to all of Lehman’s books and records. At any given moment, there were as many as a dozen government officials buzzing around Lehman’s offices.

Former U.S. Securities and Exchange Commission Chairman Christopher Cox.
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Former U.S. Securities and Exchange Commission Chairman Christopher Cox.

These officials, whose work was kept under wraps at the time, were assigned by Timothy Geithner, then president of the New York Fed, and Christopher Cox, then the S.E.C. chairman, to monitor Lehman in light of the near collapse of Bear Stearns.

Similar teams from the S.E.C. and the Fed moved into the offices of Goldman Sachs, Morgan Stanley, Merrill Lynch and others.

There were plenty of reasons to send in these SWAT teams. With investors on edge about the veracity of valuations on Wall Street — and with hedge fund managers like David Einhorn publicly questioning Lehman’s numbers — the government examiners rifled through Lehman’s accounts. They also interviewed executives about various decisions, and previewed the quarterly earnings reports.

Yet now, two years later, we learn through a 2,200-page report from Lehman’s bankruptcy examiner, Anton R. Valukas, that the firm was taking a creative approach with its valuations and accounting.

One crucial move was to shift assets off its books at the end of each quarter in exchange for cash through a clever accounting maneuver, called Repo 105, to make its leverage levels look lower than they were. Then they would bring the assets back onto its balance sheet days after issuing its earnings report.

And where was the government while all this “materially misleading” accounting was going on? In the vernacular of teenage instant messaging, let’s just say they had a vantage point as good as POS (parent over shoulder).

The new mystery is why it took this long for anyone to raise a red flag. “Even though Lehman dressed up its accounts for the great unwashed public, it did not try to fool the authorities,” Yves Smith, the author of “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism,” wrote on her blog last week. “Its game-playing was in full view.”

Indeed, it now appears that the federal government itself either didn’t appreciate the significance of what it saw (we’ve seen that movie before with regulators waving off tips about Bernard L. Madoff). Or perhaps they did appreciate the significance and blessed the now-suspect accounting anyway.

Oddly, when the bankruptcy examiner asked Matthew Eichner of the S.E.C., who was involved with supervising firms like Lehman, whether the agency focused on leverage levels, he answered that “knowledge of the volumes of Repo 105 transactions would not have signaled to them ‘that something was terribly wrong,’ ” according to the examiner’s report.

There’s a lot riding on the government’s oversight of these accounting shenanigans. If Lehman Brothers executives are sued civilly or prosecuted criminally, they may actually have a powerful defense: a raft of government officials from the S.E.C. and Fed vetted virtually everything they did.

On top of that, Lehman’s outside auditor, Ernst & Young, and a law firm, Linklaters, signed off on the transactions.

The problems at Lehman raise even larger questions about the vigilance of the S.E.C. and Fed in overseeing the other Wall Street banks as well.

“I’m concerned that the revelations about Lehman Brothers are just the tip of the iceberg,” Senator Ted Kaufman wrote in a speech he was preparing to give Tuesday on the Senate floor. “We have no reason to believe that the conduct detailed last week is somehow isolated or unique. Indeed, this sort of behavior is hardly novel.”

Here’s how Repo 105 worked in simple terms: At the end of each quarter, to reduce its all-important leverage levels, Lehman would “sell” assets (typically highly liquid government securities) to another firm in exchange for cash, which it would use to pay down its debt. The assets were typically worth 105 percent of the cash Lehman received. Several days later, after reporting its earnings, it would buy the assets back. Normally, this would be considered a loan, or repurchase agreement, but instead it was booked as a sale.

Huge piles of cash were moving in and out. According to the examiner’s report, “Lehman reduced its net balance sheet at quarter-end through its Repo 105 practice by approximately $38.6 billion in fourth quarter 2007, $49.1 billion in first quarter 2008, and $50.38 billion in second quarter 2008.”

Perhaps tellingly, there is no evidence that Lehman kept two sets of books or somehow tried to hide what it was doing from regulators. The bankruptcy examiner spent over a year searching through virtually every e-mail message at the firm and didn’t say he found any evidence of a cover-up.

That may explain why so few at the firm seemed to think that what they were doing was wrong, based on the e-mail traffic reviewed by the examiner. They talked openly about Repo 105. And while some apparently felt queasy about it, they also repeatedly said that it was legal (there are no e-mail messages from Richard Fuld Jr. or any senior executive directing another executive to use Repo 105 to mask earnings).

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.

Whatever the case, in an age calling for more accountability on Wall Street, it seems we could use some in Washington too.