Experts’ Biggest Fear: New Dodd Bill Won’t Stop Another Meltdown, “Epidemic” of Wall Street Fraud

The political jousting since Sen. Chris Dodd proposed new financial reforms on Monday seems at first to be just another Washington ideological rift: liberals favoring regulating an industry, and Big Business and Republicans opposing it. With the Chamber of Commerce willing to spend $3 million to defeat Dodd’s bill, plus $50 million in a broad-based campaign targeting dozens of vulnerable Democrats, some liberals doubtless feel it must surely be a powerful blow against the excesses of the financial industry.

After all, Senator Dodd proclaimed about the importance of his reform bill: “There hasn’t been a financial reform on the scale that I’m proposing this afternoon since the 1930s.” In truth, it’s significantly weaker than the one he introduced last fall as he’s fruitlessly sought Republican votes. And, it’s worth noting, FDR’s original reforms that reined in Wall Street and protected consumers were not filled with the sort of carve-outs for financial industries and traders that spent nearly $500 million in lobbying last year, money well spent when one considers the loophole-laden bills in the House and Senate (with the House bill having a more independent consumer agency.)

“This bill wouldn’t have prevented the past crisis, and it won’t prevent a future crisis,” says William K. Black, an economics and law professor at the University of Missouri, Kansas City, and the former senior financial regulator who cracked down on the savings and loan industry in the 1980s. In a wide-ranging interview with Truthout, Black, joining other critics, raised alarms about assorted obscure bookkeeping ploys and outright scams that are laying the groundwork for the next meltdown. Moreover, the ongoing partisan tussling over financial reform and the independent consumer agency he supports are drawing attention away from the importance of getting the Obama administration to crack down on the corporate criminals now.

“Let’s jail the crooks and we don’t have to wait for new legislation,” he said. He argued that there are plenty of laws and regulations on the books – and more rules that can be written under regulators’ current authority – allowing for a widespread crackdown, from civil lawsuits to prosecutions, targeting those who hid the collapsing value of “toxic” assets and investments they sold and evaluated. He pointed out, “During the savings and loan debacles, the Justice Department had 1,000 priority felony convictions – that’s almost one every three days of the news cycle.” He also observed, “At this stage among the subprime lending specialists, we have zero convictions. We have zero indictments.”

While progressives have been clamoring for Obama and the Democrats to seize the populist mantle to help pass their agenda and keep control of Congress, Black is pointing to a straightforward way for the Obama administration to gain populist cred. On top of that, he noted, such tough law enforcement and regulatory actions “create the space and momentum to pass reform legislation.” Yet, critics say, the coziness of Obama’s top economic advisers, along with Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner, with their former Wall Street colleagues makes it highly unlikely we’ll see full-scale reform, true transparency by Wall Street and federal regulatory agencies, or the aggressive (and crowd-pleasing) prosecution of wrongdoers.

In looking over the full scope of the proposed Senate legislation, Black argued, “This is actually going to make it harder for us to take regulatory steps that are needed to reduce the risk of financial collapse.” That may sound like an extreme claim, but Black argued that real enforcement is undermined by what he calls “window-dressing” reforms in the Dodd bill – like having a presidentially appointed head of the all-important New York Fed or, even riskier, having limited clearinghouses for often overvalued “derivatives,” thus creating a dangerously false sense of security while free-wheeling trading with phony pricing continues. Derivatives are bets or investment vehicles supposedly based on underlying assets, and there’s a good reason that Warren Buffet has called them “financial weapons of mass destruction.”

Despite the unpopularity of the big banks, Congress hasn’t been overrun with a populist rage demanding specific financial reforms, so industry lobbyists have been free to seek out arcane loopholes as Dodd sought to craft a bill that could gain the 60 votes to break a Republican filibuster. As Bloomberg News declared bluntly, “Dodd Overhaul Bill Dilutes Obama Plan to Seek Support.” Bloomberg reported:

Senate Banking Committee Chairman Christopher Dodd’s plan for the biggest Wall Street regulatory overhaul since the 1930s drops provisions he sought in November and dilutes others as he seeks bipartisan support.

The measure shelves a single regulator that would have stripped the Federal Reserve and Federal Deposit Insurance Corp. of bank-supervision roles, and a plan to hold brokers to the same fiduciary standard as investment advisers. Dodd’s plan for an independent consumer protection agency becomes a unit within the Fed and the so-called Volcker Rule to limit risky trading by banks would be introduced only after a period of study.

Critics point to other dangerous compromises: more exemptions for the risky investment bets known as derivatives; allowing banks and investment firms to continue to mask their losses through over-valued assets and shady accounting tricks; and muzzling an independent consumer protection agency by housing it in the pro-banking Fed, although it would be nominally “independent.”

Yet, the Fed’s new in-house consumer bureau could only regulate the largest banks and mortgage companies, while everyone from most payday lenders to small banks to auto dealers could continue to peddle their dicey loans.

On top of that, the compromised agency’s actions are subjected to a veto by a “systemic risk” council made up of the same federal regulatory agencies that ignored the bubbles, scams and frauds that caused the last meltdown. As the advocacy group Consumer Watchdog’s Washington Director Carmen Balber remarked, “You can’t pull an agency’s teeth, and let other regulators tie its hands, and still call it an independent champion for consumers.”

Even so, in the world of pragmatic politics on the Hill, most reformers aren’t nearly as harsh as Black or Balber because they’re hoping that some reform is better than none at all, while working in a harsh political climate to strengthen what’s been introduced. Heather Booth, the executive director of the 200-group, progressive Americans for Financial Reform, told reporters this week that she was “concerned” and “troubled” by the limitations on the consumer agency and other loopholes, but they’re not drawing any lines in the sand yet over the legislation:

“We are troubled by the provisions that allow Consumer Financial Protection Agency decisions to be appealed to a council dominated by institutions that failed consumers in the past, and by holes in its enforcement authority. Derivatives, and other elements of the shadow markets must be clearly and effectively regulated, without exceptions or loopholes that undermine these rules, and we must put real measures in place to take on the menace of ‘too big too fail’ banks playing heads they win tails we lose games with our economy….

“It has been well over a year since the Big Banks bought our economy to the edge of the abyss. It is far past time for action.”

In this case, though, unlike the value of a compromise health care law, if Democrats settle for what could turn out to be a fig leaf of reform, it may not provide any political benefit at all. That’s because of the off-balance sheet accounting and other tricks to hide losses from regulators and investors that are still allowed to continue. The result could well be another financial collapse, abetted by trillions in taxpayer loans, bailouts and guarantees that make risk-taking so pervasive that “all we get is moral hazard,” Black said, citing the perverse incentives to risk wrecking the economy for short-term gain.

With his years of studying fraudulent banks, Black said, “accounting fraud is the ideal weapon.” When combined with lavish executive compensation for short-term profits, our current system – fundamentally unchanged by the Dodd proposal, he said – creates what he called a “criminogenic environment” leading to “epidemics of accounting fraud.”

In the recent report on Lehman Brothers’ failure, for instance, the court-appointed examiner revealed that Lehman Brothers, apparently with the acceptance or possible collusion of then-New York Fed President Geithner (which he denies), temporarily sold off its often-shaky assets to raise $50 billion in cash to hide its losses. It’s yet another Enron-style move known as “Repo 105.”

Black’s colleague, L. Randall Ray, an economist at the University of Missouri, Kansas City, contended in the blog Naked Capitalism that the Lehman Scandal should be called “Timmy-Gate,” and asked, “Did Geithner Hide Lehman Fraud?” He argued:

Just when you thought that nothing could stink more than Timothy Geithner’s handling of the AIG bailout, a new report details how Geithner’s New York Fed allowed Lehman Brothers to use an accounting gimmick to hide debt. The report, which runs to 2200 pages, was released by Anton Valukas, the court-appointed examiner. It actually makes the AIG bailout look tame by comparison. It is now crystal clear why Geithner’s Treasury as well as Bernanke’s Fed refuse to allow any light to shine on the massive cover-up underway.

Recall that the New York Fed arranged for AIG to pay one hundred cents on the dollar on bad debts to its counterparties-benefiting Goldman Sachs and a handful of other favored Wall Street firms. The purported reason is that Geithner so feared any negative repercussions resulting from debt write-downs that he wanted Uncle Sam to make sure that Wall Street banks could not lose on bad bets. Now we find that Geithner’s NY Fed supported Lehman’s efforts to conceal the extent of its problems. Not only did the NY Fed fail to blow the whistle on flagrant accounting tricks, it also helped to hide Lehman’s illiquid assets on the Fed’s balance sheet to make its position look better. Note that the NY Fed had increased its supervision to the point that it was going over Lehman’s books daily; further, it continued to take trash off the books of Lehman right up to the bitter end, helping to perpetuate the fraud that was designed to maintain the pretense that Lehman was not massively insolvent.

Indeed, Geithner somehow just couldn’t remember if he knew about the still-legal accounting scam, according to the court examiner’s report (via Zero Hedge):

From 2003 to 2009, Treasury Secretary Timothy Geithner served as President of the Federal Reserve Bank of New York (“FRBNY”). The Examiner described to Secretary Geithner how Lehman used Repo 105 transactions to remove approximately $50 billion of liquid assets from the balance sheet at quarter-end in 2008 and explained that this practice reduced Lehman’s net leverage. Secretary Geithner “did not recall being aware of” Lehman’s Repo 105 program, but stated: “If this had been a bank we were supervising, that [i.e. Lehman’s Repo 105 program] would have been a huge issue for the New York Fed.”

The Lehman report, the first truly thorough probe of any financial institution involved in the crash, illustrates a broader scandal at work in Wall Street and across the financial industry, Black believes. Yesterday, he and Eliot Spitzer called in an op-ed for an immediate Congressional investigation and potential prosecutions:

The damning 2,200-page report, released last Friday, examines the reasons behind Lehman’s failure in September 2008. It reveals on and off balance-sheet accounting practices the firm’s managers used to deceive the public about Lehman’s true financial condition. Our investigations have shown for years that accounting is the “weapon of choice” for financial deception. [Bank examiner Anthony] Valukas’s findings reveal how Lehman used $50 billion in “repo” loans to fool investors into thinking that it was on sound financial footing … Such abusive off-balance accounting was and is endemic. It was a major cause of the financial crisis, and it will lead to future crises.

According to emails described in the report, CEO Richard Fuld and other senior Lehman executives were aware of the games being played and yet signed off on quarterly and annual reports. Lehman’s auditor Ernst & Young knew and kept quiet.

The Valukas report also exposes the dysfunctional relationship between the country’s main regulatory bodies and the systemically dangerous institutions (SDIs) they are supposed to be policing …

The Federal Reserve Bank of New York (FRBNY) knew that Lehman was engaged in smoke and mirrors designed to overstate its liquidity and, therefore, was unwilling to lend as much money to Lehman. The FRBNY did not, however, inform the SEC, the public, or the Office of Thrift Supervision (which regulated an S&L that Lehman owned) of what should have been viewed by all as ongoing misrepresentations….

Black, Spitzer and other experts are especially worried at the continued fakery in pricing and valuation of assets, along with unchecked accounting fraud, that are all setting us up for another fall. They point to the little-noticed change when an obscure federal accounting board was successfully pressured to allow banks to ignore traditional market-value pricing for their near-worthless assets. Instead, bank officials were allowed to value them at nearly the inflated prices they were bought for at the height of the real estate bubble – thus allowing banks and Wall Street executives to artificially boost their profits (and their multi-billion dollar bonuses). As Spitzer and Black warned:

Three years since the collapse of the secondary market in toxic mortgage product, we have yet to see significant prosecutions of the kind of fraud exposed in the Valukas report. The Systematically Dangerous Institutions (SDIs), with Bernanke’s open support, extorted the accounting standards board (FASB) to change the rules so that banks no longer need to recognize their losses. This has made the SDIs appear profitable and allows them to pay their executives massive, unearned bonuses based on fictional profits.

If we are to prevent another, potentially more devastating financial crisis, we must understand what happened and who knew what. Many SDIs are hiding debt and losses and presenting deceptive portraits of their soundness. We must stop the three card monte accounting practices that create the potential and reality of fundamental misrepresentation.

Yet, casino-style risky investments and bogus accounting schemes are still widespread – and not really addressed in pending legislation and too weakly enforced under current laws. As Frank Partnoy, a financial journalist, observed in his scathing Daily Beast article, “The Dodd Wall Street Charade”:

“The gaping hole in the bill involves a concept known as off-balance sheet accounting. The dirty secret of the markets is that financial statements of major Wall Street banks were, and still are, a fiction. Until bank balance sheets reflect reality, financial reform will not work.”

In fact, Partnoy reprints Citigroup’s balance sheet from 2006 through 2009, with its claim that its assets during the worst year of the financial crisis, 2008, were $1,938 billion. He observed:

There is not even a hint in these numbers that the value of Citigroup’s business went from a quarter of a trillion dollars to nearly zero. There is no indication that Citigroup suffered massive losses in 2007 and 2008, and then a major post-rescue recovery in 2009. Instead, the balance sheet suggests that Citigroup’s was steadily and consistently healthy for all four years. This balance sheet is, in a word, fiction.

Citigroup is not alone. The balance sheets of every major Wall Street bank are equally fictitious. They do not reflect trillions of dollars of swaps. They do not include so-called “Variable Interest Entities,” the subsidiaries banks use to avoid recording risks. Instead, the banks’ exposure is off-balance sheet. Their financial statements do not show many of their actual liabilities.

This mostly legal deception isn’t just another variation of white collar crime we can hope gets punished someday. It actually affects the soundness of our economy and the ability to rein in Wall Street’s most destructive abuses that have already cost American households $12 trillion in lost wealth. L. Randall Ray says there will be even more fallout for yet another underreported accounting scam, the federal government’s own E-Z “stress tests” for banks, once described by William Black as “a complete sham that makes us chumps.” Ray argued:

As our all-time favorite Fed Chairman Alan Greenspan liked to put it, “history shows” that when financial institutions pass their own stress tests, they are actually massively insolvent. There is no reason to believe that this time will be different. Mike Konczal reports that there is every reason to believe the biggest banks are hiding huge losses on second liens. These are second mortgages or home equity loans that amount to about $1 trillion of which almost half are held by the top four banks…. Since the first principal of a mortgage is paid first, it is likely that much of the second liens are worthless…. [if counted accurately] the four largest banks would have “an extra $150 billion hole in the balance sheet”

What will that mean for the rest of us? Ray’s warning couldn’t be any more dire:

Of greater importance is the recognition that all of the big banks are probably insolvent. Another financial crisis is nearly certain to hit in coming months-probably before summer. The belief that together Geithner and Bernanke have resolved the crisis and that they have put the economy on a path to recovery will be exposed as wishful thinking. In the bigger scheme of things, this is only 1931. [Emphasis added.]

One of the few mainstream journalists to make all these dangers crystal clear is MSNBC’s loud, but forceful, Dylan Ratigan, who isn’t buying what he sees as weak reforms that ignore fundamental deceptions in the financial marketplace:

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