As I noted a few days ago, Lehman used what any normal human being would have called, “accounting fraud.”

Well, we have some more details, and it appears that the New York Bank of the Federal Reserve, and its president, current Treasury Secretary Timothy Geithner, knew it, and did nothing about it.

Basically, this was all about what is called “Repo” transactions.

Essentially, it’s a way to get short term cash by turning over assets as collateral, which is normal and ordinary. It’s a lot like pawning your wedding ring, only the amounts are much larger, and typically the periods of the loan are typically shorter.

So, what is the problem?

Well, ignoring the fact that the assets were in reality absolute crap, which is really a matter of due diligence for the lender, if you remain responsible for any losses in value of these assets, and you structure the transaction so that it does not show up on your balance sheet, because they booked the transaction as a sale of assets, as opposed to borrowing money.

The thing is, that this is illegal, or at least without precedent, in the United States, so they justified the activities, which took place in the United States, by claiming that they operated under UK law:

When Lehman first designed Repo 105 in 2001, however, there was one catch. The firm couldn’t get any American law firms to sign off on the aggressive accounting, namely that these transactions were true sales instead of what amounted to the parking of assets. From the firm’s own Repo 105 accounting policy document, according to the report:

Repos generally cannot be treated as sales in the United States because lawyers cannot provide a true sale opinion under U.S. law.

Enter Linklaters, [a “magic circle” law firm, the US equivalent is a “white shoe” law firm] which grounded its legal brief in English, rather than American, law. The firm explicitly said: “This opinion is limited to English law as applied by the English courts and is given on the basis that it will be governed by and construed in accordance with English law.”

The full legal opinion is after the break.

In any case, other investment banks are denying that they use this accounting gimmick, to which I reply, “Yes, and you will respect me in the morning, the check is in the mail, and you won’t cum in my mouth.”

It’s no wonder that the bankruptcy examiner described the behavior as, “grossly negligent.”

Let me make this clear, I have not read the report, it’s 1053 pages long not counting appendices, but Yves Smith did, and she finds that the NY Fed did not exercise due diligence, and cites the footnotes:

Liquidity was an important factor in the stress testing that Lehman was required to run under the CSE Program. After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress‐testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank.⁵⁷⁵³ The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.”⁵⁷⁵⁴ Lehman failed both tests.⁵⁷⁵⁵ The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed.⁵⁷⁵⁶ However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed.⁵⁷⁵⁷ It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

(emphasis mine)

So it appears that little Timmy Geithner allowed Lehman to game the stress tests so as to pass, which makes one wonder about the stress tests of the remaining financial institutions last year?

Geithner is either incompetent, or completely captured by the finance industry, or corrupt.

In any of these cases, he should have been given the boot long ago.

You know the one where Geithner negotiated the results with the banks?

A final note on all this, for some reason, the blogs are doing a good job of covering all of this, but the papers are burying the story on inside pages, with the WSJ placing it on page C7, and the NYT placing it on B2.

Legal opinion after the break:

Linklaters Letter to Lehman Brothers re Repo 105