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Robert Kuttner

Robert Kuttner

Posted: March 28, 2010 08:58 PM

Next, Banking Reform

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It was a pleasure to see President Obama exercise some leadership and muscle towards health reform, and more recently to pass a true "public option" for student loans. Apparently, the experience of leadership felt good, for the president decided to follow up by deciding to damn the torpedoes and making fifteen recess appointments, including Craig Becker to breathe some life into the National Labor Relations Board.

Now, we need to see a similar display of presidential leadership on financial reform. The bill that passed the House last December is far too weak on all of the key issues. Gigantic banking conglomerates will remain "too big to fail." There is no separation of commercial banking from investment banking or proprietary trading, nor meaningful reform of corrupted credit rating agencies. Regulation of derivatives such as credit default swaps is far too weak. Private equity companies and hedge funds are largely left alone. There is no serious reform of executive compensation. The next generation of bubbles is already incubating while we are still recovering from the damage of the previous one.

The Dodd bill that will come before the full Senate later this spring is slightly worse in some respects, slightly better in others. The bill does include a version of Obama's call to restore the Glass-Steagall wall between commercial and investment banking (the "Volcker Rule"); but where the House bill created an independent consumer financial protection agency, the Dodd bill places this new agency, of all places, in the Federal Reserve. It was the Fed's total failure to enforce consumer protections on the books that invited the abuses that caused the collapse.

The bankruptcy examiner's revelations in his 2,200 page report about the behavior of Lehman Brothers should cause the White House to rethink its entire approach to financial reform. Basically, Lehman Brothers cooked its books for a few days four times a year, so that its quarterly reports would make the firm look far more solvent than it actually was. It used repurchase agreements ("repos"), which are short term loans, to disguise $30 to 50 billion worth of liabilities. This balance-sheet manipulation began in 2001, according to the examiner, Anton Valukas.

This kind of behavior demonstrates the failure of three separate systems that are supposed to protect investors, creditors and the larger economy from willful corporate fraud. First, the Securities and Exchange Commission, which actually had personnel investigating Lehman at the time, and utterly missed what was going on right under the commission's nose, in a lapse comparable to the Madoff scandal.

Second, Lehman's outside auditors, Ernst and Young, failed to blow the whistle. These abuses mostly occurred after Congress enacted the 2002 Sarbanes-Oxley Act, explicitly to improve corporate auditing in the wake of the Enron fraud. Obviously, though corporate lobbies have been complaining that Sarbanes-Oxley inflicted too much red tape, the Lehman affair demonstrates that it is too weak to do the job. Auditors and executives, in principle anyway, are criminally liable for accounting fraud. But that did not deter Lehman from faking its books and Ernst and Young from going along.

According to the examiner's report, despite the auditor's acquiescence, Lehman was not able to find a law firm in the US to sign off on its bogus accounting. So Lehman went to the U.K., found a law firm, Linklater's, to provide an opinion letter under British law okaying the dubious bookkeeping, and then ran the transactions through a London subsidiary.

One backstop, that has been weakened in recent years both by Congressional action and by Supreme Court rulings, is the right of investors or creditors injured by fraudulent behavior to sue. The original securities laws of the Roosevelt era envisioned that this kind of litigation--"private right of action"--would keep both corporations, their auditors and the SEC honest. But bipartisan legislation in the 1990s and two major Supreme Court decisions on 1994 and 2008 have effectively eliminated liability for aiding and abetting securities fraud. You can be sure if this right were still available, Ernst and Young would have though twice about giving Lehman a clean bill of health.

The politics of financial reform are drastically different from the politics of health care reform. For starters, Wall Street is massively unpopular in the country. By contrast, in the case of health care, some of the bill's own weaknesses - the mandate, the diversion of Medicare funds, the tax on premiums of high-quality insurance - raised legitimate questions among many voters; Republicans succeed in creating lies about the bill (pulling the plug on Grandma, etc.) that only multiplied concerns. In the end, passing the bill was a genuinely difficult vote for many Democrats.

Financial reform is a whole other story. It's not a difficult vote to tighten restrictions on predator banks (except when it comes to campaign finance). Judging by the recent comments of Senator Bob Corker, one of the senior Republicans on the Senate Banking Committee, Republicans are genuinely worried about finding themselves on the wrong side of a populist issue if they try to block financial reform the same way they tried to block health reform.

On financial reform, the real problem is not the Republicans--but whether Democrats will be tough enough. They have far more political room to force the Republicans to take a difficult vote than they are exercising. A cynic might think that Democrats such as Chris Dodd and Chuck Schumer are more worried about keeping Wall Street and the Fed happy than about maximizing the moment for reform and demonstrating to regular Americans which side they are on.

And if President Obama wants to appeal to bipartisanship, here is an area where bipartisanship can actually go hand in hand with good government. One example is the amendment to require an independent audit of the Federal Reserve, which was cosponsored by one of the most progressive Democrats in the House, Alan Grayson of Florida, and the libertarian Republican Ron Paul of Texas. With the support of over 300 House Democrats, that bipartisan provision made it into the final House bill.

Another good bipartisan bill was the Fraud Enforcement and Recovery Act, cosponsored by Democratic senators Ted Kaufman of Delaware, Pat Leahy of Vermont, and Republican Chuck Grassley of Iowa, the same Grassley who was part of the obstructions and myth-mongers when it came to health reform. But Grassley and other heartland Republicans are fed up with the double standard that places Wall Street ahead of Main Street. The Act, approved last May, helps--but does not fully restore the right of an injured investor or creditor to sue for damages in cases of securities, including those who aided or abetted a fraud, such as auditors who signed off on cooked books.

As Sen. Kaufman said in a recent floor statement,

"I'm concerned that the revelations about Lehman Brothers are just the tip of the iceberg. 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. Enron engaged in similar deceit with some of its assets. And while we don't have the benefit of an examiner's report for other firms with a business model like Lehman's, law enforcement authorities should be well on their way in conducting investigations of whether others used similar 'accounting gimmicks' to hide dangerous risk from investors and the public."

A good place to start would be to require real audits, similar to the autopsy performed on Lehman Brothers, of all the banks that took taxpayer money under the TARP program. Anyone who thinks that this sort of cooking of books was confined to Lehman Brothers is a good candidate to buy the Brooklyn Bridge--or worse, a bond backed by a sub-prime loan. President Obama could accomplish audit this simply by directing his Treasury Secretary to do it.

Obama has at last discovered that the public expects him to lead; and that Republican whining about the perils of majority rule cuts no ice. His administration has now squandered more than a year, being far too soft on the Wall Street system that crashed the rest of the economy. Now, with his own stock risking, he can show his mettle by demanding much tougher financial reform and daring the Republicans to block it.

Robert Kuttner is co-editor of
The American Prospect and a Senior Fellow at Demos. His new book is A Presidency in Peril (Chelsea Green, April 2010)