06/20/2010 05:12 am ET | Updated May 25, 2011

The Real Lehman Lesson: Break Up The Banks

Tuesday's hearing on Lehman Brothers' now infamous Repo 105 scam was only tangentially related to the megabank's accounting deceptions and subsequent collapse. That story is simple: Lehman almost certainly committed fraud, regulators failed to stop it, and many of the people who screwed up under President George W. Bush inexplicably remain in power under President Barack Obama.

But most of the hearing consisted of Republican members of Congress attempting to paint the failure of Republican regulators as proof that no regulator can ever regulate effectively ever, no matter what. After observers had been subjected to several hours of this argument, former bank regulator William Black took the stand and eviscerated it.

When Black was working as a bank regulator in the early 1990s, his agency helped block a major subprime lending outbreak by cracking down on the banks that were engaging in reckless and predatory lending. Nobody ever talks about the subprime crisis of 1991, because it didn't happen. Regulators stopped it.

By contrast, Bush-appointed regulators at the Federal Reserve, the Securities and Exchange Commission and the Treasury Department all dropped the ball in the years leading up to the Great Wall Street Crash of 2008. For their failure, everybody but Treasury Secretary Henry Paulson and SEC Chairman Christopher Cox were given top posts in the Obama administration (it should be emphasized that FDIC Chairman Sheila Bair deserved to keep her position).

The U.S. effectively regulated the banking industry for 50 years after the Great Depression, because regulators believed in regulating, and Congress didn't enact destructive deregulatory legislation. Both regulators and Congress have spent the past 30 years destroying that system.

Here's how Repo 105 worked. Lehman took a big batch of assets, and sold them to another company, on the condition that Lehman would buy them back at lower price in a few days. That's basically a loan from the other company to Lehman. But Lehman was characterizing these deals as a sale. That allowed Lehman to tell investors it wasn't leveraged as heavily as it actually was. "Highly leveraged" basically means "borrowing tons of money," and when asset prices are falling, as they were in 2008, lots of leverage also means losing tons of money. So far as investors were concerned, the less leverage, the better.

So Lehman structured these transactions around their quarterly financial statements, allowing them to drop leverage for a few days just before the company filed its investor reports. When it bought back the assets a few days later, its leverage ratio jumped up again, but investors didn't know.

Lehman insiders referred to this as a "sham transaction." Lehman's President and Chief Operation Officer referred to Repo 105 as "a drug." The purpose was to deceive Lehman's investors about how highly leveraged Lehman actually was.

Black argued that Lehman's Repo 105 actions constitute not only civil fraud, but criminal fraud. He should know. When Black was a regulator during the savings and loan crisis, nearly 1,100 bank officials went to prison for fraud. The SEC didn't stop Lehman's scam, and to date, there have been no arrests.

The S&L crisis was much smaller than the catastrophe our economy has been living through since the summer of 2007. Regulators clearly have a lot of work to catch up on regarding corporate accountability. That's not likely to happen so long as the same people who allowed the mess to take place are overseeing the clean-up. Regulation works, but not when the powerful regulators are focused on covering their own tails.

So Republicans are wrong to argue that regulation can never, ever work, and Obama made a big mistake by keeping Ben Bernanke, Timothy Geithner and John Dugan when he came into office. That means it's important for Congress to establish another economic line of defense, just in case regulators do drop the ball again in the future. One of the most interesting exchanges of the day came when Rep. Brad Miller (D-NC) pressed Lehman CEO Dick Fuld and Lehman director Thomas Cruikshank on too-big-to-fail.

Miller noted that every single published report of the negotiations surrounding Lehman's collapse have indicated that Fuld believed the government would bailout his company. Miller asked what Congress could do to convince major decision-makers on Wall Street that big firms would not be bailed out in a crisis.

Both Fuld and Cruikshank dodged the question. Here's the real answer: Nothing.

The only way to convince bigwig bankers that their firms are not too-big-to-fail is to break up their companies into smaller institutions that are not too-big-to-fail. Democrats pushing reform want people to believe that a new "resolution mechanism" will solve the problems regulators faced in 2008. Republicans just want to block any reform whatsoever. Congress should establish that new resolution mechanism, but doing so will not end too-big-to-fail.

The FDIC currently has a resolution authority that it uses to shut down failing commercial banks, like Wachovia and Washington Mutual. That authority does not extend to complex bank holding companies that do both commercial banking and other investment banking activities. The FDIC invoked its powers when it shut down Washington Mutual, a $300 billion bank, in September 2008. When Wachovia, a $700 billion bank, found itself on the brink of collapse a few days later, FDIC Chair Sheila Bair wanted to do the same thing.

But the FDIC didn't shut down Wachovia. Timothy Geithner led a push to skirt the resolution mechanism, and put the government behind a merger between Wachovia and another bank. Geithner won. Even though regulators had the authority to shut down Wachovia and wipe out its shareholders, the government arranged a merger with Wells Fargo that landed Wachovia's shareholders $15 billion in Wells Fargo stock. A few weeks later, the government kicked Wells $25 billion in TARP funds, another gift to the Wachovia shareholders, who were now Wells Fargo shareholders.

Even though the government had the authority to shut down Wachovia, it chose not to do so, even though the head of the agency with the authority to shut down the bank actually wanted to shut it down. This absurdity will repeat itself the next time any megabank gets into trouble. If we want to protect the economy against Wall Street excess and regulatory failures, breaking up the big banks is the only serious option.