Has the Financial Services Industry Learned its Lesson?
On September 10, 2008, one day after Lehman Brothers Holdings Inc. stock lost nearly half its value amidst investor concerns about the firm’s ability to raise capital in the aftermath of an accounting fraud, the investment bank reported an expected quarterly loss of $3.9 billion after writing down its assets by $5.6 billion. This event ultimately culminated in a 90 percent loss in its stock value from its highest ever price of $86.18 in February 2007.
Lehman filed the largest corporate bankruptcy in U.S. history on September 15, 2008. This was despite reporting record-breaking revenues and net income year after year since 2003, and despite a stronger than expected earnings report for the first quarter of 2008 which lead to a 46 percent increase in its stock price on March 18, 2008.
Lehman’s bankruptcy caused the Dow Jones Industrial Average (DJIA) to drop by more than 500 points in a few hours, costing 26,000 employees their jobs and triggering a 50 percent decline from the DJIA’s October 2007 all-time high. The consequent chain reaction in the stock market obliterated nearly $10 trillion dollars of wealth for investors and plunged the global economy into what has become known as the Great Recession.
Fast forward 6 ½ years and finally the lawsuit filed against Lehman’s auditor, Ernst & Young LLP (EY), has been settled. On April 15 it was announced that EY will pay $10 million to settle a New York lawsuit accusing the accounting firm of helping Lehman deceive investors in the years leading up to its 2008 collapse.
The 2010 lawsuit claimed Ernst & Young's auditing facilitated a "massive accounting fraud" and sought $150 million in fees that the firm earned from Lehman between 2001 and 2008, plus investor damages and equitable relief. While the $10 million was much smaller than what the attorney general's office had sought, EY agreed to pay $99 million in damages to investors in a class action settlement approved a year ago.
According to the complaint, Ernst approved the "surreptitious" removal of tens of billions of dollars of debt from Lehman's balance sheet to make the investment bank appear less indebted at the close of financial quarters. The complaint alleged that, for more than seven years before Lehman's bankruptcy, the bank made use of transactions known as "Repo 105s," short-term financing that temporarily moved as much as $50 billion from its balance sheet. According to New York Attorney General Eric Schneiderman, "If auditors' reports...provide cover for their clients by helping to hide material information, that harms the investing public, our economy and our country," he said.
What about prosecutions of top management of Lehman? Former Lehman CEO Dick Fuld and three other Lehman executives were arrested back in February 2013 for crimes related to the collapse of the investment bank. The four bankers were apprehended at John F. Kennedy International Airport in New York where they were attempting to flee the country to escape imminent federal charges of filing false financial statements.
According to multiple sources, Ferdinand Pecora - the U.S. District Attorney for the Southern District of New York -, obtained a grand jury indictment against Fuld, former CFO Erin Callen and two lower level accounting managers. The indictment alleged that the four knowingly deceived investors and regulators over Lehman's use of its Repo 105 accounting techniques, concealing the firm’s true financial condition until it was too late.
Fuld has been treated as something of a pariah since the revelation of the frauds that brought down the financial services industry. His narcissistic behavior was uncovered and the lawsuits came flowing in. Fuld’s professional nightmare has also become a legal one. He’s been named as a defendant in more than 50 lawsuits, including those brought by New Jersey, the Washington State Investment Board, the California Public Employees’ Retirement System, and a class action by Lehman shareholders. Some have been settled; others are still being litigated, including suits by a group of California cities and municipalities and the Retirement Housing Foundation, a charity affiliated with the United Church of Christ, which lost tens of millions of dollars.
Lehman’s $250 million insurance policy has covered many of Fuld’s legal bills and those of other senior managers. There have been reports that the fund was fully depleted by settlements and attorneys’ fees. That means Fuld had to pay his own legal bills and any judgments rendered against him. This isn’t unprecedented. The directors of Enron and WorldCom, the second- and third-largest bankruptcies after Lehman’s, wound up paying millions out of their own pockets.
Has the banking industry learned its lesson about playing fast and loose with investors’ money and making risky investments? I have my concerns given that other frauds have occurred over time, including the savings and loan debacle in the 1990s, so there may be no reason to assume there won’t be other periods where financial transactions and loose accounting standards run amok.
A federal regulator recently said increased risk is creeping back into the financial system, warning in a report that U.S. banks are relaxing loan-underwriting standards in a manner similar to the years preceding the 2008 financial crisis.
The largest U.S. lenders have loosened requirements for corporate loans and consumer borrowing such as credit cards and auto loans for three years in a row, the Office of the Comptroller of the Currency (OCC) said in an annual report. The easing comes as banks search for higher-return investments amid low interest rates and competition from nonbank lenders
The OCC’s examination of 91 large banks with $4.9 trillion in loans found the greatest relaxation among leveraged loans—or loans to companies that already have large amounts of debt—as well as auto loans, credit cards, large corporate loans and international loans.
Among regulators’ concerns are what they view as risky auto-lending practices, including an increasing number of loans to borrowers with poor credit, and long loan terms of as many as seven years.
The OCC survey, which covered the year that ended June 30, 2014, was broadly consistent with other data looking across the banking industry.
Is it déjà vu all over again?I’d like to think that banks have learned their lesson but I also know that history tends to repeat itself with respect to business frauds. Despite new legislation under the Dodd-Frank Financial Reform Act, the banking industry has not learned its lesson and greed is once more raising its ugly face. My fear is we all will pay the price down the road as we did during the recession.
Blog posted by Steven Mintz, aka Ethics Sage on April 29, 2015. Dr. Mintz is a professor in the Orfalea College of Business at Cal Poly, San Luis Obispo. He also blogs at ethicssage.com.