The inevitable SEC action against Goldman Sachs took the financial system by storm on Friday, so the weekend has been a feast of blogosphere analysis on the implications of the lawsuit. The best way to follow daily developments in the case is over at Clusterstock where Joe Weisenthal and Henry Blodget have their fingers on the blogosphereís pulse in regard to the SEC lawsuit.

The best analysis of the lawsuit that Iíve read in the blogosphere to date comes from Larry Ribstein, Erik Gerding and UHís Craig Pirrong. Read their posts and you will have a good understanding of the issues involved in the case.

Frankly, the SEC action against Goldman looks a lot more about public relations than effective regulation. As Blodget pointed out on Friday morning, the timing of the filing pushed the highly embarrassing SEC Inspectorís report on the SECís bungling of the investigation into Stanford Financial off the publicís radar screen. One would hope that the SECís due diligence in regard to its action against Goldman is better than its research into Stanford Financial, which was widely known in Houston financial and legal circles to be a sketchy outfit for over a decade before it blew up last year.

The key to the SEC’s case is that Goldman apparently did not disclose to ACA nor IKB and ABN knew that uber-mortgage short specialist John Paulson was placing bets against the underlying securities upon which the synthetic CDO was based at the same time as Paulson was helping Goldman and ACA choose the underlying securities.

Thus, the theory goes, Paulson presumably had an incentive to enhance the failure of the securities. Accordingly, the SEC contends that Goldman and Paulson structured the deal to lose, that Goldman knew the investors wouldn’t buy if they knew that, and that Goldman didn’t disclose those details because it was making fees all over the place.

My sense is that the case is far from a slam dunk (see also here and here) for the SEC, but it probably doesn’t make any difference. If Goldman defends itself and loses, then the trial penalty is that private civil lawsuits by other investors will use the judgment in favor of the SEC to establish liability against Goldman (interestingly, Goldman elected not to disclose its receipt of the Wells Notices related to the SEC lawsuit). Although Goldman could manage the payment of an SEC fine, damages in those civil lawsuits could seriously harm the firm.

Thus, my sense is that Goldman has to settle with the SEC, and probably for a good chunk of change to make the SEC look good. That will likely suit Goldman just fine because it would continue to distract the public from the far larger travesty, which was the way in which the federal government bailed Goldman out from its massive risk of loss in regard to AIG.

From a policy standpoint, the SEC action is a part of the Obama Administration’s public relations campaign to promote federal regulation of the derivatives markets, a point that Professor Ribstein makes in this post:

In other words, the SEC, under pressure to come up with something on the eve of Congress’s final push toward financial regulation comes with a case that the complaint makes clear is much more about the creation of systemic risk than about securities fraud.
This reflects, in part, the new Wall Street, more than three quarters of a century after the securities laws were enacted. Financial regulation is now much more about sophisticated market intermediaries than about individual investors who need somebody to ensure they have the truth about securities.
This is not to say that securities fraud is irrelevant. However, the SEC has struggled on that front ñ the Bank of America settlement, Madoff, Stanford.
And so now we are left with . . . Goldman.

Inasmuch as such regulation will allow federal regulators to exercise the same judgment in regard to derivatives regulation that it applied to regulating the likes of Stanford Financial and Bernie Madoff, count me as decidedly unconvinced that this development constitutes progress.

However, one positive aspect about the SECís complaint is that it provides a stark reminder to investors of the risk of doing business with the likes of Goldman. As Arnold Kling has been saying for years, perhaps it wouldnít be such a bad thing if investors didnít rely so much on the chauffered investment bankers of Wall Street and their friends in government.

Mike over at the Crime and Federalism blog (a good blog, by the way) thinks my explanation yesterday of Lehman Brothers’ controversial repo 105 transactions is bullshit.

Well, I’m as full of bullshit as anyone, but my sense is that Mike’s analysis is flawed. That’s not to say that the folks involved in reporting Lehman’s earnings to the marketplace after those repo 105 transactions didn’t commit fraud. I don’t know enough about the facts to know one way or the other.

The main point of my post is that a whole bunch of of executives, accountants, auditors, counterparties and governmental officials were swirling around Lehman at the time of these repo 105 transactions. As a result, the responsibility for any fraud is better allocated among the responsible parties in the civil justice system than in the criminal justice system, where guilt is adjudicated with a sledgehammer when a scalpel is more appropriate.

But one of the interesting aspects about Mike’s post is that he is very sure that he understands that Lehman committed fraud. So, let’s take a look at his example of what he thinks happened with regard to Lehman and the repo 105 transactions (my observations are in italics below each of his statements):

I ask you to invest $100,000 in my new business. You ask me how much money I have in my business account. I only have $5,000, but do not tell you this.

Okay, as my prior post noted, I concede that Lehman may have misrepresented its true liquidity position through the repo 105 deals.

I can sell everything the business owns (including all of our inventory) to a pawn shop for $100,000.

If Mike can sell all the assets of the business to a pawn shop for $100,000, then the business owns much more than $100,000 in assets. Pawn shops – much like the financial institutions with whom Lehman was dealing – do not engage in repo 105 transactions unless they are darn sure that they can liquidate the assets that they purchase for more than they paid if the seller breaches his obligation to repurchase the assets.

The pawn shop will sell me everything back for $105,000 if I come up with the money within 48 hours.  They won’t even take possession of the property if I pay them within 48 hours.

I do not know of any pawn shop – or financial institution for that matter – that would be willing to leave property that they purchased in the hands of a financially-troubled seller, even for just 48 hours. Moreover, my understanding of the repo 105 transactions is that Lehman was not obligated to repurchase the asset for the sale price plus 5%. My understanding is that the “105” in repo 105 relates to the fact that financial institutions require property at least worth 105% of the purchase price that the financial institution pays the seller for the asset. I’m sure that Lehman’s counterparties required a steep fee for engaging in the repo 105 sales, but not 5% of the purchase price.

I make the “sale” to the pawn shop. I show you a copy of my bank statement. You can see that I have $105,000 cash in my bank account. I’m, in other words, liquid 100 grand. You loan me $100,000.

Here is where Mike is confused. Prior to taking the $100,000 loan, his company’s balance sheet actually looks a bit worse because of his sale to the pawn shop. The company has sold assets worth more than $100,000 in order to increase its liquidity to $105,000. No rational investor would make a $100,000 unsecured loan to a company with assets of only $105,000 cash that the investor would not have been willing to make when the company had $5,000 cash and over a $100,000 in non-liquid assets. But let’s play along with Mike to get to his main point. After the loan, his company now has $205,000 in cash with a $100,000 liability.

I buy my stuff back for $105,000. I now have, thanks to you and some quick accounting fraud, $95,000.

No, that’s only part of it. The company now has repurchased its assets that are worth over $100,000, it has cash of $100,000 and a $100,000 liability. So, the company’s balance sheet is pretty much the same had the investor made his loan when the company only had $5,000 cash and over $100,000 of non-liquid assets. The only difference is that the investor feels deceived because he would not have made the loan under those circumstances.

So, maybe Mike’s investor in the example above has a good fraud case against the company (I’m not sure that’s the best way for the investor to recover his loan, but that’s another issue). But maybe not, too. And the situation that Lehman faced was far more complex than Mike’s hypothetical and involved a large number of well-intentioned people who were attempting to find any loophole available to save Lehman.

And that’s no bullshit.

The big news in the business world at the end of last week and over the weekend was the publication of the examiner’s report in the Lehman Brothers bankruptcy case.

The mainstream media jumped all over the report as a precursor to criminal indictments of former Lehman executives because of allegations in the report (that’s all they are at this point) that Lehman used repo 105 transactions at the end of several quarters to make its balance sheet look more attractive than it really was.

Fancy that, executives trying to stem a run on a trust-based business!

Despite the gathering MSM lynch mob, the truth is that the examiner’s report is shaky grounds, at best, for criminal indictments against former Lehman executives.

As folks who are experienced in bankruptcy realize — but those who aren’t don’t — an examiner’s report is hardly an objective analysis of a debtor’s affairs. Bankruptcy examiners are highly incentivized to recommend as many legal actions against the debtor’s insiders and counter-parties as possible.

The fruits of those legal actions inure to the benefit of the bankruptcy debtor’s creditors, which is really the only constituency in most bankruptcy cases that really can effectively challenge an examiner’s compensation. As a result, feather nesting is not an unusual tactic of bankruptcy examiners.

Moreover, examiner’s reports in bankruptcy cases are far from dispositive. I haven’t read the Lehman examiner’s report yet, but I’m skeptical of the MSM’s initial rave reviews. The Enron examiner’s report met with similar early favorable reaction, but it turned out to be chock full of plain factual errors and dubious conclusions based on those errors.

For example, the MSM’s reporting of the examiner’s conclusions regarding the timing of the repo 105 transactions doesn’t make sense to me.

As I understand those transactions, they improved Lehman’s balance sheet by increasing its liquidity position at the end of several quarters through converting non-liquid assets to cash. When Lehman repurchased the assets after the date of the financial statement, the balance sheet didn’t change much except for showing less liquidity because the repurchased asset – which went back on the balance sheet after the repurchase – was probably worth more than the liquidity used to repurchase it (I seriously doubt that the sharpies who were dealing with Lehman as it was going down in flames were consenting to using Lehman’s trash assets in the repo deals).

At any rate, Peter Henning and Larry Ribstein have both done a good job of analyzing the main problem facing the Lehman insiders from a criminal standpoint. It is different and potentially more troublesome than the honest services wire fraud theory that was the basis of most Enron-related prosecutions. That is, the Lehman executives are subject to the provisions in the Sarbanes-Oxley legislation enacted after Enron’s bankruptcy that impose criminal liability on executives who falsely certify the (i) accuracy of the financial statements and (ii) absence of deficiencies in internal controls regarding the preparation of the financial statements.

By the way, although Henning’s analysis is quite good, his analogy of the repo 105 transactions to the Nigerian Barge transaction in the Enron-related criminal prosecutions is a stretch.

The Nigerian Barge transaction was a relatively small deal in which Enron — about an $80 billion market cap company at the time — sold its interest in the Nigerian barges to Merrill Lynch to make a $12 million profit at the end of the particular quarter.

On the other hand, the examiner alleges that Lehman was using repo 105 transactions to raise $35 – $50 billion of liquidity at the end of several quarters. Big difference.

Also, flying beneath the radar (as usual) is current Treasury Secretary Timothy Geithner and former Treasury Secretary Hank Paulson’s role in all of this.

As closely as Geithner (as head of the New York Federal Reserve) and Paulson (as Treasury Secretary) were monitoring Lehman during much of this time, it strains credulity that Geithner and Paulson didn’t have at least some idea of what Lehman was doing to make its balance sheet as attractive as possible. Both Geithner and Paulson were intimately involved in attempting to broker a Bear Stearns-type bailout of Lehman.

So, if Geithner and Paulson knew what was going on, then how on earth is the federal government going to single out Richard Fuld and other former Lehman executives for criminal conduct?

Which brings us to the real lesson of all this — that is, the inherently fragile nature of a trust-based business and the misguided nature of the notion that more governmental regulation will somehow protect investors from the next bust of such a business.

Larry Ribstein has been insightfully pointing out for years that more regulation of those businesses will not prevent the next meltdown, just as the more stringent regulations added under Sarbanes-Oxley after Enron’s collapse did not prevent Lehman Brothers from failing.

More responsive forms of business ownership certainly are a hedge to the inherent risk of investment in a trust-based business. But also helpful would be better investor understanding of the wisdom of hedging that risk and the importance of short sellers in providing information on troubled companies to the marketplace.

And as for criminal prosecutions? Unless there is evidence beyond a reasonable doubt of a crime, far better to allow the civil justice system allocate responsibility for Lehman’s failure among the multitude of potentially responsible parties. Professor Ribstein nails this point in the final paragraph of his post:

The lesson here is that pursuing high-profile criminal prosecutions in Lehman after the problems with such prosecutions in these situations proved so manifest in Enron would prove that after a decade of hugely costly trials and a massive new law that was supposed to change everything, we still haven’t learned a thing about the unsuitability of criminal liability for these kinds of cases.

Finally, Lawrence Kudlow and John Carney have an excellent seven-minute discussion below of the failure of governmental regulation in regard to Lehman: