Lessons From Lehman's Fall

The conclusions from last week's report have surprised many about what went on leading to the downfall of Lehman Brothers.

How could management have been allowed to manipulate the investment banks' results so materially, even as they painted a different story to investors in their public filings? Why does it appear that the auditors, Ernst & Young, were so complicit with what management was doing in the months leading up to Lehman's bankruptcy filing? How was the board of directors not informed that this was going on? And most importantly, what should be learned from all of this going forward?

Some have opined that this "black eye" for E&Y will be their Enron. It will suffer the same negative publicity that Arthur Andersen did after it became clear that the energy company was cooking its books under the watch of the auditor. This bad publicity eventually led to the collapse of the accounting firm.

We're still in the early days of discovering what E&Y knew and didn't know about what happened at Lehman, so it's a little premature to suggest that E&Y is headed for the same fate as Andersen.

Even if it is discovered that E&Y was just as "guilty" as Andersen, there are many reasons to think that E&Y will continue. The world is in a much more fragile place today than it was in 2002 -- at least according to the Obama administration and government officials in many other large countries. Real reform of the financial system has been put on the back-burner. Saving the existing system is the priority.

What's the different between E&Y and Andersen? Andersen/Enron was a discrete failure, with culpable and easy scapegoat actors. What we're living through is the aftermath of a systemic failure where even the government was to blame. Where do you start with reform?

When you're living through a four-alarm fire, the thinking on the part of the government seems to go, you don't repaint the trim on the house. They're trying to put the fire out, and that means keeping the status quo.

If you think about the areas to potentially reform coming out of the last two years, you could easily point to

Fannie Mae

( FNM),

Freddie Mac

(FMC) - Get Report

,

AIG

(AIG) - Get Report

, credit ratings agencies (such as

Moodys

(MCO) - Get Report

and

S&P

( MHP) , auditors such as the Big Four, and governmental regulators such as the SEC, CFTC, and FASB (overseeing the auditors).

And don't forget the too-big-to-fail banks

Citigroup

(C) - Get Report

,

Wells Fargo

(WFC) - Get Report

,

JP Morgan

(JPM) - Get Report

, and

Bank of America

(BAC) - Get Report

and other key financial players such as

Goldman Sachs

(GS) - Get Report

and

Morgan Stanley

(MS) - Get Report

.

For the vast majority of those listed above -- even with Sen. Christopher Dodd's (D., Conn.) proposed reforms this week -- the government has taken the position that all these players and agencies need to be maintained as is.

The Volcker Rule has been proposed to limit big banks' levering up deposits for trading purposes. Yet, it's been attacked by a majority of financial players for "over-reaching" and "not addressing the real cause of the meltdown." Many have speculated that the Volcker Rule will be "dead on arrival" and never see passage. (I disagree.) If they're right, the government will have done a great job of saving the financial system and preserving all the parties -- as they were -- who caused the system breakdown.

For E&Y, I think they will continue (with some big or small slap on the wrist and mea culpa). Too many people don't want to see a Big Three vs. a Big Four. (Hello, bigger audit fees.) Besides, would the remaining Big Three do anything better than the current Big Four? Unlikely.

Clearly, auditors paid by firms the oversee leads to issues, just as it does for credit ratings agencies paid by debt issuers. But what's the alternative? Change the business model or change the existing way these two players do their jobs with the existing business model.

There was an interesting exchange in a recent

60 Minutes

interview between Steve Kroft and hedge fund manager Michael Burry, who correctly foresaw the housing crash in 2005 and successfully profited from it through credit default swaps. Kroft asked Burry why someone at the credit ratings agencies hadn't read through the same offering memorandums as Burry had to notice the quality of mortgage bonds were deteriorating. Burry explained that the ratings agencies just don't have the incentives to do this and don't have the time to do this work.

"Yeah, but you're just one guy...", Kroft retorted. Burry paused, and smiled. He had no response.

My belief is that the business models will likely have to be changed for both auditors and credit ratings agencies to avoid the kinds of problems we've seen last week with Lehman.

However, none of these actors want this and they'll likely win over enough politicians to their hope that they can put better oversight protections in place. If I were in their place, I'd move heaven and earth to maintain the status quo way of getting paid. It's very attractive from their point of view (and the point of view of those paying them).

Will it ever be changed? Not until the next big discrete event -- after the system's been solidified. We all hope that the next event will be a discrete event and not a larger systemic failure than what we saw in 2008.

-- Written by Jackson in Naples, Fla.

At the time of publication, Jackson's fund was long Citigroup.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. You can follow Jackson on Twitter at www.twitter.com/ericjackson or @ericjackson