Ben Bernanke and Timothy Geithner at Lehman Brothers hearingTreasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke told lawmakers on Tuesday that the bankrupcty of Lehman Brothers serves as perhaps the best example of the need for the Obama administration's proposed financial regulatory reforms. Geither didn't have to say it, but the Securities and Exchange Commission's civil fraud suit against Goldman Sachs (GS) is probably Exhibit B in the government's case for pressing on financial regulatory overhaul.

Perhaps predictably, the Treasury and Fed chiefs' assessment of the forces behind Lehman's collapse differed from those of former Lehman CEO Dick Fuld, who presided over the biggest bankruptcy in history and who also testified at the Tuesday hearing.

"There are few better examples of why we need comprehensive financial reform than Lehman Brothers," Geithner read from his prepared testimony before the House Committee on Financial Services, which is conducting hearing on the collapse of the once high-flying investment bank.

"Vulnerable to Fragility"

"Lehman caused Lehman's insolvency," Geither added. "But in many ways, Lehman Brothers serves as an iconic example of what went wrong with our financial system in the years leading up to the crisis."

Geithner took lawmakers through a litany of problems at Lehman within the larger financial system that the administration's reforms would seek to address. The so-called shadow banking system (or unregulated inter-institutional lending), derivatives, flawed compensation practices and a "breakdown in basic checks and balances" were among the factors contributing to Lehman's demise, the Treasury Secretary said.

Just as important was a light regulatory environment and weak or nonexistent capital requirements, Geithner said. "Lehman Brothers operated with very high levels of leverage, and it financed itself to a large extent through the issuance of short-term debt," said Geithner. "Financing long-term, risky assets with short-term debt was a reliable formula for rapid growth
and robust earnings during the boom. But these activities were vulnerable to fragility and rapid deleveraging when conditions deteriorated, as they inevitably did."

The Fed Had No Means to Rescue Lehman

Bernanke reminded the committee that the Federal Reserve wasn't Lehman's supervisor when its troubles began because the Wall Street firm didn't own a commercial bank. Bernanke added that the Fed was unaware that Lehman was using so-called Repo 105 transactions to manage its balance sheets. Lehman has been accused of using such transactions to hide toxic assets on its balance sheet.

"Indeed, according to the bankruptcy examiner, Lehman staff did not report these transactions even to the company's board," Bernanke read from his prepared testimony. "However, knowledge of Lehman's accounting for these transactions would not have materially altered the Federal Reserve's view of the condition of the firm, [which] suggested that the capital and liquidity of the firm were seriously deficient."

Bernanke also defended the decision to let Lehman fail, a much-criticized move that led to the seizure of the credit markets and the worst stock market plunge since the Great Depression. "Neither the Federal Reserve nor any other agency had the authority to provide capital or an unsecured guarantee, and thus no means of preventing Lehman's failure existed," Bernanke said.

Fuld: Lehman Didn't Have a "Huge Capital Hole"

Former Lehman chief Dick Fuld blamed the firm's demise on a cliche, saying in his prepared testimony that a "perfect storm of events. . .forced Lehman into bankruptcy." Fuld disputed Bernanke's contention that the Fed was in the dark, saying the nation's central bank and the SEC were fully aware of the firm's situation before it collapsed in September 2008.

"The SEC and the Fed were privy to everything as it was happening," said Fuld. "I am not aware that any data was ever withheld from them, or that either of them ever asked for any information that was not promptly provided."

Fuld also took issue with the report of the court-appointed bankruptcy examiner, Anton Valukas, as well as popular perception. "The world still is being told that Lehman had a huge capital hole," Fuld said. "It did not. I believe that the Examiner's report distorted the relevant facts, and the press, in turn, distorted the Examiner's report. The result is that Lehman and its people have been unfairly vilified."

Regarding the contentious Repo 105 transactions, which have brought no formal charges, Fuld said he had "no recollection whatsoever" of ever hearing of such deals. He reminded lawmakers that as CEO he "oversaw a global organization of more than 28,000 people with hundreds of business lines and products, and with operations in more than 40 countries spread over five continents."

Regardless of his memory, Fuld denied that the Repo 105s were used to misrepresent the firm's health, and he said they didn't contribute to its failure, in any case. "Lehman was forced into bankruptcy amid one of the most turbulent periods in our economic history, which culminated in a catastrophic crisis of confidence and a run on the bank," Fuld said.

Mary Shapiro, chairman of the SEC, and bankruptcy examiner Valukas were also among those testifying before the committee Tuesday.

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