Regulators Say Lehman Failure Makes Case for Financial Reform

Driven to bankruptcy by massive downgrades of its failed subprime mortgage-related assets, now-defunct Lehman Brothers presents several lessons for lawmakers writing the policy response to ongoing financial fallout, expert witnesses told the House Financial Services Committee today. Sen. Ed Perlmutter (D-Colo.) cited a recent report on the causes of the Lehman bankruptcy, which found regulators supposedly knew of accounting gimmicks that allowed the firm the liquidity freedom to take on increasingly risky investments, but did not enforce corrective action. The regulator quickly named in the failure to prevent risk-taking at Lehman was the Securities and Exchange Commission (SEC). “Each agency was making mistakes, and I think SEC was at the heart of it,” Perlmutter told the Committee. The SEC faced harsh criticism from Committee members, as well. Saying the SEC did not enforce its existing regulatory authority and “failed to do their job in the first place” when Lehman was still collapsing, Rep. Spencer Bachus (R-Ala.), criticized it and other regulators that call for increased authority in the financial reform bills passed in the House and heading to the Senate floor this week. Perlmutter said, however, that provisions of the reform bill would create an “oversight council” where the SEC and other regulatory agencies would be “forced” to discuss financial institutions and developing systemic risks. SEC chairman Mary Schapiro, appearing in another panel before the Committee, said that capital adequacy rules under the Basel framework were flawed and assumptions regarding liquidity risk proved overly optimistic in the case of Lehman. US Treasury Department secretary Timothy Geithner indicated the regulatory environtment bred increasingly risk-laden business practices at Lehman, including the firm’s reliance on the “repo” market. Repos are loans collateralized by assets on dealers’ balance sheets, which financial institutions use to finance securities inventories, typically on an overnight basis. “Financing long-term, risky assets with short-term debt was a reliable formula for rapid growth and robust earnings during the boom,” Geithner said in prepaerd remarks (download here). “But these activities were vulnerable to fragility and rapid deleveraging when conditions deteriorated, as they inevitably did.” Federal Reserve chairman Ben Bernanke told the Committee the Lehman failure presents two key lessons in forming policy decisions. First, he said, lawmakers should eliminate gaps in the financial framework that allow the formation of large, complex and interconnected firms. “Second, to avoid having to choose in the future between bailing out a failing, systemically critical firm or allowing its disorderly bankruptcy, we need a new resolution regime, analogous to that already established for failing banks,” Bernanke said in prepared remarks (download here). “Such a regime would both protect our economy and improve market discipline by ensuring that the failing firm’s shareholders and creditors take losses and its management is replaced.” Write to Diana Golobay.

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