NEW YORK (CNNMoney.com) -- Facing criticism for failing to prevent the collapse of Lehman Brothers, the nation's top finance officials told lawmakers Tuesday that the largest bankruptcy in U.S. history highlights the need for more vigorous regulation of the financial markets.
In testimony before the House Financial Services Committee, Treasury Secretary Tim Geithner, Federal Reserve chairman Ben Bernanke and Securities and Exchange Commission chairwoman Mary Schapiro all stressed that an overhaul of the financial system is necessary to limit the damage of future crises.
"No regulatory regime will be able to prevent major financial firms from reaching the point of insolvency," said Geithner. "But a well-designed regulatory framework must put in place shock absorbers to contain the damage caused by a major firm's default."
Geithner's comments came at the opening of a hearing to explore policy issues related to the bankruptcy of Lehman, which unleashed a crisis of confidence that threw financial markets worldwide into turmoil and sparked the worst downturn since the Great Depression.
The witnesses all came under sharp criticism from lawmakers for failing to adequately oversee Lehman over a period of several years in which the firm engaged in dubious accounting practices aimed at hiding its exposure to risky derivatives.
The hearing convened as lawmakers debate ways to overhaul how the government oversees Wall Street, including tougher rules governing derivatives and capital requirements. At the same time, financial reform has been in the spotlight since the SEC charged Goldman Sachs (GS, Fortune 500) with fraud last week, a bold step that unnerved many investors.
At issue are charges Lehman failed to disclose its use of an accounting gimmick called "Repo 105" to mask its dire financial situation in the months leading up to its September 2008 bankruptcy.
According to a recent report from Anton Valukas, a New York-based lawyer who was appointed by a state bankruptcy court to investigate the causes of Lehman's failure, the defunct broker dealer used Repo 105 to strip some $50 billion of undesirable assets from its balance sheet at the end of the first and second quarters of 2008, instead of selling those assets at a loss.
In opening remarks, committee members from both parties railed against Lehman's reported misconduct and the failure of regulators to reign in Wall Street excess.
"It deeply troubles me that we must once again explore how reckless Wall Street titans profited at the expense of innocent shareholders on Main Street," said Rep. Paul Kanjorski, D-Pa. "I am also deeply disappointed in the performance of auditors and regulators who failed to uncover wrongdoing, mismanagement and capital shortfalls even as they fiddled in Lehman's offices."
Lehman's "unscrupulous practices" illustrate why Congress needs to pass the Wall Street reform bill passed by the Senate Banking Committee last month, Kanjorski added.
The tone of the hearing quickly took a partisan turn with Republican committee members criticizing Democratic proposals as reinforcing a broken system.
Rep. Spencer Bachus, R-Ala., said the Valukas report revealed a "gross regulatory failure" in which the Federal Reserve and SEC were complicit. "Lehman is gone, but the failures of the Fed and SEC are still with us, and should not be rewarded with new regulatory powers," he said.
Lawmakers pressed Schapiro, who took over the SEC shortly after Lehman collapsed, with questions about why Wall Street's main watchdog didn't crack down on the firm earlier.
"The SEC didn't have the staff, the resources or -- quite honestly -- the mindset to be a prudential regulator of the largest financial institutions in the world," Schapiro said of the SEC under her predecessor.
She said the agency had only 24 people monitoring the five largest investment houses in the world at the time of Lehman's failure. "I don't think any of us would claim that the oversight of Lehman was a success."
As the agency with primary authority over Lehman, the SEC has come under withering criticism. But the SEC has learned from its mistakes and is taking more aggressive steps to crack down on the type of practices that led to Lehman's failure, Schapiro said.
When asked if the Repo 105 transactions should be banned, Schapiro acknowledged that current accounting rules allow for such deals under "limited circumstances."
"If there is an accounting loophole here...we will look very closely to see if it should be prohibited," she said. "I have profound questions about that."
Schapiro said the SEC has sent letters to major financial institutions asking for detailed information on accounting and disclosing Repo 105 and related transactions. She said the agency is in the process of reviewing that information and will make its findings public at some point in the future.
All three witnesses said the nation's regulatory framework needs to be strengthened so that large, interconnected investment firms such as Lehman do not pose a systemic risk to the economy. The regulators also said the government needs the authority to break up "too-big-to-fail" intuitions.
If such policies had been in place at the time of Lehman's failure, the regulators said the outcome could have been avoided.
"The government would have had the ability to step in early and put Lehman or AIG into receivership and manage the unwinding of that firm with less risk to other institutions," Geithner said.
Bernanke added: "In the case of Lehman, we only had the nuclear option of letting it fail." With resolution authority, however, "we would have been able to force Lehman to take action."
In addition, the regulators said investment firms should be required to hold more capital in reserve to help limit risky behavior and provide a cushion for potential losses.
Later Tuesday, the committee will hear from from Valukas and Dick Fuld, former chief executive of Lehman Brothers.
In written testimony, Fuld said the Valukas report "distorted the relevant facts" about the firm's bankruptcy and denied that he knew anything about Repo 105.
"The result is that Lehman and its people have been unfairly vilified," said Fuld.
Fuld said he had "absolutely no recollection" of hearing anything about Repo 105 transactions at Lehman. However, based on what he has recently learned, Fuld argued that such transactions had nothing to do with the company's bankruptcy.
Instead, Lehman was forced into bankruptcy by unprecedented turbulence in the financial markets, which culminated in a crisis of confidence and a run on the bank, he said.
The financial crisis, he goes on to say, nearly brought down other financial institutions. "But those institutions were saved because of government support in the form of additional capital and fundamental changes to the rules and regulations governing banks and investment banks."
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