WASHINGTON (MNI) – The following is the full text of testimony by
Federal Reserve Chairman Ben Bernanke prepared for Tuesday’s hearing by
the House Financial Services Committee on the failure of Lehman
Brothers:

Chairman Frank, Ranking Member Bachus, and other members of the
Committee, I appreciate the opportunity to testify about the failure of
Lehman Brothers and the lessons of that failure. In these opening
remarks I will address several key issues relating to that episode.

The Federal Reserve was not Lehman’s supervisor. Lehman was exempt
from supervision by the Federal Reserve because the company did not own
a commercial bank and because it was allowed by federal law to own a
federally insured savings association without becoming subject to
Federal Reserve supervision.

The core subsidiaries of Lehman were securities broker-dealers
under the supervisory jurisdiction of the Securities and Exchange
Commission (SEC), which also supervised the Lehman parent company under
the SEC’s Consolidated Supervised Entity (CSE) program. Importantly, the
CSE program was voluntary, established by the SEC in agreement with the
supervised firms, without the benefits of statutory authorization.

Although the Federal Reserve had no supervisory responsibilities or
authorities with respect to Lehman, it began monitoring the financial
condition of Lehman and the other primary dealers during the period of
financial stress that led to the sale of Bear Stearns to JPMorgan
Chase.1 In March 2008, responding to the escalating pressures on primary
dealers, the Federal Reserve used its statutory emergency lending powers
to establish the Primary Dealer Credit Facility and the Term Securities
Lending Facility as sources of backstop liquidity for those firms.

To monitor the ability of borrowing firms to repay, the Federal
Reserve, in its role as creditor, required all participants in these
programs, including Lehman, to provide financial information about their
companies on an ongoing basis. Two Federal Reserve employees were placed
onsite at Lehman to monitor the firm’s liquidity position and its
financial condition generally. Beyond gathering information, however,
these employees had no authority to regulate Lehman’s disclosures,
capital, risk management, or other business activities.

During this period, Federal Reserve employees were in regular
contact with their counterparts at the SEC, and in July 2008,
then-Chairman Cox and I negotiated an agreement that formalized
procedures for information-sharing between our two agencies. Cooperation
between the Federal Reserve and the SEC was generally quite good,
especially considering the stress and turmoil of the period.

In particular, the Federal Reserve, with the SEC’s participation,
developed and conducted several stress tests of the liquidity position
of Lehman and the other major primary dealers during the spring and
summer of 2008. The results of these stress tests were presented jointly
by the Federal Reserve and the SEC to the managements of Lehman and the
other firms. Lehman’s results showed significant deficiencies in
available liquidity, which the management was strongly urged to correct.

The Federal Reserve was not aware that Lehman was using so-called
Repo 105 transactions to manage its balance sheet. Indeed, according to
the bankruptcy examiner, Lehman staff did not report these transactions
even to the company’s board. 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; the information we obtained
suggested that the capital and liquidity of the firm were seriously
deficient, a view that we conveyed to the company and that I believe was
shared by the SEC and the Treasury Department.

Lehman did succeed at raising about $6 billion in capital in June
2008, took steps to improve its liquidity position in July, and was
attempting to raise additional capital in the weeks leading up to its
failure. However, its efforts proved inadequate. During August and early
September 2008, increasingly panicky conditions in markets put Lehman
and other financial firms under severe pressure.

In an attempt to devise a private-sector solution for Lehman’s
plight, the Federal Reserve, Treasury, and SEC brought together leaders
of the major financial firms in a series of meetings at the Federal
Reserve Bank of New York during the weekend of September 13-15. Despite
the best efforts of all involved, a solution could not be crafted, nor
could an acquisition by another company be arranged. With no other
option available, Lehman declared bankruptcy.

The Federal Reserve fully understood that the failure of Lehman
would shake the financial system and the economy. However, the only tool
available to the Federal Reserve to address the situation was its
ability to provide short-term liquidity against adequate collateral;
and, as I noted, Lehman already had access to our emergency credit
facilities. It was clear, though, that Lehman needed both substantial
capital and an open-ended guarantee of its obligations to open for
business on Monday, September 15. At that time, 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.

The Lehman failure provides at least two important lessons. First,
we must eliminate the gaps in our financial regulatory framework that
allow large, complex, interconnected firms like Lehman to operate
without robust consolidated supervision. In September 2008, no
government agency had sufficient authority to compel Lehman to operate
in a safe and sound manner and in a way that did not pose dangers to the
broader financial system. 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. 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.

Thank you. I would be glad to respond to your questions.

** Market News International Washington Bureau: 202-371-2121 **

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