Prepared Testimony of Richard S. Fuld, Jr.

In the end, despite all our efforts, we were overwhelmed, others were overwhelmed, and still other institutions would have been overwhelmed had the government not stepped in to save them. What happened to Lehman Brothers could have happened to any firm on Wall Street, and almost did happen to others. A litany of destabilizing factors: rumors, widening credit default swap spreads, naked short attacks, credit agency downgrades, a loss of confidence by clients and counterparties, and strategic buyers sitting on the sidelines waiting for an assisted deal were not only part of Lehman's story, but an all too familiar tale for many financial institutions. The fallout from these repeated onslaughts is what has caused the government to intervene to dramatically change the rules and provide substantial support to other institutions.

Now is not the time or place for a detailed analysis of everything that has happened to the international economy in the last year. I do not have the perspective or the information necessary to analyze all of the causes and to propose cures for these problems. Nor do I think anyone can do that yet in a comprehensive fashion. However, I want to address some of the factors that led to this, and what we can do moving forward.

First, ultimately what happened to Lehman Brothers was caused by a lack of confidence. This was not a lack of confidence in just Lehman Brothers, but part of what has been called a storm of fear enveloping the entire investment banking field and our financial institutions generally. As evidenced by Congress' efforts to pass an emergency rescue plan, there is a systemic lack of confidence in the system that without emergency intervention could result in an across the board failure.

While all investment banks were prepared for shocks in the market, none of us was prepared for this one. And all of us are now forever changed. Investment banks depend on the confidence and trust of employees, clients, investors and counterparties.

Investment banks, unlike commercial banks, are subject to mark-to-market accounting. The result was we all had to mark our positions to the weakest competitors' fire-sale prices of assets. The commercial banks did not. This put investment banks at a disadvantage. Chairman Bernanke himself recognized there is "good value" over the long-term for these assets being sold at fire-sale prices. These write-downs have been a large contributor to shaking general confidence in investment banks and the banking system. Importantly, the SEC is now addressing this issue.

Lehman Brothers was a casualty of the crisis of confidence that took down one investment bank after another. Bear Stearns collapsed. Merrill Lynch was forced to sell itself to Bank of America. Goldman Sachs and Morgan Stanley received expedited approval to convert themselves to bank holding companies, providing substantial comfort to investors and facilitating their receipt of substantial capital infusions. Again, there are no major stand-alone investment banks left.

The second issue I want to discuss is naked short selling, which I believe contributed to both the collapse of Bear Stearns and Lehman Brothers. Short selling by itself can be employed as a legitimate hedge against risk. Naked short selling, on the other hand, is an invitation to market manipulation. Naked short selling is the practice of selling shares short without first borrowing or arranging to borrow those shares in time to make delivery to the buyer within the settlement period – in essence, selling something you do not own and might not ultimately deliver to the buyer.

Naked short selling, followed by false rumors, dealt a critical, if not fatal blow to Bear Stearns. Many knowledgeable participants in our financial markets are convinced that naked short sellers spread rumors and false information regarding the liquidity of Bear Stearns, and simultaneously pulled business or encouraged others to pull business from Bear Stearns, creating an atmosphere of fear which then led to a selffulfilling prophecy of a run on the bank. The naked shorts and rumor mongers succeeded in bringing down Bear Stearns. And I believe that unsubstantiated rumors in the marketplace caused significant harm to Lehman Brothers. In our case, false rumors were so rampant for so long that major institutions issued public statements denying the rumors.

Following the Bear Stearns run on the bank, we and many others called on regulators to immediately clamp down on naked short selling. The SEC issued a temporary order that went into effect on July 21 prohibiting "naked" short selling of certain financial firms, including Lehman, Merrill Lynch, Fannie Mae and Freddie Mac. This measure stabilized the share prices of Lehman Brothers and the other firms. However, this restriction was temporary, and on August 13 it expired after 17 trading days. History has already shown how wrong and ill-advised it is to allow naked short selling.

Many of the firms that have recently collapsed or have been forced into emergency mergers, takeovers, or government bailouts – Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, AIG – did so during the gaps of time in which there was no meaningful regulation of naked short selling. On September 15, when the market opened after the collapse of Lehman, naked shorts appeared to turn their attention to Morgan Stanley and Goldman Sachs. In the three days between the announcement of Lehman Brothers' bankruptcy and the SEC instituting an emergency ban on short selling, Goldman Sachs' and Morgan Stanley's share prices fell 30% and 39% respectively. None of this was a coincidence.