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In Exclusive Interview, Harry Markopolos Warns Against Off-Balance Sheet Accounting as Geithner, Schapiro Testify Before Congress on Lehman

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Noting that the collapse of Lehman Brothers in September 2008 “illustrates many of the fundamental flaws in our financial system,” and that Lehman’s failure “helped push our financial system to the brink of collapse,” U.S. Treasury Secretary Timothy Geithner told the House Financial Services Committee in testimony April 20, that the Lehman collapse should be “subjected to careful, independent scrutiny.”

Referring to what the financial reform legislation should do, Geithner went on to say that “the best strategy is to force the financial system to operate with more transparency and with clear rules that set unambiguous limits on leverage and risk so that taxpayers never have to come in and protect the economy by saving firms from their mistakes.”

In her testimony before the House Committee the same day, SEC Chairman Mary Schapiro noted that the SEC supervised Lehman through its Consolidated Supervised Entity program, which was “flawed in its design and never properly” staffed or supervised. The program was discontinued by former SEC Chairman Christopher Cox in September 2008.

Rep. Spencer Bachus (R-Alabama) noted at the House Financial Services hearing that Lehman engaged in “misleading accounting,” and it was regulators’ failure to detect an “accounting manipulation by Lehman,” including off-balance sheet accounting.

In a recent interview with Investment Advisor, Harry Markopolos, the securities executive turned investigator who warned the SEC for nearly a decade that Bernie Madoff was a fraud, said the final financial services reform package should do away with off-balance sheet accounting. Financial reform has “to eliminate all use of off-balance sheet accounting–for any use whatsoever. Everything must be on balance sheet,” Markopolos told IA. “…We don’t know what’s hiding offshore at the major firms because they may not be telling us. You need to mandate that reporting so you know where the surprises are… if you’re only regulating three miles offshore of the U.S., it’s the stuff that’s four or more miles offshore that bothers me, and that’s where the risks are going to come from. All of sudden they are going to come onto the balance sheet and that’s what’s going to surprise regulators and the markets.”

Markopolos went on to say that he “came from the derivatives world, so I saw the off-balance sheet, offshore dealings first hand, and they are ugly, with hair and warts. Nothing good can come from off-balance sheet transactions.”

Geithner and Schapiro’s testimony comes during the same week that Senator Christopher Dodd’s (D-Connecticut), chairman of the Senate Banking Committee, financial services reform bill may go to the full Senate floor for debate. Dodd and his Republican counterparts on the committee are said to be in negotiations now on the legislation, with ranking GOP member Senator Richard Shelby scheduled to brief Senate Republicans on the status of the negotiations this afternoon, April 21.

Schapiro said the Lehman failure, “both individually and within the context of the broader financial crisis, sheds light on many interconnected and mutually reinforcing causes that contributed to the failure of many major financial institutions, both bank and non-bank.” Those failures included, she said in her testimony, “Irresponsible lending practices, which were facilitated by a securitization process that originally was viewed as a risk reduction mechanism; excessive reliance on credit ratings by investors; a wide-spread view that markets were almost always self-correcting and an inadequate appreciation of the risks of deregulation that, in some areas, resulted in weaker standards and regulatory gaps; and the proliferation of complex financial products, including derivatives.”