March 27, 2008

Paulson admits Plunge Protection Team doesn't work

By Jeffrey H. Birnbaum
Washington Post Staff Writer
Thursday, March 27, 2008; Page D01

Paulson Wants to Tighten Reins on Investment Banks

Treasury Secretary Henry Paulson makes remarks at the second annual Capital Markets Summit, Wednesday, March 26, 2008, in Washington. (AP Photo/Lawrence Jackson)
Treasury Secretary Henry Paulson makes remarks at the second annual Capital Markets Summit, Wednesday, March 26, 2008, in Washington. (AP Photo/Lawrence

Treasury Secretary Henry M. Paulson Jr., tempering the Bush administration's long preference for limited regulation of financial markets, called yesterday for strengthened federal oversight of investment banks in the wake of the collapse this month of Wall Street giant Bear Stearns.

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Paulson urged that investment banks provide more information about their operations, especially since the Federal Reserve has begun to allow these firms, for now, to borrow public money when they run short on cash. He said the heightened oversight should also be temporary. This would subject investment banks to some of the oversight applied to commercial banks, which have long had ready access to Fed loans.

His recommendation comes after the Fed helped prevent the bankruptcy of Bear Stearns by brokering its sale to J.P. Morgan Chase and guaranteeing about $30 billion in Bear Stearns's risky securities with public funds. Two Senate committees said yesterday that they would investigate the rescue.

"This latest episode has highlighted that the world has changed, as has the role of other non-bank financial institutions and the interconnectedness among all financial institutions," Paulson said. "These changes require us all to think more broadly about the regulatory and supervisory framework."

In calling for a greater federal role, Paulson joins a growing consensus that high finance has changed so quickly in the past few years that it has outstripped the government's ability to regulate it. Although economists and officials are debating how to revamp federal oversight, they increasingly agree that steps must be taken to prevent a repeat of the credit market crisis that has beset the global economy since last summer.

"People in Washington are finally beginning to recognize that the financial institutions and products have changed dramatically and the regulatory scheme has changed very little," said Harvey J. Goldschmid, a former commissioner of the Securities and Exchange Commission. "It's time to take a serious look at who does what."

The Treasury will soon unveil a plan to streamline the regulatory system and strengthen federal oversight of investment banks and the esoteric instruments they sell. Lawmakers are considering an even tougher regimen. House Financial Services Committee Chairman Barney Frank (D-Mass.) has proposed creating a mega-regulator to oversee a wide range of financial institutions or giving that power to the Fed. Many institutions are supervised, with varying rigor, by multiple separate agencies.

The credit crisis started with overly lenient lending -- particularly subprime mortgages -- to financially shaky home buyers and then spread across the global financial system as those mortgages were packaged together and sold as securities.

The regulation of the markets for mortgages, mortgage-backed bonds and other securities "has lots of holes, about as many as Swiss cheese," said Charles W. Calomiris, a finance professor at Columbia University. American Enterprise Institute scholar Vincent Reinhart said, "Where things have gone bad is where regulation is the weakest."

The last decade has also seen enormous growth in intricate types of financial trading that occurs largely below federal radar. Trillions of dollars of securitized commodities -- mortgages and other investments that are grouped together -- are bought and sold with little federal regulation. Hedge funds, once a rare kind of investment fund for millionaires, now are relatively common vehicles for quick churning of stocks and bonds.

Paulson said yesterday that federal regulation, which largely dates from the Depression era, has had trouble keeping pace with this rapid innovation. Commercial banks are closely scrutinized while investment banks like Bear Stearns are more lightly overseen though their transactions and products are often similar. Hedge funds, private-equity firms, and various players in the mortgage industry are also barely regulated.

This patchwork is mostly an accident of history rather than the result of considered policies. Commercial banks and thrifts, formerly known as savings and loans, shoulder the highest level of scrutiny by federal and state governments. This control extends to capital requirements and management operations. In return, deposits are federally insured to a certain limit.

In contrast, mortgage lenders and brokers, whose practices contributed to the credit problems, get far less rigorous oversight.

"The mortgage lenders and the mortgage brokers are regulated at the state level, if at all,"
said Alice M. Rivlin, a former Fed governor now at the Brookings Institution.
"That's a definite hole."

A report this month by the President's Working Group on Financial Markets, a high-level advisory panel consisting of the federal government's top financial-market overseers, said lax oversight of mortgage brokers was in part to blame for allowing homeowners to get loans they could not afford.

Earlier this decade, the late Fed governor Edward M. Gramlich tried repeatedly to convince his colleagues to rein in these brokers and impose tighter restrictions on subprime lending. But Alan Greenspan, Fed chairman at the time, rebuffed Gramlich, and lobbyists for mortgage brokers also fought the move. In the wake of the current crisis, however, the Fed will soon unveil new rules to force brokers to follow tighter guidelines, according to financial lobbyists.

Hedge funds have also concerned some federal officials in recent years. The funds were able to avoid oversight because they were generally open to only wealthy investors, who were deemed sophisticated enough to watch out for themselves. But Goldschmid, a Democrat, and former SEC chairman William H. Donaldson, a Republican, concluded that the proliferation of these funds threatened the wider financial system, and they approved a measure to monitor them more closely.

A federal circuit court rejected the plan in 2006, and the current SEC chairman, Christopher Cox, declined to appeal. At the time, Cox said his legal advisers had concluded an appeal would be futile.

The government's regulatory regimen can often be hard to follow. The SEC is charged with protecting investors in securities and enforcing laws designed to stop fraud and market manipulation by people who buy and sell those securities. But it has limited ability to address the activities of investment banking firms that operate brokerage houses.

Since 2004, the SEC has been allowed to monitor the five largest securities firms' funding, risk management and soundness. But unlike the Fed, it cannot inject cash into a struggling institution to help when it faces a liquidity squeeze, as Bear Stearns did two weeks ago.

The Bush administration and some senior lawmakers have also tried to strengthen the regulation of mortgage finance giants Fannie Mae and Freddie Mac. The proposal to hand oversight of the companies to a new and more powerful agency gained prominence when Freddie Mac reported serious and previously undiscovered accounting problems in 2003.

The companies initially lobbied vigorously to block the change but have now said they would welcome a new regulatory system. They are still haggling over details, which has hung up the plan in the Senate.

Not everyone agrees, however, that more-strict regulation is the best way to solve financial problems. "People like me who want to reduce regulation do not want to make more and more companies wards of the government," said Peter J. Wallison a former Treasury official under President Ronald Reagan now at the American Enterprise Institute.

Even those who prefer more regulation have difficulty deciding which new powers to sanction. "The real problem if you have an overall regulator is, 'What do you really expect that regulator to do?' " Rivlin said. "It is extremely difficult to manage risk at the level of a Citibank or a Merrill Lynch; they are involved in so many things, and the markets move so rapidly. The best a regulator can do is assure itself that the institutions have good risk management procedures."

Regulators will inevitably have a hard time keeping up with financial advances. "The markets are always a generation ahead of the regulators," said Adam Lerrick, an economics professor at Carnegie Mellon University. "The best you can hope is for regulators to catch up to the current crisis, but they might not be able to do that."

Staff researcher Richard Drezen contributed to this report.

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