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Paulson's Regulation Plan Won't Fix Current Economic Crisis
By Kevin G. Hall
McClatchy Newspapers
Sunday 30 March 2008
Washington - Treasury Secretary Henry Paulson makes public on Monday a new blueprint
for regulation of the turbulent financial markets, one that has plenty to do with
the future and little to fix what ails the economy right now.
The plan would merge some federal bank regulators, weaken the agency that regulates
the stock market and broaden the shoulders of the Federal Reserve, which will
become the chief regulator for the safety and soundness of financial markets.
It's the broadest reform of oversight in the financial markets since the aftermath
of the Great Depression and is sure to touch off a frenzy by Gucci-shoed lobbyists
in the months and years ahead.
The Paulson plan does not lack big ideas. It would allow insurance companies to
opt out of state regulation in favor of a proposed federal insurance regulator.
It would merge the regulation of the stock market and futures market. This is
to better reflect how commodities like oil and soybeans have become a new investment
vehicle that rivals stocks and bonds.
And for the first time, hedge funds, which are private pools of capital for the
ultra wealthy, would come under federal regulation, albeit with a light touch.
The idea of modernizing the regulation of financial markets predated today's current
turmoil, and it was one of the reasons Paulson left his post as CEO of investment
bank Goldman Sachs & Co. to take what many two years ago saw as a dead-end
job.
In a tacit admission that the federal government failed in overseeing the housing
boom from 2001 to 2006, Paulson would set up a new federal Mortgage Origination
Commission, comprised of several bank regulators, to oversee mortgage finance.
"The high levels of delinquencies, defaults and foreclosures among sub-prime
borrowers in 2007 and 2008 have highlighted gaps in the U.S. oversight system
for mortgage origination," said a draft executive summary to be included
in Monday's report.
During the boom years, President Bush touted his vision of an "ownership
society" with record levels of home ownership. Lending standards eroded,
particularly for sub-prime loans, which are issued to the weakest borrowers.
These sub-prime loans are now at the heart of the nation's financial problems.
Banks seldom hold a mortgage on their books but sell into a secondary market,
where mortgages are pooled and sold to investors as mortgage bonds. But as lending
standards weakened, and almost anyone with a pulse could get a loan, these loans
were passed into the secondary mortgage market and on to unsuspecting investors.
As sub-prime loans began defaulting in record numbers - one in five adjustable-rate
sub-prime mortgages is now delinquent - the mortgage bonds became toxic and in
August spurred a crisis of confidence in credit markets. Because of the lack of
transparency in the issuance of these mortgage bonds and in other similarly constructed
products, banks stopped trusting each other or the people they do business with.
The collapse of confidence recalls market behavior during the Great Depression,
and is the reason the Federal Reserve stepped on March 16 in to prevent the failure
of a giant investment bank - Bear Stearns -and made available short-term loans
worth an unimaginable half a trillion dollars.
Paulson's plan places particular emphasis on housing finance. The new Mortgage
Origination Commission would be comprised of five federal banking regulators and
an association of state banking supervisors. It would oversee the adoption by
states of federal minimum standards for mortgage brokers - who originated about
two-thirds of the sub-prime loans now going bust - and would establish licensing
and qualification standards, records of personal conduct and standards under which
a broker could loose a license.
But Paulson leaves it to states to enforce federal regulations on independent
mortgage brokers - the same states that failed to rein them in during the housing
boom.
Paulson's call for an super-regulator of financial markets mirrors ideas already
presented in legislation by Rep. Barney Frank, D-Mass., chairman of the House
Financial Services Committee.
Frank welcomed Paulson's plan but said it gave insufficient attention to the non-bank
lenders who issued the problem home loans. The largest of these companies - New
Century Financial Corp. and Ameriquest Mortgage Co. - are now bankrupt. They fell
through the cracks of federal legislation and state regulation.
Paulson's plan "goes too far in diminishing the role of the states, and not
far enough in conferring needed new powers on the Federal Reserve over non-bank
financial institutions for which they now have greater responsibility," Frank
said.
President Bush has viewed financial markets as self-regulating, believing that
investment banks, which aren't subject to the same kind of scrutiny as commercial
banks, can be held to good behavior by the companies they do business with, called
counterparties.
This process broke down when mortgages were being bundled and sold to investors.
Investors relied on credit rating agencies like Moody's, Fitch and Standard &
Poors, which gave the prestigious AAA rating to many of the mortgage bonds. But
the rating agencies had a conflict of interest. One branch of their business worked
with investment banks to pool and package the bonds while another arm rated them.
Only in mid-2007 did the Securities and Exchange Commission (SEC), which regulates
the stock market, obtain the powers to regulate the rating agencies. Despite the
shortfalls in regulation, Paulson's report recommends that the SEC streamline
self-regulatory provisions and make it possible for even more self regulation
to increase "product innovation and investor choice."
The last major effort to regulate financial markets followed the collapse of energy
giant Enron, and resulted in new accounting standards that many experts warn have
caused companies to list on foreign stock exchanges instead of on Wall Street.
That's why financial industry players greeted Paulson's report with an eye toward
deregulation instead of regulation.
"The U.S. apparatus of financial supervision remains a patchwork of legal
entity- and product-focused regulatory fiefdoms with overlapping jurisdictions
and varying statutory responsibilities and powers," said Rob Nichols, president
of the Financial Services Forum, an industry trade association.
Added David Hirschmann, president of the U.S. Chamber of Commerce's committee
on financial markets, "Band-aid solutions such as simply layering on new
regulation upon a duplicative, creaky old system won't do."
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