Paulson's Regulation Plan Won't Fix Current Economic Crisis

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By Kevin G. Hall

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."