This column was written by Robert Gordon and James Kvaal.
Witnessing the collapse of one Wall Street titan after another seemed unthinkable a year ago, but the U.S. has seen worse before. When Franklin Roosevelt took office, four thousand banks had closed in just two months. From his improvisatory response--like a quarterback calling plays, as he once described it, back when quarterbacks called plays--the framework for the modern banking system emerged.
With wiser leadership, that framework might have prevented the current meltdown. For years, Senator Paul Sarbanes pressed for anti-predatory lending measures that would have slowed the disastrous subprime boom. At the Federal Reserve, the late Ned Gramlich sought new scrutiny of loans by the barely regulated bank affiliates with the worst portfolios. Arthur Levitt, then chairing the Securities and Exchange Commission, opposed the deregulation of the credit default swaps market in which AIG placed its most disastrous bets. And only months ago, Representative Barney Frank pressed for aggressive federal action to work out defaulting loans and stem the decline of foreclosures.
But policymakers put too much faith in "market discipline" to stem excess risk, and now here we are. The first focus is stemming the crisis, which may soon require a new entity to manage the liabilities that government is taking on. But whatever happens on that score, the time will soon come to rethink the entire regulatory structure. The aim should be a system that can withstand the bubble-based thinking that has brought us so low. That will require major changes.
The alphabet soup created by Roosevelt and his successors no longer tastes so good. Regulatory responsibilities are hopelessly muddled, and the jurisdictional lines between the regulators no longer make much sense. There are five federal banking regulators, plus state regulators. While the SEC regulates the sale of stocks and bonds, a different agency regulates some derivatives, while others go unregulated. Insurance--one of the largest financial industries--is regulated almost entirely by states. In a world of complicated new instruments, like collateralized debt obligations and credit default swaps, it's become difficult to know who is supposed to regulate what. Today's large financial institutions compete in multiple markets and across state and national lines. By adjusting their legal status, companies can effectively choose their own regulator, making it difficult to hold them to strict rules.
Despite all the regulators in place, the current system overlooks many of the most important transactions. Half of our financial markets--controlling some $10 trillion in assets--are barely regulated at all. These entities include investment banks, hedge funds, and mortgage companies (which are not banks but made the bulk of subprime mortgages).
Straightening out the system will require both reorganizing and strengthening the regulators. Senatorclearly does not grasp this.
Never one to worry about consistency, he bitterly assailed Wall Street this week--but only after weeks of sending coded love notes to the very same crowd. He has maintained his close ties with Phil Gramm, the former senator who never met a financial regulation he didn't hate. McCain warned earlier this week that "We cannot tolerate a system that handicaps our markets and our banks." Earlier in the year, in a major address on the housing crisis, he called for "removing regulatory, accounting and tax impediments to raising capital."
Of course, the removal of regulatory requirements for raising capital has played a part in the current crisis. The most interesting line in's speech Tuesday was his comment about how "we repealed outmoded rules instead of updating them"--a veiled shot at late 1990s deregulation pressed by Gramm and signed into law by Bill Clinton.
Obama went on to lay out six principles for reform that get the big things right. Most important are stronger safeguards in areas of the greatest risk. Many investors have borrowed to increase the size of their investments, lifting their potential profits but leaving no cushion if things go sour. As Roger Altman and Steve Rattner have argued, these risky investments will need to be backed by more reserve capital. They should also be subject to stronger disclosure requirements, to give markets a chance to work.
The Federal Reserve has decided to make investment banks eligible for short-term loans previously made only to traditional banks, putting taxpayer dollars on the line to prevent widespread economic damage. But this federal benefit should come with some of the same oversight given traditional banks. Otherwise we are effectively allowing investment banks to gamble with taxpayer money.
As Obama said, we need to reorganize our regulatory agencies around what institutions do, not what their legal status happens to be. The current system is like setting different speed limits for different brands of cars. Obama didn't specify an alternative, but one natural possibility is to give different regulators different core missions--system risk here, consumer protection there. Regulations would depend on the nature of the risk, not the legal status of the entity regulated.
Also important are two steps beyond the six principles Obama enumerated in his address. The most urgent task is resolving the millions of troubled mortgages, whose value is still unknown. We need to get homeowners into mortgages they can afford to repay--a step that would accelerate our recovery as well as help millions of families. And then, as many have sought for years, Congress should ban the predatory and abusive mortgages that sparked the crisis, starting with prepayment penalties that lock homeowners into unaffordable loans.
The final issue, important for its symbolism, is excessive executive pay. CEOs of companies whose stock underperforms Treasury bonds routinely earn nearly $3 million a year. More spectacularly, Merrill Lynch's leadership trio, who saw their venerable firm's value plummet until it needed to be taken over by Bank of America, may make $200 million this year alone. Such absurdities threaten the trust and cinfidence that markets need to thrive.
Stripping the Fannie and Freddie CEOs of their golden parachutes was a fine first step, but the SEC ought to go further and let shareholders vote on CEO pay packages. Loopholes have made a mockery of the Clinton-era law limiting the deductibility of executive pay unless it is based on performance; repairing that law is worth a closer look too.
Some people call these kinds of measures a step on the road to socialism. But Franklin Roosevelt, having used his first moments as president to declare that the money changers had fled the temple, would have disagreed. And his willingness to rein in the capitalists ultimately saved them. Besides, with the Federal Reserve taking an 80 percent stake in a gargantuan private insurance company, it is hard to know who the socialists are anymore.
By Robert Gordon and James Kvaal
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