Out of order

Henry Paulson wants to fix America's financial regulatory apparatus, an outmoded, jury-rigged collection of federal and state overseers governing an ever more complicated and intertwined industry. But in many ways the Treasury secretary's solution now seems as rickety as the jalopy he wants to overhaul.

Unveiled in March as the credit crisis continued to engulf Wall Street, his "blueprint" for capital markets reform has been overtaken by political reality and his own ad hoc attempts to calm investors. Part of his plan includes immediate initiatives aimed at dealing with the liquidity crunch bearing down on investment banks and government-sponsored mortgage securitizers Federal National Mortgage Association, or Fannie Mae, Federal Home Loan Mortgage Corp., or Freddie Mac. Longer-term ideas were meant to bring coherence to the overlapping patchwork of federal and state agencies that oversee commercial banks, Wall Street and insurance companies. He has imposed most of his short-term goals by fiat, with help from Federal Reserve Board Chairman Ben Bernanke and New York Federal Reserve Board President Timothy Geithner.

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With or without Paulson, it's doubtful that a sweeping reorganization of financial regulators will go through, and perhaps even doubtful whether it should be a priority. The changes would be controversial within the various financial sectors and with congressional committee chairmen, who jealously guard their authority over agencies and industries under their jurisdiction. The resulting battles would be a distraction that could prevent Congress from addressing more pressing economic problems, such as the country's ballooning entitlement programs, national debt and trade imbalance.

When he unveiled it, Paulson conceded that the most sweeping parts of his plan would take years to implement, including merging banking regulators and eliminating the thrift charter for housing-focused savings and loans. But the Treasury secretary will soon exit with the rest of the Bush administration, robbing the plan of its chief advocate. A new Congress and president will be handed the chore of restoring faith in financial regulation, and many of his most controversial ideas won't get much traction.

Congressional committees and the various financial sectors are quite comfortable with the status quo. There would be vicious turf fights over any attempt to consolidate power within one or two agencies. "You want regulators focused on problems in the banking industry today, not whether they have a job tomorrow," says Gerard Comizio, senior partner in the financial services practice group at Paul, Hastings, Janofsky & Walker LLP. "For things like eliminating the thrift charter, there's nothing driving that right now."

Democratic nominee Barack Obama criticized the plan as insufficient when it was unveiled, while Republican nominee John McCain praised it as "long overdue." Beyond that, neither candidate has offered any detailed alternatives, but such technical proposals would be of little interest to voters. The new administration's plan will likely come well after the next president is sworn in.

One key element to Paulson's plans has been to increase the role of the Fed. Regardless of who is elected, consolidating the power of the central bank -- with its myriad of enemies in Washington -- will face intense opposition. Paulson may be a former head of Goldman, Sachs & Co., but Wall Street generally opposes expansion of the Fed's holding company oversight to securities firms. The idea makes the firms nervous because of the aggressive oversight the agency already exercises over holding companies of commercial banks. The Fed examines a parent's operations to ensure the bank is insulated from potentially risky activities of the company's other business lines. Resistance to such intrusive oversight is a big reason why few securities firms have acquired commercial banks since Congress gave them that right in 1999. Rather than subject themselves to Fed scrutiny, investment banks have more often acquired savings and loans and thrifts, which focus on mortgages or credit cards rather than commercial lending. The Office of Thrift Supervision exercises much less intrusive parent company supervision.

Paulson says eliminating just that sort of "regulatory arbitrage" is a big rationale for consolidating regulators. But many also see the Fed as having a major conflict between its role as the nation's central banker and as bank supervisor. In theory, the central bank is charged with creating sound monetary policy, but in practice it faces constant political pressure to keep interest rates low and the economy expanding. Critics argue that a Fed preference for easy credit fueled the housing bubble and helped spawn many woes the economy faces today.

As a banking regulator, the Fed's performance has also been questioned. It failed to detect problems in bank holding companies' mortgage securities portfolios. It oversees independent mortgage brokers' compliance with consumer protection laws as part of its duty to enforce the Truth in Lending Act. But the Fed failed to stop them from churning out loans that borrowers couldn't afford -- the ones going bad today.

One element of Paulson's proposed Fed expansion already has been pushed aside. The blueprint proposed usurping the Securities and Exchange Commission's oversight of investment banks and handing it to the Fed. That emboldened SEC Chairman Christopher Cox, who has not developed a reputation as a forceful defender of his agency's turf, to fend off a possible take over of SEC duties during negotiations with the central bank over sharing oversight of investment banks and their parent companies. The memorandum of understanding penned July 7 left nearly all the hands-on oversight of investment banks with the SEC. Cox successfully defended the agency despite its failure to foresee the meltdown at Bear Stearns Cos. and its relegation to the sidelines as other agencies resolved that crisis.

Georgia's Saxby Chambliss, the Senate Agriculture Committee's ranking Republican, mapped out how difficult the road to regulatory overhaul would be when, only a few days after Paulson unveiled his plan, he disparaged the Treasury secretary's call to merge the SEC with the Commodity Futures Trading Commission.

The notion, which others have suggested, would bring to bear the best attributes of each agency on both securities and futures markets. For instance, the SEC's enforcement would better prevent abuses in futures trading while the CFTC's experience with European-style "principles-based" regulation would give securities regulators more flexibility in approving new products and allow them to step in when they see problems that pose a risk to market stability. It also makes sense to combine regulation, because most of the futures trading introduced on CFTC-regulated exchanges since the 1970s is securities-based rather than pegged to agricultural commodities, as nearly all futures were a century ago.

Chambliss showed just how difficult it would be to build support for a SEC-CFTC merger by running off a checklist of the constituencies. They include investors, traders and farmers, all of whom would like to fight that single element of regulatory consolidation.

"The broad rationale for merging the SEC and the CFTC fails to properly account for the distinct and necessary differences involving margin, insider trading, customer suitability and short sales regulations for futures and securities," Chambliss said in a March 31 statement. "Additionally, I am concerned that agricultural market participants, namely farmers and ranchers, may not continue to receive adequate attention that only focused expertise can provide."

Doomed though it may be, Paulson's proposed reordering of financial oversight will likely get plenty of attention in congressional hearings and eat up a lot of time when the new Congress reconvenes. House Financial Services Committee Chairman Barney Frank, D-Mass., and his Senate counterpart, Banking Committee Chairman Christopher Dodd, D-Conn., have pledged to hold lengthy rounds of hearings on altering the regulatory landscape. Frank, for his part, has indicated that he backs making the Fed a super-regulator. Although there may be legitimate criticisms of the Fed, Frank at a hearing said, "I don't see any alternative to the Federal Reserve."

That same hearing provided a glimpse of what we're in for if the idea of expanding Fed power is pressed too hard. Alabama's Spencer Bachus, the Financial Services Committee's ranking Republican, predicts that if it is ordained as super-regulator, the Fed will be loath to permit a major institution to fail on its watch because to do so would indicate the central bank can't handle the expanded supervisory obligations.

"The logical extension of this 'too big to fail' perception is that markets no longer work and that government must not only exercise greater control of our capital markets, but also be the ultimate guarantor of financial solvency," Bachus argued. "That would be a conclusion I could not endorse."

Another Paulson idea that may go by the wayside is creating a federal regulator for nonbank mortgage companies. It's true that mortgage companies and their brokers, overseen primarily by state officials, lack a consistent level of regulation. But the states will likely be unwilling to relinquish their authority. As a result, the emphasis will be on beefing up state authority rather than ceding it to a federal regulator.

Paulson's penchant for dramatic overtures has begun to seem as much show as substance. At a press conference in July, the Treasury secretary, flanked by Federal Deposit Insurance Corp. Chairman Sheila Bair and other regulators, unveiled a program to coax banks back into creating mortgage-backed securities by encouraging them to issue "covered bonds." Unlike asset-backed securities prevalent in the U.S., covered bonds require lenders to keep the loans on their books. These facilities are the primary vehicles for financing mortgages in Europe and keep the default risk with the bank rather than transferring the exposure to investors.

Despite the fanfare, bankers predicted covered bonds would provide only a modest benefit to the U.S. market. Paul Baalman, structured finance executive at Bank of America NA, predicted that covered bonds could eventually account for $1 trillion of the $12 trillion U.S. mortgage market, not enough to be a primary driver. Meanwhile, covered bonds might prove a hard sell to banks. Attorney John Douglas of Paul, Hastings, Janofsky & Walker LLP says because banks must maintain the bonds on their balance sheets, they must hold capital against them. With the industry already having difficulty raising capital, compounding their need for additional cash won't make bankers' lives easier.

Despite all this, Paulson has made a big mark. As Bear Stearns was crashing, he approved using the Fed's emergency powers to temporarily open its low-cost lending facility, known as the discount window, to Wall Street firms. Before, it served only commercial banks and other deposit-holding institutions. The move reassured investors that other firms wouldn't run out of cash. Before the credit crisis, such a unilateral decision would have caused a firestorm. Now the escape valve for today's crisis has not only been accepted, but absorbed into the permanent regulatory landscape.

Much of the credit goes to Paulson, says Paul Quinn, an attorney with Buchanan Ingersoll & Rooney PC's federal government relations section. Over the objections of ideologues in the administration who would have been happy to see Fannie Mae and Freddie Mac pushed to insolvency, Paulson so far has made restoring stability a priority. "The rescues of Bear Stearns, Fannie Mae and Freddie Mac could not have happened but for Paulson," Quinn says. "His forceful reputation and sophisticated knowledge of the industry persuaded Bush to cut the necessary deals."

Like a park ranger tamping out brush fires, Paulson has often acted on the fly. Lawmakers now must impose rules to guide future Treasury secretaries during the next crisis. For instance, they must decide which firms can use the Fed's lending powers and when.

Stemming investment banks' mostly self-inflicted woes raises another question. Will Wall Street now expect Washington to bail it out whenever it messes up? Critics say that knowing that a taxpayer-funded bailout will be served up if things go badly, financial firms will be encouraged to take crazy risks, a type of recklessness economists call moral hazard. Dodd says the Bear Stearns intervention "fundamentally altered our financial market landscape and our system of financial market regulation."

Without established rules from Congress, the ad hoc approach Paulson concocted for Bear Stearns by default will become the model for interventions.

Paulson argues that unwise risk taking can be discouraged only if Washington makes it clear it will authorize bailouts only when necessary to protect the financial system. "For market discipline to effectively constrain risk, financial institutions must be allowed to fail," Paulson told the House Financial Services Committee in July. If a firm's collapse isn't likely to spread contagion to other firms, it must be allowed to go under, he insists. As a consequence, Congress must also enact legislation spelling out how the government will deal with the failure of a big Wall Street firm.

There also are issues Paulson hasn't addressed, such as the how to handle the ongoing rash of home foreclosures and the shaky condition of the country's commercial banks and thrifts, which hold more than $3 trillion in federally insured deposits. Banks need to set aside more capital to cover bad loans, and as a consequence Congress may have to be more receptive to new types of owners, such as private equity firms, and revisit whether non-financial firms like Wal-Mart Stores Inc. should be able to buy banks.

"We could get foreclosures at such a rate that, politically, the federal government is going to have to step in," Comizio says.

Second, deposit insurance coverage must be addressed. "With the volume of bank failures, Congress may have to rethink the $100,000 guarantee." He thinks the coverage for general deposits (retirement accounts have a $250,000 guarantee) is too low, leading depositors to withdraw their money at the first rumor of trouble. A panic reminiscent of the 1930s forced the government to take over IndyMac Bancorp, but "slow runs" at Countrywide Financial Corp. and other banks have also led to liquidity problems.

Bank regulators must also prepare taxpayers for a possible "doomsday scenario" that would require a bailout of the Federal Deposit Insurance Fund. The failure of IndyMac will likely wipe out $8 billion of the fund's $53 billion pool. Typically, the banking industry would be saddled with rebuilding the fund, but the industry as a whole is so weakened by the real estate collapse and the shaky commercial lending market that it probably could not afford the assessment necessary if one or more major banks fail.

"The banking industry is facing increased premiums at a time when it can least afford it," Comizio says. "One very large institution coming down could really exhaust the fund."

Finally, many in Washington think the problems are too fundamental for a reordering of the regulatory deck chairs to solve. Instead of pursuing politically unpalatable regulatory streamlining, which may produce only mild improvements, some suggest Congress should focus on major issues such as the budget and trade deficits, funding Social Security and healthcare coverage and the loss of manufacturing jobs.

"I'm not sure our regulatory structure makes such a big difference," says Ron Glancz, chair of the financial services group at Venable LLP. "We have a unique system. Nobody starting from scratch would have dual federal and state banking regulators and three regulators at the fed level, but it does work."

Instead, Washington should deal with global and macro issues. "We're living on credit as a society, we have a weak dollar, huge deficits and high oil prices," he says. "Those are more serious problems than whether to merge the Office of Thrift Supervision and the Comptroller of the Currency."

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