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— Regulatory —
Henry Paulson and his harried band of financial fixers are trying to douse Wall Street's fires with a bucket brigade stretching from Washington to Manhattan to capitals around the world. The great houses of finance, now burning, must negotiate terms if they hope for a splash of government relief. There's no predicting where Fire Marshal Henry will aim next. Bear Stearns and its buyer J.P. Morgan Chase & Co. got some help. Fannie Mae and Freddie Mac got a lot; Lehman Brothers Holdings Inc. got nothing. American International Group Inc. landed an $85 billion bridge to who knows where.
-- Browse other stories in this Special Report -- Wall Street's passages Estate matters The abyss Business as usual Between the cracks Under what circumstances the government will provide the next big assist is a wild guess. Paulson's decision to let Lehman go into Chapter 11 was hailed as a line in the sand by those worried about moral hazard, a declaration that no more government money would go to shore up the charred rafters of high finance adventurers. That line was crossed at the next bout of trouble a few days later, when insurance giant AIG was teetering. The reality is that the more risk a firm has spread around the globe, the better its chances of getting help. The biggest firms, especially those that recklessly entered all sorts of swaps and other counterparty agreements with international clients, are the ones getting a piece of the action. Jose Vivar, real estate capital markets partner at national accountancy RSM McGladrey in Chicago, thinks Paulson and his teammates at the Federal Reserve Board are fighting the raging wildfires just about right. Like many others, Vivar says a failure of AIG posed a genuine threat to global markets not only because of the size of its insurance business but also because it was a huge provider of insurance against credit default risk. Lehman, on the other hand, was out of luck because the market could handle the aftereffects on its own. "The Fed action seems to signal that the effects of a Lehman blowup is not large enough, is containable within a relative small radius and can be absorbed by the markets." To use a phrase coined in more bullish times, there has been a clear advantage to being the first mover. Bear Stearns was the first major institution to fall and wouldn't likely be a candidate for government assistance if it were collapsing now. "In retrospect, the Fed probably would not have helped bail out Bear Stearns, based on their recent actions," says Vivar. Paulson will need to let more institutions fall, because his actions are battering the Fed's balance sheet. On Sept. 17 the Treasury issued $40 billion in new debt to help shore up the Fed's books. The next day, central banks of Canada, England, Japan, Switzerland and the European Central Bank authorized new swap facilities to alleviate pressure in U.S. dollar short-term funding markets. The Fed's Federal Open Market Committee also authorized a $180 billion expansion of its temporary currency swap lines to better ensure dollar liquidity in those countries. As the fighting moves from one flare-up to the next, Paulson hasn't had time to talk about fixing the wider regulatory landscape. Though he introduced a sweeping plan for overhauling financial markets regulation at the end of March, it was overshadowed by Bear Stearns' implosion the weekend of March 14. There has since been little expectation that any grand scheme would be passed so soon before an election and while the financial fires are burning. Nevertheless, there has been no shortage of ideas, ranging from how to dispose of the scores of billions in tainted meltdown-causing mortgage securities to ways to ensure a similar firestorm never ignites again. Hearings are being scheduled by the House Financial Services Committee and Senate Banking Committee to examine all sectors of the financial industry. House Government Oversight Committee Chairman Henry Waxman, D-Calif., plans to bring Lehman CEO Richard Fuld and AIG CEO Robert B. Willumstad and his predecessors Martin J. Sullivan, and Maurice R. Greeberg to testify in October. One news report Thursday said Paulson is taking the advice of experts and lawmakers on both sides of the aisle, and is trying to set up an entity modeled somewhat on the Resolution Trust Corp., which took over failed savings and loans and managed or sold their assets. If that turns out to be true, the government would likely fund a workout institution simply to hold troubled assets, not the financial houses themselves, and slowly put them on the market to prevent them from flooding the market at near-zero prices. The government would purchase illiquid mortgage assets, either from financial or retail institutions or both, at a discount through auctions. Then, it would refinance them. At this stage, it is unclear how such a fund, known as a bulk auction facility, would be created. Would it buy individual mortgages or packaged mortgage debt from financial institutions that are either bankrupt or struggling under the weight of illiquid collateralized debt obligations? Would it pick up undeveloped land assets, such as those owned by Lehman Brothers? The Federal Reserve Board was expected later in September to address some of those questions in a report detailing how such a vehicle could be structured. Senate Banking Committee Chairman Christopher Dodd, D-Conn., isn't ready to commit but says he's "anxious to hear what the administration would have to say." House Financial Services Committee Chairman Barney Frank, D-Mass, says he's interested in the idea, as is Republican Paul Kanjorski of Pennsylvania, a senior member of Frank's committee. House Minority Leader John Boehner, R-Ohio, and Alabama's Richard Shelby, the Senate Banking Committee's senior Republican, however, indicate they are opposed. "We don't need more federal involvement in our markets," Boehner says. "What we need to do is allow our markets to work." Skeptics of greater government regulation want to see the government fix Wall Street's "broken plumbing," rather than impose a new set of rules of limiting investment banks' exposure to exotic instruments or other limits on what they can do. Charles Calomiris, Henry Kaufman professor of financial institutions at Columbia University's School of Business, supports the notion of a central clearinghouse for credit default swaps and perhaps other derivatives. A clearinghouse, he says, would reduce risk to the financial system by netting positions to pay counterparties rather than leaving them to extract payments from a failed institution. Members could establish assessments to share losses if one fails. Noting that Federal Reserve Board Chairman Ben Bernanke has endorsed the idea, Calomiris said market lockups can be prevented with an independent clearing mechanism. "By fixing the way the over-the-counter market clears, we could reduce some of the complexity and asymmetric information problems that attend those transactions," he says. Calomiris is encouraged by the major banks' decision to start a $70 billion private fund to provide liquidity to the industry when needed. "That shows they understand the principle that there is an externality among these banks and that they want to protect each other as a collective, with private liquidity assistance and orderly loss sharing." Making sure such a mechanism is available during bankruptcies would be an advantage, too, he says, because it would make the chance of federal intervention less likely. The government could continue buying and providing bridge loans but these kinds of bailouts could lead institutions to take further risk with expectations of government assistance. Critics of the Securities and Exchange Commission question whether Bear Stearns and Lehman Brothers sufficiently diversified their investments and if the SEC did a good enough job supervising their asset allocation controls. Even GOP presidential candidate Sen. John McCain has gone so far as to call for the firing of Chairman Christopher Cox. Feeling the political heat, Cox is going through the motions with an investigation into just what went wrong with the SEC's oversight. "In some cases, the broker-dealers weren't completely aware of their own concentration problems," says Matthew Comstock, associate at Willkie Farr & Gallagher LLP in Washington. "The SEC could require investment banks to have tighter internal controls and perform better due diligence on the assets they own." That could lead to tighter capital requirements, most likely disqualifying some instruments from counting toward an institution's loss cushion or requiring some riskier ones to be tallied at a steeper discount to market value. That is sure to spark a fight. Calomiris acknowledges that the risk-based capital standards that applied to Bear and Lehman allowed them to be highly leveraged, but whether they should face tougher standards is "a fairly complicated issue," he says. Calomiris, a member of the Shadow Financial Regulatory Committee, a free-market think tank of economists and scholars, argues against imposing the rigorous regulatory capital regime commercial banks face onto investment banks. "We don't believe that the same model of prudential capital regulation should be applied to investment banks. We're worried about the stifling effect that kind of risk-averse regulation system would have on innovation." Given the havoc wreaked by the latest crop of complex financial instruments, there is a wide swath of belief that too much deregulation created the crisis in the first place. Congress might find arguments by the likes of Boehner, Shelby and Calomiris less-than-persuasive when it comes to new restrictions on a range of institutions. |
If what the markets need most is certainty, they won't get it from Washington any time soon.
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