The ownership society

It's official, or so people think. Washington has ended its affair with laissez-faire. We have gone from a $700 billion bailout of financial institutions to taxpayers taking national stakes in them. With government participation in the private sector at levels not seen since the New Deal, re-regulation is the new obsession. The common wisdom has it that the financial industry will be saddled with new, heavy-handed rules in reaction to the worst global economic crisis since the Great Depression.

Senate Banking Committee Chairman Christopher Dodd, D-Conn., summed up the mood of U.S. policymakers recently. "It is clear that our current economic circumstances demand that we rethink, reform and modernize supervision of the financial services industry," he said at the opening of one of the congressional hearings on the financial meltdown. "If we learn nothing else from this crisis, it is that the failure to protect consumers can cause the collapse of our largest financial institutions, the loss of hundreds of thousands of jobs and the draining of billions of dollars of wealth from hardworking Americans."

That a new age of regulation is dawning is the conventional wisdom. But reality will be more nuanced. That may be a fitting direction for government oversight, given the Bush administration's derision of concepts such as so "Old Europe."

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Now that same administration has been following Europe's example. After resisting calls to take direct investments in struggling U.S. banks as France, Germany and the U.K. had done, Treasury Secretary Henry Paulson last week broke down and announced a $250 billion capital infusion as the centerpiece of his bailout plan. Similarly, after a host of European countries decided the best way to halt bank runs was to insure all deposits, the Federal Deposit Insurance Corp. did more or less the same.

The financial crisis has tarnished U.S. financial leadership in two ways. First, the glut of homes and failing subprime loans, coupled with the creation of billions of dollars in barely regulated credit default swaps have relegated American-style abhorrence of government intervention to the trash heap. Second, U.S. regulators' inability to design a solution to stabilize the markets has drawn into question their claim to unrivaled technical prowess over the world's financial machinery.

The growing clout of European regulators, who have always been more willing to intervene in the market if they believe it will improve a hairy situation, may mean more regulation is coming. That may not be entirely bad news for American companies. Business has been pushing U.S. policymakers to drop their dichotomized approach to financial oversight -- which veers from heavy-handed mandates (the Sarbanes-Oxley Act's accounting requirements) to nonexistent (the lack of meaningful federal oversight over mortgage brokers). Reform may give the financial industry an opportunity to push the U.S. to adopt European-style, "principles-based" regulation, which gives officials more power to step in when they see practices that harm consumers or put the financial system at risk but allow the industry to roll out new products without a lot of up-front resistance.

How might this new regulatory framework take shape? Given the public's anger over the financial industry's self-inflicted wipeout, it would be hard to imagine that some level of tougher oversight isn't on the way. Even before the meltdown, Paulson had been pushing a restructuring of Washington's regulatory apparatus. His so-called blueprint would form a single, overarching agency that would oversee financial holding companies. He would reassign other regulatory duties to separate offices responsible for protecting overall financial stability, ensuring safe business practices are carried out at banking institutions and protecting consumers. He also would like to do away with separate charters for banks and thrifts. So far his proposed changes are structural, and he has said little specifically about what new rules would be imposed.

Others are calling for strict new rules on mortgage origination practices, capital requirements for exotic financial instruments and retention of mark-to-market accounting. While the new burdens would be distasteful for some segments of the financial industry, it could make the best of things by convincing policymakers that the new rules should be coupled with flexibility that lets regulators ease burdens during times of financial stress. For instance, regulators could insist on tough capital standards in boom times but ease up when a declining overall market makes it impossible to raise funds.

"More flexibility might be built into the regulatory framework than we have now," says Jim Eckenrode, a bank analyst with Tower Group Inc. Such a move would better harmonize U.S. oversight with Europe, he says.

Despite all the talk of new regulations, so far the steps Washington has taken when it comes to the big banking and investment houses have been decidedly deregulatory. In addition to easing mark-to-market rules, which the SEC did Sept. 30, regulators have relaxed other rules to help financial institutions endure the crisis. On Sept. 14, for instance, the Federal Reserve greatly expanded the types of collateral it will accept from institutions that participate in the central bank's primary dealer credit facility. Two weeks after that, banking regulators made it easier for institutions to meet capital requirements by reducing the amount of "goodwill" banks must deduct from capital after acquiring another institution.

Congress, meanwhile, is moving quickly to figure out what new rules are needed. Dodd has said his priorities include additional legislation to stop "predatory lending" practices such as low-doc mortgages and teaser rates that allowed individuals to move into homes they couldn't afford. He also wants to rein in credit card marketing and billing abuses and give homeowners more protection in bankruptcy proceedings. As for the risky practices that turned housing market woes into a rout on Wall Street -- the explosive growth of credit default swaps and other complex financial instruments -- Dodd and his House counterpart, Financial Services Committee Chairman Barney Frank, D-Mass., are holding their thoughts until they can hold hearings examining how they ballooned into such a hazard.

On Oct. 21, Frank's committee will hold a hearing focusing on the extent to which the current regulatory system contributed to the market turmoil and how a stronger and more robust system could be designed.

Senate Agriculture Committee Chairman Tom Harkin, D-Iowa, on the other hand, has already committed to creating a regulated exchange for swaps. "Regulating these contracts is akin to employing the same sound economic policies used by businesses every day -- know what you're buying, the reliability of your seller, and if they have the assets to fulfill the transaction," he said during an Oct. 14 hearing. "Without proper regulations, trading in swaps is nothing more than casino capitalism."

The idea of a centralized trading platform for swaps is catching on, though there is debate over how strictly it should be regulated. There are two options: a formal exchange or a less strict clearinghouse. An exchange requires a standardized contract that is not subject to individual negotiation beyond price and quantity. A clearinghouse would allow trading of customized contracts.

Credit default swaps were regulated until 2000, when Congress passed the Commodity Futures Modernization Act, which declared credit default swaps are not a security and barred the Commodity Futures Trading Commission and Securities and Exchange Commission from regulating them.

"Clearly, it's time to regulate credit default swaps," Eric Dinallo, New York state's top insurance regulator, told the House Agriculture Committee at another hearing Oct. 15. Dinallo cited the "major role" CDSs played in the financial meltdown at American International Group Inc., Bear Stearns Cos. and bond insurers. "One of the major causes of this financial crisis was not how lax or tight we regulated or how easy or hard we enforced, but what we chose not to regulate" at all, Dinallo said.

Testifying at the same hearing, Walter Lukken, acting chairman of the CFTC, said some type of central clearing authority would reduce risk and gain transparency for what has been an opaque financial instrument.

"Clearinghouses have been around almost as long as trading itself as a means for mitigating the risks associated with exchange-traded financial products." Lukken noted that centralized clearinghouses ensure that every buyer has a guaranteed seller and every seller has a guaranteed buyer, minimizing the risk that one counterparty's default will ripple through the markets.

Some are pushing the clearinghouse approach so swaps parties will be free to establish terms as they see fit. Richard Fuld, the former chairman and CEO of bankrupt Lehman Brothers Holdings Inc., endorsed the clearinghouse concept in an Oct. 6 appearance before the House Oversight and Government Reform Committee. Fuld said he would like to see the creation of "a master netting system," where capital market counterparties each night download transactions to one location. "It would give whatever regulator is then in control ... a complete view of the financial landscape, the available capital to each and every asset class, flexibility within those asset classes and vulnerability within those asset classes and vulnerability of one institution versus the next."

Fuld acknowledged that additional regulation is warranted when it comes to capital requirements. "I would focus also on capital requirements ... meaning more capital for less liquid assets."

But he and many others are pointing to Lehman's collapse and other bank failures as an indication that the government's new mark-to-market, also known as fair value, accounting rules must be revised or tossed out. Wayne Abernathy, the American Bankers Association's executive director for financial institutions policy, blames mark-to-market accounting for exaggerating bank profits during the good times and for making them look worse than they should in bad.

"We had never put those accounting rules to the test," he says. "We are putting them to the sternest test now and they're flunking big time." ABA is disappointed with the SEC's Sept. 30 attempt to soften the impact of mark-to-market rules. Although the SEC let institutions use their own judgment when booking illiquid assets rather than relying solely on broker quotes, a subsequent interpretation by the Financial Accounting Standards Board required that liquidity risk posed to potential buyers be factored into the estimate. The ABA wrote, in a letter asking the SEC to overrule FASB, that the requirement would bring illiquid assets "full circle back to distressed sale values."

Abernathy referred to FASB as an "ivory tower, highly insulated program" with "very little accountability." He says FASB members seem to "take pride in the fact that they don't care what the consequences are for the economy," he says. "There's a growing recognition that accounting standards are too important to be left to the accountants."

But in a sign of how hard-fought the coming battles over regulation will be, accountants and others are digging in and urging the SEC and Congress not to make any major changes to fair value rules. "A move by the SEC to suspend fair value accounting would be a disservice to the capital markets, would be inconsistent with the views of investors, would harm the credibility and independence of the standards setting process," a coalition of groups representing accountants, institutional investors and consumers told the agency. "The current crisis of liquidity, credit, and confidence was not caused by fair value accounting; rather, sound accounting principles helped expose the problem."

Abernathy realizes there's a fight ahead. "The industry is concerned, though not quite nervous," particularly after a general election that could result in heavy turnover in Congress and the banking agencies.

"We have good working relationships with existing policymakers. The question is how many will still be overseeing the industry next year." Abernathy is keeping his fingers crossed that the next president won't be beholden to campaign supporters and pepper the regulatory agencies with political cronies. "We're going to emphasize that at this time we need financial regulators who know what they're doing. In this economy, we can't afford any on the job training."

-- Donna Block contributed to this story.

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