New York Times Editorial: Questions for Reform

New York Times Editorial: Questions for Reform
Copyright by tHe New York Times
Published: March 28, 2009
http://www.nytimes.com/2009/03/29/opinion/29sun1.html?_r=1&ref=opinion


Treasury Secretary Timothy Geithner sounded the right notes last week when he presented a first draft of the administration’s plan to reform the financial system. He said the system had failed “in fundamental ways” and would require comprehensive overhaul. “Not modest repairs at the margin,” he told Congress, “but new rules of the game.”

It is too early to say whether a fleshed-out proposal — and what Congress eventually passes — will amount to a game changer. Some of Mr. Geithner’s proposals do appear aimed at limiting dangers that have lurked for too long in dark corners of the markets. Others may simply preserve Wall Street’s prerogative to party on once the current storm has passed.

For instance, Mr. Geithner called for all large hedge funds and private equity firms to register with the Securities and Exchange Commission, a move that could bring much-needed disclosure and oversight to vast pools of capital that fed the bubble economy. But the S.E.C. would not have the full authority to resolve all concerns. Rather, it would report its findings up what could turn out to be a convoluted chain of regulatory command.

Similarly, Mr. Geithner called for oversight of unregulated derivatives, like the credit default swaps at the heart of the debacle at American International Group. But he made a troubling distinction between “standardized” derivatives and “non-standardized” ones, and proposed different regulation for each. That looks like a loophole disguised as a new rule. Derivatives, now swapped one-on-one, ad infinitum across the financial system, need to be traded on a fully regulated exchange, period.

A dual system would close off some activities, but would also invite a variation on the regulator shopping that Mr. Geithner said he wanted to stop.

The real tension in Mr. Geithner’s presentation was in what went unsaid. His proposals can serve as the basis to start a reform discussion. But there are big underlying issues that Congress and the administration should keep in mind. Here are three that concern us now:

Is too big to fail too big to exist? The notion of institutions “too big to fail” is shorthand for firms whose collapse would endanger the entire financial system. It is not just a matter of size. Such firms, like A.I.G., have proved dangerous mainly because of their involvement in a web of often conflicting financial practices and products. The A.I.G. financial unit that sold credit default swaps did not have the wherewithal to make good on its obligations, but leeched off the AAA rating of the company’s strong insurance business.

Of all the proposals Mr. Geithner laid out this week, the most far-reaching pertain to such systemically important firms. He called for a single powerful regulator to police the most powerful institutions, presumably intervening to require more capital whenever sheer size and conflicting activities appear threatening. In the all-too-likely event that firms would get too big to fail anyway, he called for new government powers to seize and restructure them, if failure seemed imminent. No one disputes that this authority is needed in today’s world to avoid calamitous bankruptcies and bailouts. The aim would be to make such takeovers as orderly as a bank seizure by the Federal Deposit Insurance Corporation.

The important question, however, is whether, in a reformed future, any firm should even come close to getting too big — too diverse, too interconnected — to fail.

Mr. Geithner’s plan assumes that such firms will be a feature of the financial landscape going forward. That is a radical shift in perspective. Depression-era legislation, after all, prevented financial firms from mixing commercial banking with investment banking and insurance. Only in the last 10 years — with the passage in 1999 of the Gramm-Leach-Bliley Act — have such financial supermarkets been allowed to re-emerge.

Supporters of Gramm-Leach-Bliley recognized that too-big-to-fail firms posed a risk of taxpayer bailouts. Their concerns were soothed by a belief that market discipline, combined with innovative ways to reduce risk — namely derivatives like credit default swaps — would mitigate the danger. We now know that discipline failed and the innovations actually amplified risk greatly.

In some cases, these big firms allowed ever more financial risk to be piled on ever-thinner cushions of capital. That helped to juice Wall Street profits, but did it really outweigh the disadvantages that are now so painfully evident in taxpayer-funded bailouts?

If there is no proven way to reduce the systemic risk in big and interconnected firms, why should they be allowed to exist? It would take some time to dismantle them, so the government should, in the meantime, be granted the resolution authority to seize them if needed. But that should not substitute for a debate on whether such firms should be allowed to exist at all.

What are we trying to fix, anyway? The urgency to repair the financial system is mainly political. Crises create intense public awareness and with it, the opportunity for change that reform-minded officials do not want to squander. Even lawmakers who would prefer the status quo feel the pressure to act.

But does anyone understand with specificity what brought on the financial meltdown? Can the lawmakers and other officials charged with writing the new rules explain the transactions, interactions, norms, products and relationships that got us in this mess? Can anyone parse how much of the crisis is due to regulatory failure, how much to recklessness and greed, how much to fraud and manipulation? Why, exactly, did Goldman Sachs get $12.9 billion in the A.I.G. bailout?

Without the answers, which we do not yet have, Congress and the administration cannot be confident that they are coming up with the right reforms.

It is clear, however, that there is bipartisan resistance to a thorough investigation of what caused the collapse. There have been hearings galore. But they are often little more than hazings of corporate executives and government officials. Even the illuminating hearings have not been connected in a meaningful way that will help us all understand what went wrong.

Without an investigation, the reform effort will be at best, hit or miss, and at worst, a charade. Congress should start now to gear up for an investigation, using as its model the 1930s Pecora inquiry into the stock market crash, or the Watergate hearings of the 1970s. The investigation should not be performed by outside experts, like the 9/11 commission, whose report Congress is free to accept or reject. It should be part of the Congressional process and include an investigator with subpoena power and the right to participate in the questioning of witnesses, as well as to prep lawmakers for the hearings.

A real investigation might serve as a channel for the public anger now used by politicians to score quick populist points on television without tackling the real issues.

Who is to carry out the reforms? Any serious call for reform has to acknowledge the severe institutional damage that has been done to the nation’s regulatory agencies. For 30 years, the political tide in this country has run against regulation and for deregulation. In the last 10 years, opponents of financial regulation have been especially successful in dismantling and undermining regulation — putting their faith and the nation’s future in the hands of a market discipline that turned out not to exist and can’t-miss financial products that missed, big.

There is not an agency that has not suffered a diminution of expertise or reputation.

Recent examples include the Federal Reserve’s repeated failures to use its consumer-protection authority to stop unfair mortgage lending; the Securities and Exchange Commission’s failure to heed repeated warnings about the Madoff Ponzi scheme; the efforts by the Office of the Comptroller of the Currency, a bank regulator, to block state regulators’ efforts to police lending violations; and the utter failure of the Office of Thrift Supervision, A.I.G’s federal regulator, to understand — or, even worse, care about — what was going on at that company.

Unfortunately, there are many, many more examples. Advocates of deregulation point to the failures as evidence that the government has no intrinsic ability to police markets. That is incorrect. The nation’s regulatory agencies have been allowed to languish, underfunded, understaffed — and too often headed by political appointees who are true believers only in the dogma of deregulation and not in their agencies’ missions.

If the United States is going to have meaningful reform of its out-of-control financial system, new rules will only be a first step.