New set of rules to leash markets

Once the smoke clears from the conflagration in the financial markets, Congress and the next administration will face a new challenge: how to keep the next fire from burning down the house.

New regulations, or better enforcement of the old, are certain to be high on the agenda.

“We’ve got to have the most dramatic rethinking of our regulatory structure since the New Deal,” says former Securities and Exchange Commissioner Harvey J. Goldschmid, now a law professor at Columbia University.

Legal and political observers believe lawmakers will probably focus first on three broad areas: tightening regulation of mortgage lending, streamlining regulatory enforcement and establishing oversight of unregulated financial markets.

Mortgage lending is an obvious target because so much of the bad debt dragging down banks originated with the lax practices of brokers and lenders, who handed out loans to poorly qualified buyers with scant collateral.

“The ‘three Cs’ of mortgage lending have always been credit, collateral, capacity to pay,” says Edward Kramer, executive vice president for regulatory services at consulting firm Wolters Kluver Financial Services. “These are the most basic elements of loan underwriting, and we lost sight of that.”

Lawmakers may also try to revamp the patchwork of government authority over banks. Banks are now regulated by four agencies -- the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Office of Thrift Supervision and the Federal Reserve -- with overlapping jurisdictions.

Treasury Secretary Henry M. Paulson proposed such an overhaul in March. His plan involved converting the Fed into a banking “supercop” and merging the SEC and the Commodity Futures Trading Commission into a single regulator.

At the time, many observers saw his proposal as a pretext for deregulation. But in a deeper financial crisis, the idea is gaining new currency.

“This is clearly a system that was built a piece at a time as opposed to on a blank sheet of paper,” says Donald P. Gould, president of Gould Asset Management, a Claremont investment firm. “That has led to a lot of finger-pointing and made it easy for things to fall into the gaps.”

Lawmakers may also try to bring unregulated markets, such as those for arcane derivative securities known as credit default swaps, under control.

The case against regulation has been that these markets are dominated by sophisticated investors such as hedge funds and other major institutions that don’t need government oversight to protect them. But the market for credit default swaps alone has grown to $44 trillion in face value -- so gigantic that a glitch at any large participant poses the risk of global destabilization.

Credit default swaps are complex securities that allow investors to speculate on the chances that a banking firm will default on its obligations. Like several of the initiatives likely to surface in the wake of the crisis, efforts to regulate these swaps are not new.

In 1998, the Commodity Futures Trading Commission proposed bringing credit default swaps and other risky derivatives -- by then a $100-trillion business -- under its jurisdiction. The move followed the collapse of Long Term Capital Management, a hedge fund that owned $1.25 trillion in derivatives contracts, supported by a bare $4 billion in capital.

The proposal led to a ferocious attack on then-CFTC Chairwoman Brooksley Born by her fellow government regulators, and the plan was never approved. Two years later, Congress exempted over-the-counter derivatives from any CFTC regulation. The exemption was heavily lobbied for by Enron Corp., then riding high as a derivatives merchant, and sponsored by then-Sen. Phil Gramm (R-Texas).

But thanks to the pressure of impending disaster, the landscape has shifted on the issue. Just this week, SEC Chairman Christopher Cox begged Congress for jurisdiction over the same derivatives, urging lawmakers to give him authority “to enhance investor protection and ensure the operation of fair and orderly markets.”

Experts say that among the most urgent fixes for today’s regulatory system is to reverse the decline of disclosure -- the bedrock principle of financial regulation.

“I’m a big believer that you can get away with less regulation if the market can get the information it needs,” says Lynn E. Turner, a former SEC chief accountant. “When people can make so much money behind closed doors and can’t be caught, they do very bad things.”

Over the last decade, however, regulators have consistently allowed less disclosure. In 2001, a blue-ribbon committee of bankers advocated a dramatic expansion of banks’ disclosures of the risks of their credit portfolio. The recommendations were rejected by the Federal Reserve Board.

The dearth of disclosure not only kept corporate managements in the dark about the risks in their portfolios, but also prevented government overseers from detecting the coming catastrophe.

“We need to set up a framework that will give government the ability to know in systemic terms when something is going wrong,” Goldschmid says.

The dimensions of the regulatory failure in the current crisis may provide support to relieve another long-standing problem with America’s oversight agencies -- their relative poverty.

The SEC’s 2007 budget, for example, was $882 million. That was only slightly higher than the $812-million budget of the Financial Industry Regulatory Authority, the self-regulatory agency for the country’s securities brokerage firms. The SEC’s jurisdiction includes not only brokers but also supervision of stock exchanges and exchange-listed companies and the ferreting out of fraud.

The burden on the SEC and other regulators is only going to become more onerous. This week the Federal Reserve acquired jurisdiction over the giant investment banks Goldman Sachs and Morgan Stanley, which received approval to remake themselves as bank holding companies, bringing them for the first time under the eyes of Fed banking examiners.

“Unfortunately, the current examiner force is not yet prepared for this increased oversight responsibility,” says Mark T. Williams, a former examiner at the Federal Reserve banks of San Francisco and Boston who is now on the faculty of the Boston University School of Management.

“We need sophisticated, experienced staff, and that staff has to be paid better than it’s paid today so people with home mortgages and kids in college can’t be enticed away,” adds Ernest T. Patrikis, a former general counsel at the New York Federal Reserve Bank and former executive at American International Group.

Several experts caution that one looming danger is overreaction -- too much regulation harbors its own risks. One example may be the SEC’s initiative last week in barring short selling in hundreds of financial stocks. (Short sellers borrow shares of companies they expect to lose value, then sell them in hopes of making a profit by buying the shares back at reduced prices.)

The SEC’s step was aimed at stemming a downdraft in shares of banks and investment companies. Even with the ban, many of the protected stocks have fallen sharply in price. Many market professionals believe short sellers play an indispensable role in identifying overvalued companies.

“If you take short sellers out of the market, you’ve got the government setting prices,” Turner says. He advocates less draconian measures, including enforcing rules requiring short sellers to actually borrow the shares they are shorting rather than merely promising to locate them if necessary.

-=-

michael.hiltzik@latimes.com