After the Deal, the Focus Will Shift to Regulation By FLOYD NORRIS

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September 29, 2008
High & Low Finance
After the Deal, the Focus Will Shift to Regulation By FLOYD NORRIS

Even before Congress passes a $700 billion bank bailout that nearly all legislators believe to be both necessary and unpopular, the jostling has begun over legislation that may prove to be the first test for the next president: How to reshape the financial system and its regulation.

It is clear that the old system failed — it wouldn’t need the bailout otherwise — but the diagnosis of why that happened may be crucial in deciding what changes are needed.

Already, liberals are blaming the deregulation that began under Ronald Reagan for letting a financial system get out of control, and conservatives are pointing to market interventions by liberals — notably efforts to assure mortgage loans for the poor and minorities — as being the root cause of the mess.

Conservatives are also pointing to accounting rules, which forced banks to write down the value of their loans, and to excesses by Fannie Mae and Freddie Mac, the government-sponsored mortgage enterprises that have since been nationalized, whose troubles they have tried to tie to Democrats.

Both sides roundly denounce Wall Street greed, but there is no clear legislative solution to that, so such rhetoric is more likely to shape the campaign than the postelection legislative battle.

When the liberals talk about deregulation, they most often point to the Gramm-Leach-Bliley Act of 1999, which tore down the last remaining walls between commercial banks and investment banks.

But there is little evidence to tie much of the problem to that law. Most of the walls, erected during the Depression, had already been breached over many years, with the approval of regulators. Besides, the first major failures of this crisis, Bear Stearns and Lehman Brothers, were investment banks that did not go into commercial banking in a big way.

Instead, it might be more appropriate to describe the problem as “unregulation.” That regulation was scaled back was less of a factor than Wall Street’s finding ways around regulation by establishing new products that could work between the cracks. Those new products grew to dominate the financial system, and they turned out to be prone to collapse.

Both parties bear responsibility for that, because there was little controversy over it when it was happening. Alan Greenspan, then the chairman of the Federal Reserve, believed that the new products could distribute risk to investors, who were better able to bear it than was the banking system he was charged with regulating, and few legislators were willing to challenge Mr. Greenspan on what appeared to be an arcane issue.

But the family that can take the most credit for that is the Gramms, Phil and Wendy. It was Wendy Gramm, as chairwoman of the Commodity Futures Trading Commission in the early 1990s, who championed keeping her agency out of derivative trading. It was Phil Gramm, as the chairman of the Senate Banking Committee, who pushed through legislation in 2000 to assure that no future C.F.T.C., let alone any other regulator, would have jurisdiction over such products.

At the same time that the credit-default swap market was growing, so were hedge funds, which became behemoths that were largely exempt from any regulation.

The logic behind both of those decisions was that regulation was about protecting individual investors. Because small investors could not invest in hedge funds or mortgage-backed securities or credit-default swaps, the government had no reason to interfere with private enterprise.

It turns out that those products could threaten the entire financial system, and their abuse could produce a credit crisis affecting virtually everyone.

One obvious answer is that the new regulation system should not have so many loopholes. It is possible that the old markets and old products do have too much regulation, and that deregulation in some areas would be appropriate. But the guiding principle should be that similar products and similar institutions deserve similar regulation. If large institutional investors are required to disclose their positions every quarter, why should large hedge funds be treated differently?

That principle will need to be applied internationally as well, which will require diplomacy and a willingness to consider views of governments that are much less sympathetic to financial innovation.

The growth of the new financial system also tends to undermine the conservative argument that much of the problem can be traced to the Community Reinvestment Act, which was passed by Congress in 1977. It has been cited by some bankers as a reason they made what turned out to be bad loans, but most of the worst loans appear to have been made outside of the banking system, by mortgage brokers not subject to its rules.

Similarly, Fannie Mae and Freddie Mac undoubtedly bought many loans that should not have been made. But the worst loans were privately syndicated and snapped up by investors.

The accounting rule requiring banks to mark their assets to their market value has been widely blamed for producing losses that alarmed investors. Newt Gingrich, the former House speaker, said Sunday on the ABC program “This Week” that “between half to 70 percent of the problem” was caused by the rule, and some Republican legislators pushed to have the bailout bill suspend the rule.

But if one wants to look at accounting rules as a cause, it would be more productive to examine the rules that permitted the crisis to grow without being noticed, not at the rule that finally brought the truth to public attention.

When the Financial Accounting Standards Board met after the Enron scandal to tighten the rules over off-balance-sheet entities, it permitted banks to continue keeping many assets off their balance sheets, under rules that now — belatedly — are being changed. Out of sight should not have meant out of mind, as many of the off-balance-sheet items have produced major losses.

Similarly, the rules permitted banks to turn groups of mortgages into securities and report profits even though they retained some of the risk that the mortgages would go bad. By underestimating that risk, the banks reported higher profits than they should have, and the executives qualified for larger bonuses. Many of the recent losses are just reversing profits that, in reality, were never earned.

In any case, it is too late to abandon mark-to-market accounting. Just how reassuring to investors would it be for the government to issue a rule saying it is O.K. for banks to value assets for far more than anyone would pay for them?

Perhaps the most important cause of this disaster is one that probably does not need legislation: belief in so-called rocket scientists and their computer models, which used the past to forecast the future, and did so with complete, and completely unjustified, assurance.

It was that faith that led rating agencies to give top-grade classification to securities that were in fact very risky and led investors to buy them. It was that faith that led regulators to defer to the banks’ own risk models in determining how much capital they needed. It was that faith that led senior managements of Wall Street firms — many of whom had only a general understanding of what their traders were doing — to assume that risk was under control when it was not.

That faith is gone now. It will not come back soon.

The legislation next year will shape the efforts of the American financial system to right itself, and to provide credit to families and businesses without taking undue risks that can again threaten to destroy the system. The details of those decisions will be far more important than the details of the bailout that is about to be approved.