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New set of rules to leash markets

Increasing government regulation takes on heightened urgency.

September 25, 2008|Michael A. Hiltzik | Times Staff Writer

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.

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