March 31, 2008: 1:15 PM EDT
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Fed up with the Fed

Some wonder why Paulson wants to expand the powers of an agency that sat idly by as the housing bubble took shape.

By Colin Barr, senior writer

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NEW YORK (Fortune) -- Some people think Henry Paulson's backing the wrong horse in the race to rework financial regulation.

The Treasury secretary on Monday formally unveiled his Blueprint for a Modernized Financial Regulatory Structure. The plan, which had been in the works for almost a year, envisions an expanded role for the Federal Reserve in preserving market stability and overseeing the financial services industry. Defining those responsibilities has taken on new urgency in the wake of a credit crunch that has led to some $200 billion in writedowns by big firms and now threatens to exact a toll on the economy.

"The Federal Reserve's responsibilities would be broad, important and difficult to undertake," Paulson concedes in Treasury's blueprint. But while episodes of market instability are difficult to predict, let alone counter, "The Federal Reserve's enhanced regulatory authority along with clear regulatory responsibilities would complement and attempt to focus market discipline to limit systemic risk."

Yet Paulson's proposal leaves some observers wondering whether the Fed - which currently oversees the nation's banks as well as setting interest rate policy - is up to that task.

"The Fed as a bank regulator has done a very poor job overall," says Joseph Mason, a professor at Drexel University's LeBow College of Business in Philadelphia. "There are tremendous risks of using [the credit crunch] as an excuse ... for an umbrella regulatory structure."

Skeptics contend that under former chief Alan Greenspan, the Fed played two roles in inflating the housing bubble that has since burst with such serious consequences for the financial sector. It's well accepted that Greenspan helped to fuel the housing bubble by cutting interest rates as low as 1% back in 2003, and keeping them there even as the economy began to recover.

But beyond that, some criticize Greenspan's Fed for failing to curb a sharp decline in mortgage underwriting standards that helped fuel the price run-up, particularly in hot markets such as California and Arizona. Indeed, Greenspan appeared at times to be defending some of the high-risk loans that were being abused by lenders and mortgage brokers.

"American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage," Greenspan said in a February 2004 speech to the Credit Union National Association in Washington.

Since then, Greenspan has retired, making way for Ben Bernanke to take the reins at the Fed. But the newfangled loans remain with us, in an unpleasant reminder of regulators' laxity.

To be sure, many of the biggest issuers of aggressive, newfangled mortgages are regulated by the Office of Thrift Supervision, not the Fed. Big issuers of option adjustable rate mortgages - loans that let the borrower choose to make minimal payments in early years before the interest rate resets - include thrifts Countrywide (CFC, Fortune 500), which agreed to sell itself in January to Bank of America (BAC, Fortune 500) amid questions about its liquidity, and Washington Mutual (WM, Fortune 500).

The problems in those loans are amply illustrated by the difficulties at another thrift, Downey Financial (DSL), of Newport Beach, Calif. Downey reported two weeks ago that delinquent loans accounted for nearly 11% of the bank's assets at the end of February, up from 6% at Nov. 30.

Still, it is the Fed - along with the Securities and Exchange Commission - that shoulders the burden of being the most visible regulator. Indeed, Bernanke told Congress back in September that the Fed has been acting to protect consumers from abusive lending practices. "The Federal Reserve takes responsible lending and consumer protection very seriously," Bernanke told the House Committee on Financial Services back on Sept. 20. "Along with other federal and state agencies, we are responding to the subprime problems on a number of fronts. We are committed to preventing problems from recurring, while still preserving responsible subprime lending."

But by then billions of dollars of bad loans were already on the books. And though the contrary view wasn't popular at the time, there were those who foresaw problems in the mortgage industry even before house prices crested. Dean Baker, co-director of the Center for Economic and Policy Research in Washington, called option ARMs "the latest and most pernicious financial innovation of the current bubble" in a piece back in September 2006. "It's too bad," he wrote, "that no one in a position of authority was awake before the bubble grew to such proportions."

That observation helps to explain why Paulson's Fed plan is raising eyebrows in some quarters. Gregory Valliere, political strategist at Stanford Financial Group, told CNBC Monday that charging the Fed with maintaining market stability "is like putting Eliot Spitzer in charge of the morals division."  To top of page

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