How to crack the credit crunch
Fixing Wall Street means getting investors better information - and the sooner the better
NEW YORK (Fortune) -- Financial reformers have a chance to give stressed-out markets a desperately needed reality check.
This month's near collapse of Bear Stearns (BSC, Fortune 500) has brought new urgency to the debate about how to shore up the financial sector. Fears that another firm will implode, and the observation that individuals have reaped millions of dollars in pursuit of policies that led their employers to the edge of the abyss, are fueling a drive to strengthen oversight of financial firms.
U.S. Rep. Barney Frank has called for a program of "sensible regulation" that could involve the creation of a systemic risk watchdog. In an opinion piece published Friday in The Wall Street Journal, U.S. Sen. Charles Schumer laid out six points that legislators must consider in undertaking any overhaul.
"We need to rethink the regulatory framework that governs our financial system," Schumer writes. He says it may be time to consider replacing the current alphabet soup of overlapping federal regulatory agencies, such as the Securities and Exchange Commission and the Commodity Futures Trading Commission, with the U.K. model of "a single strong, effective financial regulator, focused on results and not rules, with the power to act."
The government has taken an important first step with the release of the Treasury's Blueprint for Financial Regulatory Reform. Treasury Secretary Henry Paulson, who announce the plan Monday, says the key to any long-lasting reform is to update a regulatory framework that was largely put in place in response to the Great Depression.
For now, he wants to make sure existing regulators such as the Federal Reserve communicate better with peers such as the SEC in responding to crises. Eventually, he proposes, Congress should create separate agencies that would be in charge of market stability regulation, safety and soundness regulation associated with government guarantees, and business conduct regulation. He stresses that any recommendations are only a starting point for decisions that will be made by legislators.
"This model is intended to begin a discussion about rethinking the current regulatory structure and its goals," the Treasury Department summary of the blueprint says. "It is not intended to be viewed as altering regulatory authorities within the current regulatory framework."
But some observers say any attempt at financial reform, no matter what structure it takes, will work only if it vests the power to act with investors - by helping them to make sense of the complex, hard-to-value companies and securities that are at the root of the past year's tumult. Enhancing transparency won't be easy, but it's the necessary first step to any recovery.
"This is an information crisis," says Joseph Mason, a finance professor at Drexel University in Philadelphia and a former economist at the Office of the Comptroller of the Currency. He says the market's fearful contortions "aren't going to stop till we get the information" about which institutions are facing more losses.
That notion is borne out in the tepid investor response to the Federal Reserve's efforts to ease the credit crunch. Since the mortgage-market meltdown started in earnest last summer, buyers have shunned financial stocks and risky debt. Fears tied to souring mortgage bonds have caused credit markets to seize up, making loans costlier and harder to come by.
In response, the Fed has aggressively slashed interest rates and unveiled several novel programs aimed at preventing market problems from pulling the economy into a recesssion. The Fed's efforts have ranged from the memorably named Term Auction Facility and Term Securities Lending Facility - which have had some success in bringing down interbank lending rates - to this month's sale of cash-strapped Bear Stearns (BSC, Fortune 500) to JPMorgan Chase (JPM, Fortune 500). The central bank has staked hundreds of billions of dollars to these initiatives.
Yet so far there is little sign that the credit crunch is abating. Stock prices have been slipping, and debt investors continue to demand risk-free Treasurys in lieu of other bonds. The unease in the markets has led some observers to criticize Fed chief Ben Bernanke, despite the Fed's aggressive action and Bernanke's willingness to try out new remedies.
"The market is looking for a silver bullet that will solve everything," says Jeff Miller, CEO of investment adviser NewArc Investments in Naperville, Ill. "That's just totally unrealistic."
Still, it's clear that the Fed is helpless to persuade investors to take chances on financial companies when losses have been mounting at a startling rate. Citi (C, Fortune 500), UBS (UBS) and Merrill Lynch (MER, Fortune 500) took almost $50 billion in writedowns on subprime mortgages and collateralized debt obligations in the fourth quarter alone, and there seems to be no end in sight: Wall Street estimates of first-quarter writedowns at Citi range as high as $18 billion.
Though Paulson has applauded the Fed's efforts to contain the financial crisis, he admits they raise thorny questions for Washington. "Recent market turmoil has required the Federal Reserve to adjust some of the mechanisms by which it provides liquidity to the financial system," he said last Wednesday in a speech to the U.S. Chamber of Commerce. "Their creativity in the face of new challenges deserves praise, but the circumstances that led the Fed to modify its lending facilities raises significant policy considerations that need to be addressed." For now, Paulson is pushing for greater transparency when the Fed lends to nonbank institutions, over which it currently has no regulatory authority, and better information sharing among regulators - two suggestions that seem certain to figure in any new policies that come out of Washington.
No matter what structure a new regulatory regime takes, the pain in financial markets is likely to continue for a while. The experience of other economies shows that a debt-fueled expansion can create big problems when growth slows and asset prices stop rising, no matter who's minding the shop. Schumer's model, the U.K. Financial Services Authority, recently issued a report criticizing its own supervision of Northern Rock - a mortgage lender that was nationalized after it collapsed last September in a transatlantic preview of this month's Bear Stearns mess.
Mark Gertler, an economics professor at New York University who has published papers with Bernanke, says the challenge for any regulatory regime is to ensure the soundness of a growing group of financial institutions without crimping innovation. "The problem is that markets have changed over time," says Gertler, with much lending moving off banks' balance sheets to institutions such as brokerages and hedge funds.
In a crisis, Gertler says, "The Fed can't just sit back" and see what happens. But he suggests officials can try to prevent future crises by demanding that firms hold sufficient capital to protect against losses. When financial firms need to raise new capital, he adds, regulators will want to make sure shareholders bear the brunt of the pain - as they did in the Bear Stearns case.
Similarly, the Fed's decision to act through an intermediary such as JPMorgan shows the government doesn't want to make direct investments in financial firms. "You want the institutions to recapitalize themselves," Gertler says.
As to where new capital might come from, Mason says there are hundreds of billions of dollars waiting on the sidelines at hedge funds, sovereign wealth funds and other sources - but that money will just bide its time on the sidelines till there's a sense that big firms aren't done hatching unhappy surprises.
"Someone's got the losses somewhere," Mason says. But once investors feel secure in assessing where they are, he predicts, "they'll pile into the areas that aren't affected."
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