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The Flaw In O's Wall Street Fixes

September 15, 2009

By Nicole Gelinas

PRINTER FRIENDLY

YESTERDAY, President Obama came to New York’s Federal Hall to tell Wall Street and the nation how he’d fix the financial markets. The goals he outlined were unassailable -- but his solutions fall far short.

Indeed, they’d make the chief source of the crisis -- the belief that regulators and financial firms can accurately assess market risks -- even worse.

The president made a compelling case that adequate regulation of finance isn’t a barrier to free markets, but vital to their functioning. He said he “certainly did not run for president to bail out banks or intervene in the capital markets. But . . . the very absence of common-sense regulations able to keep up with a fast-paced financial sector is what created the need for that extraordinary intervention.”

After the collapse of Lehman Bros. a year ago today, few would disagree.

So what to do? Obama argues that the financial world failed because regulators didn’t have adequate authority or discretion to control it -- so he proposes more authority and more discretion.

To wit, he’d designate the Federal Reserve (advised by other regulators) as a “systemic risk” regulator: This would address the problem that, amid lots of regulators responsible for individual companies and financial instruments, no one’s looking out for the whole system and its risks to the economy.

Problem is, Obama would add more human discretion to the world of managing financial risks -- when recent financial history shows that we need less discretion.

We’re not in this mess because the Fed didn’t think it was responsible for managing financial risk to protect the economy. For decades, it’s been a de-facto systemic-risk regulator.

In the ’80s, the Fed often used this authority properly, limiting borrowing for junk bonds. But in the ’90s and ’00s, it used its clout to counsel against adequate regulation -- encouraging Congress to exempt new financial instruments like credit-default swaps from old borrowing limits and certifying exotic mortgages as A-OK.

If that Fed had seen the need five years ago, it could have counseled Congress to impose down-payment requirements on houses -- just as, thanks to a Depression-era rule, investors must plunk down a hefty cash requirement to buy stock. That would’ve ensured that, when the housing bubble burst, it didn’t ruin banks and the economy with so much unpaid debt.

Similarly, if Washington had imposed limits on credit-default swaps as it does on other types of derivatives, AIG couldn’t have made $500 billion in possible commitments without putting cash down. That is, it couldn’t have put the whole economy at risk when its bets turned out wrong.

The reason we’re in the mess, then, isn’t that the Fed didn’t think it was responsible for managing financial risk -- but because it thought it was doing a great job.

The economy is in its greatest peril when nobody sees any risk -- something that will inevitably happen again in a long easy-money boom, no matter who’s charge. So what we really need to do is simply apply old principles to new markets -- consistent, uniform limits on borrowing for all financial firms and instruments, no matter what their name or function.

The president called vaguely for stronger capital requirements yesterday -- but didn’t specify whether he’d limit the ability of financial institutions and regular people alike to borrow heavily for certain investments, no matter how “safe” they seem. After all, houses and the mortgage securities backing them seemed perfectly safe to bankers and regulators.

Clear limits on borrowing would be a tough sell. We’d all have to get used to a world where credit isn’t as easy and cheap -- and not just temporarily, as we recover from the crisis, but indefinitely.

Yesterday, Obama assured us of just the opposite: “There are those who are suggesting” that regulating financial products “will restrict the choices available to consumers. Nothing could be further from the truth.”

For its part, Wall Street is pushing a systemic-risk regulator because it knows that it can game any such system. As memories fade, bankers could convince regulators that the Street has learned its lessons -- that it’s finally figured out how to structure certain securities in such a super-duper-safe way that institutions really can borrow liberally against them, evading any stronger capital requirements.

A failure to impose clear, uniform limits on borrowing will ensure that we’ll eventually fall prey to a bubble again, in some market that’s inadequately regulated because it seems so safe, even to the regulators.

Obama seems to realize the core problem: “For a market to function,” he said yesterday, “those who invest and lend in that market must believe that their money is actually at risk.” But, without clear borrowing limits, Wall Street will remain “too big to fail.”

And, down the road, it will eventually find a way to game any regulators -- and future bailouts will be inevitable.

Original Source: http://www.nypost.com/p/news/opinion/opedcolumnists/the_flaw_in_wall_street_fixes_8DdbiziGhR6DPru4A9ihTP

 

 
 
 

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