Rethinking the regulatory system is no small task

Once the smoke clears from the financial markets, Congress and the next presidential administration will face a new challenge: Keep the next fire from burning down the house.

New regulations, or better enforcement of the old, are sure 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 Goldschmid, a law professor at Columbia University.

Legal and political observers believe lawmakers will likely focus first on three areas – tighter regulation of mortgage lending, streamlining regulatory enforcement, and oversight of unregulated financial markets.

Mortgage lending is an obvious target because much of the bad debt dragging down banks originated with the lax practices of brokers and lenders who made loans to poorly qualified buyers with scant collateral.

“The ‘three C's' of mortgage lending have always been credit, collateral, capacity to pay,” says Edward Kramer, executive vice president for regulatory services at Wolters Kluver Financial Services, a consulting firm. “These are the most basic elements of loan underwriting, and we lost sight of that.”

Legislators may also try to rationalize the patchwork of government authority over banks. They are now regulated by four agencies — the Comptroller of the Currency, Federal Deposit Insurance Corp., Office of Thrift Supervision, and the Federal Reserve – with overlapping and sometimes contradictory jurisdictions.

Treasury Secretary Henry Paulson proposed a similar overhaul in March. His plan involved converting the Fed into a banking “supercop” and merging the SEC and Commodity Futures Trading Commission into a single regulator.

At the time, many observers saw his proposal as a pretext for deregulation. But in the wake of the 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 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, including those for such arcane derivative securities 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 huge that a glitch at any large participant poses the risk of global destabilization.

Credit default swaps are complex securities that let investors speculate on the chances a bank or investment bank will default on its obligations. Like several 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 so-called over-the-counter derivatives carrying explosive potential for losses – by then a $100 trillion business – under its jurisdiction. The move followed the collapse of Long Term Capital Management, a hedge fund that owned $1.25trillion in derivatives contracts, supported by a bare $4billion in capital.

The proposal led to an attack on then-CFTC Chair 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 Sen. Phil Gramm, R-Texas.

But thanks to the pressure of impending disaster, the landscape has shifted. Just this week, SEC Chairman Christopher Cox begged Congress for jurisdiction over the same derivatives, urging lawmakers to give him regulatory authority “to enhance investor protection and ensure the operation of fair and orderly markets.”

Experts say that among the most urgent fixes 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 Turner, former chief accountant of the SEC. “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 panel of bankers led by Walter Shipley, then the retired chairman of Chase Manhattan Bank, advocated a dramatic expansion of banks' disclosures of the risks of their credit portfolio. The recommendations were rejected by the Federal Reserve Board, then led by Alan Greenspan.

The dearth of disclosure kept corporate managements in the dark about risks in their portfolios, and kept government overseers from detecting the coming catastrophe.

“We need to set up a framework that will give government the ability to know in systemic terms when something is going wrong,” says Goldschmid.

Several experts caution that too much regulation harbors its own risks. One example may be the SEC's initiative last week in barring short selling in hundreds of financial stocks. (Short sellers sell borrowed shares of companies they expect to decline, profiting by buying the shares back at reduced prices.)

The step was aimed at stemming a downdraft in shares of banks and investment companies. Even with the ban, many of the protected stocks have fallen sharply in price. Many market professionals believe short-sellers pay an indispensable role in identifying overvalued companies.