Letter From Europe
Regulating the US financial market
THERE is no doubt that the recent sub-prime mortgage meltdown has led to a collective loss of faith in the way the United States financial system works. When the turmoil in the sub-prime market spread to other parts of the securities market it created a huge liquidity crisis, forcing the central banks on both sides of the Atlantic to pump billions of dollars into the system to create liquidity. Yet, in spite of these efforts, confidence in the credit market has remained shaky. Financial institutions are still hesitant to extend new credits.
In the United States, this unwillingness to lend has affected not only corporate and personal loans but also municipal bonds, student loans, and even government-backed mortgages. Economic activity involving both consumer spending and corporate investment across the world continues to decelerate, causing unemployment to rise. Day by day, more countries are being sucked into this steadily spreading economic crisis.
When, on March 13, a major investment bank on Wall Street, Bear Stearns, announced that it was facing imminent bankruptcy because of liquidity problem caused by its dodgy securities portfolio, it created a situation in which, according to the regulators, "the fate of the country's financial system hung in the balance."
In order to stave off the collapse of Bear Stearns and the financial system as a whole, the Fed intervened by giving a guarantee of $30 billion credit line to subsidise its takeover by J P Morgan.
It was a significant failure on the part of the SEC to assume that, in an emergency situation, investment banks like Bear Stearns could always borrow (between 93% and 97% of the value) against the securities they owned. So an investment bank's capacity to raise cash depended entirely on the valuation of its securities, which, unfortunately, was sub-contracted to bond-rating agencies like Moody's and Standard and Poor's, who often classified them as AAA, knowing jolly well that most of those mortgage-backed securities were worth nothing.
A few weeks ago, a co-president of Bear Stearns was forced to resign when it became clear that the two Bear Stearns hedge funds that had invested heavily in securities backed by sub-prime mortgages were worth virtually nothing.
As reported by some analysts, the failure of New Century Financial, one of the largest lenders, about a year ago, started the sub-prime meltdown. According to an independent report commissioned by the US Justice Department, New Century Financial engaged in "significant improper and imprudent accounting practices' that were condoned by its auditors, KPMG. Some of these allegations remind us of Arthur Andersen after the sudden collapse of Enron in 2001. They also demonstrate that things have not improved much in this field.
No one underestimates the difficulties the auditors face in trying to verify the value of some of "these unregulated financial products that are traded in unregulated markets." Samuel DiPiazza Jr., the global chief executive of Price Waterhouse Coopers, recently expressed concern about how "to determine the value of financial assets for which there is no real market."
All this has convinced many financial experts that in order to prevent other banks from falling into a similar situation, the government must increase its regulatory powers to control banks and financial institutions.
Unfortunately, the problem is that President Bush and his close collaborators headed by Alan Greenspan, former chairman of the Federal Reserve, are devoted to a free-market ideology and believe more in deregulation than in the need for a set of new regulations to control the financial market. They think that too much regulatory pressure would destroy innovation in the financial world (Remember, the collateralised debt obligations were once hailed as great innovative products), and that "market discipline" would ensure proper functioning of the financial market.
They also feel that strict regulations would hamper the ability of American markets to compete with foreign rivals. So, how does one explain Paulson's recent plan to overhaul the regulatory apparatus that oversees the US financial system?
Actually, it is a public relations ploy to respond to "the circumstances of the day," that is to assuage the anger and frustration of the American public caused by the simultaneous bursting of the housing and credit bubbles. In the words of Professor Krugman of Princeton University: "It is all about creating the appearance of responding to the current crisis, without actually doing anything substantive."
According to the plan, hedge funds and private equity firms will, for the first time, be overseen by the federal government, albeit minimally. This oversight will be limited to collecting information "until a wide-scale financial crisis has already occurred." It is only then that the government will take action.
It is almost unbelievable that Paulson's reform plan does not include any proposal to regulate complex derivatives like the CDOs and similar financial products linked to the current mortgage crisis.
In any case, by his own admission, Paulson does not expect his proposals to be considered by the lawmakers "until after the housing crisis is over," which means not before one year, by which time Bush will be out of office. Thus, the task of building a new regulatory structure for the US financial market of the 21st century with the purpose of controlling non-depository institutions like Bear Stearns will fall on the next president. Meanwhile, let us hope that the current crisis does not degenerate into a depression.
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