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Center for American Progress

Misplaced Priorities: Conservatives Spur Next Financial Crisis

Misplaced Priorities: Conservatives Spur Next Financial Crisis

Treasury’s Paulson shifts blame for the current credit and housing crises and sets the table for the next one with his new financial services regulatory reform package

Treasury’s Paulson shifts blame for current credit and housing crises, setting up the next one with new financial regulatory reform.

U.S. Treasury Secretary Henry Paulson today will unveil a financial services regulatory reform package that was largely drafted well before the U.S. housing and credit crises engulfed financial markets worldwide, which explains why his plan fails to acknowledge the central role of conservative deregulatory dogma in the current crisis yet inevitably sets the stage for the next financial crisis.

At first glance, Paulson’s plan would seem to provide some much needed reform of the financial regulatory system. His plan would merge a welter of existing commercial bank and thrift regulatory agencies into a new super-agency, the Prudential Financial Regulator, to oversee all aspects of commercial bank regulation, would extend more oversight power over Wall Street to the Federal Reserve Board, and would create a new agency, the Mortgage Origination Commission, to oversee mortgage brokers.

Problem is, the Paulson plan sticks to the central tenet of conservatives’ core governing philosophy—more deregulation, never mind market crises. This is a policy prescription that got us into the housing and credit crises in the first place because an alphabet soup of federal bank and non-bank regulatory agencies—egged on by the Bush administration and conservatives in Congress—consistently looked the other way as their regulatory charges invented ever more ways to book new mortgages and then off load the risk inherent in those mortgages to investors worldwide.

When the housing bubble burst, a series of market stabilization efforts by the Federal Reserve ultimately led the Fed to orchestrate the bailout earlier this month of Wall Street investment bank Bear Stearns Cos. by JP Morgan Chase & Co., in order to protect the rest of Wall Street from the consequences of its collapse. The Fed then opened its Discount Window to Wall Street investment banks to forestall a global credit crisis—on the same day President Bush gave an inadvertently telling speech about the state of the economy, broadly claiming that conservatives were responsible for the health of a rapidly deteriorating situation.

In a draft of his Monday speech obtained by The New York Times, Paulson also insists he does not “believe it is fair or accurate to blame our regulatory structure for the current turmoil.” He’s right that the structure itself is not to blame, but in saying so he spins away from acknowledging that conservatives’ general antagonism to regulation is at the heart of the housing and credit crises. Paulson’s new plan, however, would enshrine these same conservative mistakes in a new financial regulatory system.

Rather than provide prudent regulatory oversight backed by the discipline of money—in the form of reasonable reserve capital requirements on U.S.-based bank and non-bank institutions alike—the Paulson plan instead gives the Federal Reserve only vague regulatory oversight powers over Wall Street investment banks and other non-commercial bank lenders except in a crisis—and even then it’s not clear exactly what the Fed can do except orchestrate another Bear Stearns-like bailout to protect against wider systemic risk. Talk about moral hazard!

Paulson wants the Fed to become “the market stability regulator,” but with “authority to require correction actions limited to instances where overall financial market stability was threatened,” according to the draft of his Monday speech. In other words, the Fed will have the power to bail out Wall Street when it gets into trouble, but only have the powers of moral suasion to keep Wall Street’s creative lending and securitization and derivative instruments in check beforehand.

Because Paulson’s plan lacks the central element necessary to ensure non-commercial bank lenders on Wall Street consider the risks they take before lending—capital adequacy reserve requirements akin to those required of commercial banks—Wall Street investment banks will continue to tap the Federal Reserve’s Discount Window for cheap financing—investment banks have already accessed almost $60 billion—offering as collateral mortgage-backed securities of uncertain market value. Wall Street will then on-lend that money to hedge funds and private equity firms, which in turn take that cash to borrow more money to invest in global financial markets or lend to struggling companies.

Even if the Fed eventually decides to limit Wall Street access to its Discount Window some time in the future, nowhere in Paulson’s plan are Wall Street investment banks required to set aside defined capital reserves against their cascade of leveraged lending.

What’s worse, this huge mistake is compounded by other parts of the plan. The conservatives who drew up this plan at Treasury want to lessen regulatory oversight of financial derivatives, which are at the heart of twin crises today because they allow financial market investors to purchase these derivative assets without market regulators first blessing these hedging instruments as safe and sound for the financial system.

Under Paulson’s plan, derivative assets at the heart of the current credit crisis—collateralized mortgage obligations and collateralized loan obligations, which are pools of mortgage-backed securities or leveraged-loan securities—would receive less regulatory scrutiny, as would other financial instruments that pool assets into securities. His plan would combine the two regulatory agencies that currently oversee these derivative markets, the Securities and Exchange Commission and the Commodity Futures Trading Commission, but hand over most of their policing powers to Wall Street-run self-regulatory organizations.

The SEC and CFTC did very little to rein in the proliferation of ever more exotic financial derivatives at the heart of the current credit crisis, yet conservatives want to give these agencies even less clout over whatever new derivative products Wall Street conjures up to leverage into the next asset bubble. Why? Because the principal purpose of the Treasury’s plan is less oversight of Wall Street except in the case of a crisis, which is exactly when the Fed will have to put taxpayer money at risk to protect the markets from systemic financial risk.

Credit crises past and present teach us financial institutions simply must maintain capital reserves connected directly to the risk of their portfolio of assets. Otherwise, banks that take deposits from average Americans or non-banks that borrow from other financial institutions will eventually find ways to overextend credit to increasingly less credit-worthy customers. This happened before the Great Depression, before the Latin American debt crisis and savings-and-loan crisis of the 1980s, and before the Asian financial crisis and developing market crises of the 1990s.

Each time, pragmatic (and often progressive) politicians and regulators stepped in to set up prudent capital reserve requirements to forestall a repeat of the crisis. It happened again, of course, with the securitization of U.S. home mortgages. The next president and the next Congress need to overhaul the outdated federal financial regulatory structures that exist today. But they must do so with an eye on the prudent regulation of our capital markets, not with the dangerous mantra of deregulation chanted by conservatives over the past 20 years.


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Ed Paisley

Senior Director, Communications and Publications