Regulators in Need of Rehab
Published: October 11, 2008
STOCK market investors, even more than the average Jane, hate unpleasant surprises. Unfortunately, as last week showed, this bailout business is chock full of them.
Consider the backstop recently provided to the American International Group, the beleaguered insurer. On Sept. 16, the Treasury Department told taxpayers to lend $85 billion to it. Last Wednesday, we had to cough up another $37.2 billion to keep the company operating. As part of a new lending facility announced by the Federal Reserve Bank of New York, our stake in A.I.G. now approaches $122 billion.
That, you may recall, is more than triple the $40 billion that A.I.G. requested when it went on life support in mid-September. As a “Saturday Night Live” comedy skit last week about the A.I.G. bailout put it so memorably: “Oh my God, are you serious!?! Really!?!”
Then there was the midweek switcheroo by Henry M. Paulson Jr., the Treasury secretary. Instead of unfurling his original $700 billion taxpayer “troubled asset relief program,” or TARP, to buy crippled mortgage securities, Mr. Paulson decided that the program would now take direct ownership stakes in banks.
Those little turnabouts reveal a couple of things. First, money sure goes fast these days. (Good thing Uncle Sam’s printing presses are oiled and ready to roll.) Second, regulators are making up rules for these emergency programs as they go.
That is not necessarily bad. The TARP was, after all, full of holes. A particularly gaping one: how much taxpayers would pay for troubled mortgages. Many were rightly suspicious that the government would pony up too much money in order to bolster banks trying to jettison the junk.
But the new direct investment plan raises questions, too. Who will decide which banks receive help and which won’t? And what standards will be used to reach those decisions?
Apparently such decisions will fall to Neel T. Kashkari, assistant Treasury secretary for financial stability, and brand-new overseer of the $700 billion bailout. A former banker at Goldman Sachs, Mr. Kashkari, 35, is just six years out of business school.
That’s a good bit of power for a young man to wield, don’t you think? Sure, he’s smart and he will probably have help from others at Treasury, starting with Mr. Paulson. But choosing which financial institutions live and which die will be an interesting process to watch.
The more transparent this process is, of course, the less suspicious taxpayers will be about its outcome. Alas, transparency has not been a priority for Mr. Paulson or any of his partners at the Fed throughout this crisis.
And that has created the biggest problem for regulators right now: at precisely the moment they are entrusted with breathtaking powers, investors’ and taxpayers’ trust in them is at a nadir.
WORLD financial markets operate on confidence, we can all agree. You trust that I will deliver shares when you buy them from me. Your broker trusts that you will send in a check to cover the purchase of municipal bonds you just made.
But the leading lights of finance, whether in Washington or on Wall Street, have completely squandered any trust that taxpayers may have had in them. Earning it back is going to take time and a commitment to transparency.
One reason the trust deficit looms so large is that the same people who are scrambling to reassure investors with bold actions were as recently as July telling investors that everything was hunky-dory.
Here is Mr. Paulson, quoted by The Associated Press, on July 20: “It’s a safe banking system, a sound banking system. Our regulators are on top of it. This is a very manageable situation.”
Let’s rewind further, to early May. Mr. Paulson allowed that the worst was “likely” to be behind us. “There’s no doubt that things feel better today, by a lot, than they did in March,” he said.
His take on May 16, when the Dow Jones industrial average stood at 12,986, was as follows: “Looking forward, I expect that financial markets will be driven less by the recent turmoil and more by broader economic conditions and, specifically, by the recovery of the housing sector.”
My personal favorites, however, involve a much broader cast of characters than just Mr. Paulson. In the first half of 2007, almost every senior regulator assured us that troubles in the mortgage markets would be “contained” to subprime loans.
(A tip of the hat to Joan McCullough, market commentator extraordinaire at East Shore Partners, for gathering those nuggets.)
There are a few straight talkers in the regulatory regime, of course. One is Gary H. Stern, president of the Federal Reserve Bank of Minneapolis and co-author of “Too Big to Fail: The Hazards of Bank Bailouts.” In a speech last Thursday, Mr. Stern expressed deep unease over the consequences of using taxpayer money to rescue big and reckless financial institutions.
“The too-big-to-fail problem, with which I have long been concerned, has been exacerbated by actions taken over the past year to bolster financial stability,” he said, according to his prepared remarks. While conceding that the recent lifelines were appropriate, given the circumstances, he said that “it is critical that we address ‘too big to fail’ because, if left unchecked, it could well be a major source of future instability.”
Mr. Stern’s solution is an approach he calls “systemic focused supervision.” It involves “early identification, enhanced prompt corrective action and stability-related communication.”
First, regulators would identify what Mr. Stern described as “material exposures between large financial institutions and between these institutions and capital markets.” In other words, regulators would know where the fault lines are before the earthquake begins. And they would be better able to assess which institutions require support and which could be cut loose.
Prompt corrective action is the second leg of the stool.
“Closing banks while they still have positive capital, or at most a small loss, can reduce spillovers in a fairly direct way,” Mr. Stern said. “If a bank’s failure does not impose large losses, by definition it cannot directly threaten the viability of other institutions that have exposure to it.”
Finally, he said, regulators must communicate the actions they are taking. Otherwise, market participants might continue to believe that bailouts are coming, because policy makers had not advised them to the contrary, Mr. Stern said.
In other words, be transparent and communicate details on supervisory activities early and often.
MR. STERN made this conclusion: Supervisors must “maintain a strong grasp of the operational activities and the inherent risk profile of the financial institutions they supervise as well as the risk management systems these firms employ.”
The success of such a program, he emphasized, depends on its not becoming “an appendage to ‘routine’ supervision.”
It is indeed unfortunate that it took a calamity of this measure to restore an appreciation for vigilant regulators. Putting Mr. Stern’s ideas into action may require a complete overhaul. But the sooner we get started on that Herculean task, the better.