THE INVESTMENT BANKING industry as we knew it is no more. Change has been inevitable ever since the Bush administration and the Federal Reserve Board decided to use taxpayer money to back J.P. Morgan Chase’s takeover of Bear Stearns. R.I.P. the deregulatory trend that has dominated policy towards America’s financial institutions. Enter the lawyers, regulators, and politicians to reshape the nation’s financial markets.
Investment bankers might moan, but when they created a system rife with conflicts of interest and too few incentives to good performance, followed by acceptance of billions of taxpayer money, they sold their deregulated birthright. When Fed chairman Ben Bernanke received permission from the White House and Treasury Secretary Hank Paulson to take almost $30 billion of Bear Stearns’ paper onto the Federal Reserve Banks’ balance sheet–and to open the discount window to other investment banks, to use the jargon of the trade–it put the taxpayer at risk. If the IOUs on Bear’s books prove worthless, the taxpayer will have to bear the loss–J.P. Morgan has agreed to shoulder only $1 billion of the $30 billion of risk now transferred to the Fed’s books.
The move might have been necessary to induce J.P. Morgan Chase to take over Bear Stearns, an acquisition that in turn might have been necessary to avoid the collapse of the financial system–we will never really know. Perhaps the upcoming congressional hearings will determine why the Fed opened the discount window to investment banks only after it had arranged the takeover of Bear. In any event, the deed is done, and government is now the implicit guarantor of every major investment bank, no matter how much Paulson contends that the Bear takeover need not necessarily become the template for future policy.
Investment banks have never been as closely regulated as depository institutions, the commercial and savings banks. The depository institutions are insured by the government, which therefore feels obliged to ensure that they operate prudently and have adequate capital. Investment banks have until now not been subjected to what Paulson calls the “strong prudential oversight” to which commercial banks must submit. That suited Wall Street’s macho free-marketeers, who wanted as little to do with Washington’s regulators as possible.
Bear changed all of that. The government decided that it could not allow an investment bank to fail and, to the relief of a panicked Wall Street, committed billions of taxpayer funds to Bear’s rescue and agreed to come to the aid of other investment banks that might in the future rattle their begging bowls at the Fed’s discount window.
Paulson, the former chief of Goldman Sachs, unveiled the Treasury’s 200-page blueprint for future regulation over the weekend. He would combine some of the regulatory functions now spread among several agencies, and increase the supervisory reach of the Fed. But he hopes that any serious new regulations will be temporary, and that future rules will be light-handed, a position somewhat at variance with his concession that access to taxpayer funds “should involve the same type of regulation and supervision” as applies to commercial banks. Investment banks, assured of a government life-line in the event of trouble, will lend recklessly, unless regulation constrains them–moral hazard on a grand scale.
The specific form of the new regulation is now being negotiated between Paulson and congressman Barney Frank, the shrewd Massachusetts Democrat who chairs the House Financial Services Committee. At one level, Frank is delighted with the Treasury blueprint. He finds it encouraging that “the former head of Goldman Sachs [is] acknowledging that regulation is good for financial markets and its not going to kill them,” but wants to go further and treat investment banks the same way depository institutions are not treated. The congressman agrees that the role of the Fed should be expanded, but wants new rules that bring the regulation of investment banks into line with those under which depository institutions operate. Both echo the usual calls for “transparency.”
My own guess is that before long regulators will be empowered to require investment banks to be adequately capitalized so that they rarely need to call on the Fed for cash. To meet the new capital requirements investment banks will have to sell shares, diluting holders of existing shares. Or cut dividends. One thing is certain: it will be a long while before we again hear talk of lightening the regulation of U.S. investment banks to make it easier for them to compete with foreign rivals.
Government intervention will not be limited to the investment banking industry. Political pressures are mounting for measures to ease the plight of homeowners who are having difficulty paying off their mortgages. There are fewer of these folks than the press leads you to believe. Ninety-two percent of homeowners are paying their mortgages on time; only 2 percent of mortgages are in foreclosure. Subprime borrowers facing higher, re-set interest rates account for only 6 percent of all mortgages, but 40 percent of foreclosures. So much for economic facts.
Three political facts are more important. First, the hardest-pressed homeowners are concentrated in key electoral states. Second, most are African-Americans, and politicians are sensitive to the charge that they are ignoring these homeowners just as they are alleged to have ignored blacks after hurricane Katrina.
Third, it is difficult for voters to understand why billions in their taxes can be used to enable one investment bank to acquire another, but not one cent can be devoted to preventing a family from being tossed out on the street. Even some conservative congressional Republicans are muttering that sauce for the Wall Street goose is sauce for the Main Street gander. It will be a brave politician indeed who goes through this election cycle chanting “The free market will solve this problem; intervention postpones the solution–and will in the end make the problem worse.” Hillary Clinton and Barack Obama both want $30 billion of taxpayer money devoted to the relief of hard-pressed home owners–the same sum devoted to preserving at least some of the value of Bear’s shares, worthless without the Fed’s intervention, sold for around $10 with Fed backing of the J.P. Morgan takeover.
It took Franklin Roosevelt his first 100 days to restructure American capitalism. And he had to get Congress to go along. Paulson and Bernanke laid the basis for another restructuring of market capitalism in one-tenth of that time, and without bothering to get enabling legislation. Both men knew that making investment banks wards of the state would promote a new round of regulation. Paulson hopes to restrict the new rules to improving the functioning of financial markets, rather than hampering innovation and risk-taking. Wall Street had hoped to take the money and run. But Frank Sinatra had it right: like love and marriage, when it comes to bail-outs and regulation, “You can’t have one without the other.”
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).
