Market 'reforms' a gift to Wall St.
Jim Jubak

The Treasury chief's plan wouldn't fix the problems underlying today's financial crisis. Plus, is it wise to give the Fed -- clearly asleep at the switch -- more authority?

It's a scam, a fraud, a charade, a lie

But what else did you expect from a package of "reforms" fronted by a Treasury secretary who was formerly the CEO of investment bank Goldman Sachs, a package written by Treasury Department officials with input from Wall Street's biggest players? It's no coincidence that many of the plan's ideas echo those peddled by Wall Street lobbyists for years in the halls of Congress.

The plan throws the public and the politicians a few bones, but in reality the reforms have almost nothing to do with fixing the problems in the financial markets that have produced the current crisis. Instead, they're an astutely timed effort to use the current crisis to give Wall Street what it has wanted for years: less regulation.

Oh, to be sure, Wall Street and Treasury Secretary Henry Paulson are pretty adept at putting lipstick on a pig. The Federal Reserve would get broad new powers, we're told. The plan would combine regulatory agencies, ending overlap that, the plan's authors claim, contributed to the current crisis. Hedge funds and the other new kinds of investment vehicles that are at the heart of the current mess would have to supply the Fed with more information about their activities.

The real plan

Merge the Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission. That's not a bad idea. It doesn't really make sense to have one agency regulate the securities markets and another regulate the market in financial futures.

But the merger also would shift some of the SEC's key regulatory powers to industry groups -- so-called self-regulatory organizations. For example, investment advisers no longer would be directly regulated by the SEC but by a yet-to-be-established trade group responsible for enforcing standards of conduct and behavior.

In general, the merger would replace the prescriptive rules of the SEC with the futures commission's "principle-based" method of regulation. The former tells Wall Street what to do and precisely how to do it, while the latter sets general goals but not how to achieve them. London's financial markets have been gaining market share at New York's expense, and Wall Street has come to see London's regulatory system as a key competitive advantage.

Set up a federal insurance charter

This would allow the nation's biggest insurance companies to be regulated by one federal agency rather than by myriad state agencies. Not all state insurance regulators are equal; some are extremely lax while others are aggressive advocates for consumers in their states. In effect, because the federal charter would pre-empt state regulation, this "reform" would let big insurance companies get out from under the glare of the most active state commissioners.

A good analogy is the way that relatively lax federal environmental standards restrain the ability of more aggressive states, such as California, to adopt stricter rules. Of course, this "reform" has no connection to the current crisis, but it is a long-term goal of the biggest players in the insurance industry.

Set up new federal standards for mortgages but leave the authority over the subprime-mortgage market where it is now -- with the Federal Reserve. One reason to leave these powers with the Fed, the Paulson plan says, is that the Fed has in place a comprehensive process to balance the costs and benefits of new regulations. Oh, really? That's worked out great so far, hasn't it?

Give "nonbank" banks access to the Federal Reserve's discount window to head off any future liquidity crisis and, in exchange, require more information from these investment banks, hedge funds and other specialized investment vehicles. The nation's commercial banks long have been able to borrow short-term funds from the Fed in a pinch. In exchange, though, these institutions face strict regulations on how much capital they need to have to back their lending. The Paulson plan would leave Lehman Bros., Goldman Sachs, Bear Stearns and others of the nonbank financial world unregulated but give them the same right to tap the Fed for cash.

Ignore the crying need for better regulation of derivatives

The call for nonbank-bank transparency is a bad joke in the context of a world where nobody can tell who owes whom how much in trillions of dollars of derivative contracts. The Paulson plan would leave unregulated the markets such as those for credit default swaps, the "private" contracts that "insure" against a borrower going under.

Seems like a risk, no? Didn't the Federal Reserve just organize a takeover of Bear Stearns because that company was party to so many of these private contracts that the Fed was afraid to let Bear Stearns and its creditors quickly liquidate its portfolio?

It would be an overstatement to say Wall Street wrote the Paulson plan, but it sure had a lot of input. For example, the President's Working Group on Financial Markets, which is the ultimate source of the Treasury proposal, set up two advisory committees in September to give advice about industry best practices.

One committee was supposed to represent investors. It's the other, designed to represent the asset side, that gives the best example of who got a chair at the table while these proposals were being drafted. The committee was headed by Eric Mindich, a former Goldman Sachs partner who started Eton Park Capital in 2004. Others on this committee include D.E. Shaw, an international investment company with $35 billion in capital under management as of January, and Aetos Capital, founded in 1999 by James Allwin, the former head of Morgan Stanley's investment-management business.

What's missing here?

For example, I haven't been able to find any program for fixing the conflict-of-interest problems inherent in the current debt-rating system. Analysts at Standard & Poor's or Moody's sit down across a table to work out a rating with the Wall Street folks who are both issuing the debt and paying the bill for the rating. That certainly has contributed to the debacle of AAA-rated mortgage-backed securities going into default at junk-bond rates.

And I don't see even the glimmer of a discussion about the advisability of giving the Federal Reserve more regulatory power when the U.S. central bank has proved so reluctant to use its existing powers in either the 2000 stock-market bubble or the 2006 real-estate bubble. The Fed was asleep at the switch during two different crises under two different Fed chairmen, so you'd think it would occur to someone that there's a problem with the Fed's culture or structure or something that makes the central bank a really bad choice for regulator.

Losing to London

This is the stuff of Wall Street's nightmares: Just a day after Paulson unveiled his plan, Japan's largest brokerage, Nomura Holdings, announced it was picking London over New York as the headquarters for its international operations. Nomura CEO Kenichi Watanabe rubbed salt in the wound by saying that London would be the financial factory for originating products that the investment bank would then export to the rest of the world. Nomura's London head count has climbed to 1,400 from 1,250 at the beginning of 2008. In New York, the numbers have declined to about 900 from 1,322 since the start of 2007.

Nomura's decision is just part of a pattern. London is now home to almost 50% of global trading in derivatives and 70% of the global trading market for already-issued bonds (called the secondary market). In 2007, 419 new companies listed on the London Stock Exchange versus 36 on the New York Stock Exchange and 138 on the Nasdaq.

Wall Street blames its losses on London's looser and more unified regulatory structure. (And on the Sarbanes-Oxley rules the U.S. put into place in the aftermath of Enron and other scandals from the 2000 market bust.) The team that produced the Paulson plan began as a working group looking at ways to increase the competitiveness of U.S. financial markets. The direction of the final product owes more to those roots than it does to the current crisis.

Wrong focus?

If the dollar is the real problem, then the Paulson plan won't do much to reverse the decline in Wall Street's market share.

Makes you wish they'd just concentrate on fixing some of the problems that led us to the current crisis in our financial markets.

Editor's note: Jim Jubak, the Web's most-read investing writer, posts a new Jubak's Journal every Tuesday and Friday. Please note that recommendations in Jubak's Picks are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest-rate environment, see Jubak's portfolio of Dividend Stocks for Income Investors. For picks with a truly long-term perspective, see Jubak's 50 Best Stocks in the World or Future Fantastic 50 Portfolio. E-mail Jubak at jjmail@microsoft.com.