From the March 30, 2008 Sunday Times
March 31, 2008
by Irwin Stelzer
The investment banking industry, as we know it, is no more. Change has been inevitable ever since the Bush administration and the Federal Reserve decided to use taxpayers’ money to back JP Morgan Chase’s rescue of Bear Stearns. RIP the deregulatory trend that has dominated policy towards America’s financial institutions.
Investment bankers might moan, but when they took the government shilling - well, billions of dollars - they sold their deregulated birthright, if I might be permitted to mix my metaphors.
When Federal Reserve chairman Ben Bernanke received permission from the White House and Treasury secretary Hank Paulson to take almost $30 billion of Bear Stearns’s paper on to the Fed’s balance sheet - to open the discount window to Bear, 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 - JP 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 JP Morgan Chase to take over Bear, an acquisition that might have been necessary to avoid the collapse of the financial system - we will never know. But the deed is done, and government is now the implicit guarantor of every big investment bank.
That sector has never been as closely regulated as depository institutions, the commercial and savings banks 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 that. The government decided it could not allow an investment bank to fail and, to the relief of a panicked Wall Street, committed billions of taxpayers’ funds to Bear’s rescue. And it agreed to come to the aid of other banks that rattle their begging bowls.
Paulson, the former chief of Gold-man Sachs, hopes the new regulations will be temporary, but concedes that access to taxpayers’ funds “should involve the same type of regulation and supervision” as applies to commercial banks. Investment banks, assured of a government lifeline 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 Massa-chusetts Democrat who chairs the House Financial Services Committee. The Treasury has its own “blueprint”, but at the time of writing it remains a closely guarded document. Frank is clear: give regulators broad powers to avoid systemic risk. Here is the likely outcome.
The usual calls for “transparency” will be heard. More important, regulators will be empowered to require investment banks to be adequately capitalised 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 American investment banks to make it easier for them to compete with foreign rivals.
Government intervention will not be limited to investment banking. Political pressures are mounting for measures to ease the plight of homeowners who are struggling to pay their mortgages. There are fewer of these folks than the press leads you to believe - 92% of homeowners are paying their mortgages on time; only 2% of mortgages are in foreclosure. Sub-prime borrowers facing higher, reset interest rates account for only 6% of all mortgages, but 40% 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 of 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 thrown into 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.”
Both Hillary Clinton and Barack Obama want taxpayers to make $30 billion available to distressed homeowners - the same sum that they made available in the Bear Stearns deal.
It took Franklin Roosevelt his first 100 days to restructure American capitalism. And he had to get Congress to go along with his plans. Paulson and Bernanke laid the basis for another restructuring of market capitalism in a 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.
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 Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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