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Here's what federal regulators ought to do next

With the acquiescence of federal regulators, Wall Street went hog wild, earned gobs of money and created a whopping mess that the federal government has to clean up.

In the words of Nouriel Roubini, the New York University economist who's been predicting this debacle for more than a year, we've mastered the art of "socializing risk and privatizing gain."

With the Fed's decision to put $30-billion behind the rescue of Bear Stearns and open its lending window to investment banks, we're deep into bailout territory. Considering the alternative — a global financial market meltdown that takes the global economy down with it — this was probably the right thing to do.

The underlying problem is that, over the past 20 years, we've allowed credit creation to be shifted from banks, which are regulated and required to keep a minimum capital cushion, to largely unregulated securities markets. Like banks, these markets borrow short and lend long, which creates profit margins but makes them vulnerable to an old-fashioned bank run if short-term capital suddenly dries up. The first victims in such a scenario run the gamut from mortgage lenders like New Century and Countrywide, hedge funds such as Peloton Partners and Carlyle Capital and even venerable investment banks like Bear Stearns.

In agreeing to buy the Bear for about a quarter of the value of its headquarters building,

JPMorgan's Jamie Dimon may have made the deal of a lifetime, while getting the Federal Reserve to take on all the risks. In that sense, it's more dollar-holders rather than taxpayers who are on the hook if things don't work out, but my guess is that the Fed will wind up making money in the end.

If Bear is to become a template for future Fed rescues, the logic seems to be that while the government has no interest in bailing out shareholders and executives for their poor judgments, it has no choice but to bail out those who have lent money or entered into credit default swaps and other bets with the troubled entity. The reason for the distinction is simple: If shareholders lose their money, it's a shame for them, but their losses won't cause credit markets to collapse. Not so for creditors and counterparties.

Now that the government is in bailout mode, it has the right and the obligation to require financial institutions that are undercapitalized to find new investors. While they are at it, regulators ought to clamp down on banks and investment houses that are providing loans or repo agreements to hedge funds and others whose speculative strategies are making fragile markets even more fragile.

Certainly that was the case last week when short-selling of Fannie Mae and Freddie Mac mortgage-backed securities helped drive down prices, triggering widespread margin calls. Wise guys should not be able to pursue these highly leveraged strategies with the liquidity the Fed is providing.

Here's what federal regulators ought to do next 03/19/08 [Last modified: Thursday, October 28, 2010 9:43am]
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