Efforts to Regulate ‘Wild West’ Markets Overdue

By Beacon Staff

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke might be surprised to hear themselves compared to Wyatt Earp, the iconic figure in American history, who helped restore some order to the Wild West of the 1800s.

But Bill Gross, manager of $812 billion of investments (about 1 percent of the total financial market in the United States), refers to the nation’s financial markets as today’s “Dodge City,” and moves by the two Washington officials last week as an effort to bring a greater rule of law and order to it.

New and strengthened regulations springing from the current financial crisis will be significant and probably good, says Gross, co-chief investment officer of PIMCO, a Newport Beach, Calif., firm managing the gigantic Total Return bond fund and other mutual funds. “Only time and the election will tell how far it will go,” he says by phone.

Whenever capitalism goes badly astray, it usually results in a reaction bringing more regulation. Politicians want to do – and be seen as doing – something to patch up the mess. The major corporate and accounting scandals involving Enron, Tyco, WorldCom, and others prompted Congress to enact the Sarbanes-Oxley Act in 2002, enhancing standards for US corporations, management, and public accounting firms. The goal was to restore public confidence in the nation’s capital markets.

Now rampantly greedy and unwise behavior in selling subprime mortgages and various fancy financial instruments, combined with the bursting of the housing market price bubble, has prompted another stock market collapse, a series of failing banks, and last week’s mess surrounding Fannie Mae and Freddie Mac, two mammoth providers of credit to the mortgage industry.

“To me,” says E.J. Dionne, Jr., a fellow at the Brookings Institute in Washington and a Washington Post columnist, “the crisis calls conservative ideology into question.”

Some conservatives have zealously called for deregulation of business and for smaller government. But now it is government –Paulson and Bernanke – that is preventing financial markets from imploding by expanding government’s role, especially the Fed’s.

Dionne likes to quote former Republican Sen. William Cohen of Maine: “Government is an enemy until you need a friend.”

Some Wall Street firms and mortgage brokers have exploited loopholes in Sarbanes-Oxley and other laws to get rich on fees arising from the sale of subprime mortgages and then selling these risky assets to pension funds and other investors around the world.

Gross says PIMCO managed to avoid buying these faulty investments for its mutual fund portfolios. And he cheers the efforts to prevent such abusive lending practices in the future in order to protect investors. “It got to the point where anything goes,” he says. Tighter regulation “is more than overdue.”

Mickey Edwards, a former Republican congressman and author of a new book, “Reclaiming Conservatism: How A Great American Political Movement Got Lost – And How It Can Find Its Way Back,” basically agrees. He sees it as true and legitimate conservatism for government to protect the public from exploitation by “quick buck” financial operations. He criticizes those “who call themselves conservatives … but would let business do what it wants.” And he approves of the Fed’s moves to rescue government-sponsored Fannie Mae and Freddie Mac.

“The worst thing that can happen now is to let all of this [the financial mess] to get out of control,” he says.

Harald Malmgren, a Washington economic consultant, cautions, however, that Congress should not rush to embrace regulatory reforms now proposed by Paulson and Bernanke. It was the Fed, he says, that allowed credit quality in the mortgage market to deteriorate so badly as borrowers were subject to less and less scrutiny. Fed officials “were asleep,” Mr. Malmgren says. Though they talked in 2005 about the problem, “almost in panic,” they procrastinated and did nothing about it. Officials of the Securities and Exchange Commission were also “sleeping on the job,” he says.

In the present crisis, the Fed has taken on a new regulatory role in regard to investment banks, and now is involved in the rescue of Fannie Mae and Freddie Mac. The regulatory framework that rises from the ashes of the present crisis will play “a pivotal role” in world capital markets, says Malmgren. Since these markets are now internationalized, regulators and Congress face “a certain degree of challenge” to US financial sovereignty. Globalization could require “enhanced cooperation” with central banks and regulators abroad in major financial markets, such as London and Frankfurt.

The oddity of today is that a Republican administration is pushing an expansion of government regulation. Dionne hopes that whatever emerges in Washington will protect citizens better from Wall Street fraud and foolishness.

“A well-functioning capitalist system relies on clear rules,” he says.