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Make a Deal, Regulatory Style  MAY
2008 - The recent bailout of Bear Stearns was the ultimate irony. For years,
investment banks have been fighting against government regulation and intervention
in the free market, crying that the competitiveness of the U.S. capital
markets would suffer from greater regulation. Then suddenly, when they need
help, where do they turn? To their new favorite relative—Uncle Sam!
The decision by federal regulators to underwrite a $30 billion credit line to JPMorgan Chase for its acquisition of Bear Stearns has been controversial, to say the least. Parts of the acquisition either stretched the rules or ignored them completely. At the time the agreement was reached, JPMorgan purchased 39.5% of Bear Stearns’ stock to ensure that it would have the votes necessary for shareholder approval of the deal. This action was allowed in spite of a New York Stock Exchange rule (Listed Company Manual, section 312.03) that requires companies to obtain shareholder approval before issuing more than 20% of the company’s current outstanding stock in any transaction (with limited exceptions). So, do the ends justify the means? Subsequently, the Federal Reserve also opened up its emergency loan program—the “discount window”—to other large investment banks, a program that was previously restricted to commercial banks. Many have questioned the prudence of the Fed’s recent generosity to investment firms and called for them to be subject to increased regulation, similar to that of commercial banks, in exchange for access to the discount window. Regaining Confidence by Playing a Con Game To placate those who may have noticed the latest rule-bending, Treasury Secretary Henry M. Paulsen, Jr., outlined a new blueprint on March 31 to regain investor confidence in the U.S. financial markets. His proposal contained short-, intermediate-, and long-term recommendations for changes to the financial regulatory structure. The short-term plan would create a new mortgage commission charged with protecting homeowners. At the intermediate stage, several federal agencies would be consolidated: the Office of Thrift Supervision would be eliminated and the SEC would be merged with the Commodities Futures Trading Commission. The long-term plan would create two new regulatory agencies: a “prudential financial regulator” to focus on the well-being of financial institutions that provide specific government guarantees, and another that would monitor businesses to protect consumers. The Fed would be given broader powers, becoming a “market stability regulator” charged with the responsibility of addressing liquidity and funding problems. Although Paulsen’s blueprint offers no additional oversight or regulation for investment banks, the media are calling his proposals the “biggest market overhaul since the Great Depression.” To me, it seems like we are simply trading one set of agencies for another. Is this the government’s version of the old shell game? Paulsen made clear last year that the Treasury and other regulators believe that “market discipline is the most effective tool to limit systemic risk.” But how do we ensure market discipline in the world of investment banking, which, of late, seems to be run more like a casino where the government now covers the bad bets of players like Bear Stearns? Learning from Our Mistakes One suggestion would be to conduct a thorough review of what happened in the Bear Stearns case and analyze how it might have been prevented. Learning can be achieved in many ways. Lessons learned from our mistakes (the “hard” way) are painful, but they can also be very effective. Capital reserve requirements are an important tool that regulators could use to force a more conservative approach within the financial market system. While increasing the capital levels required of investment banks would admittedly redirect available resources away from other uses, it would be prudent and equitable to bring the reserve requirements for investment firms in line with those of commercial banks. Implementing full disclosure (e.g., by putting all structured investment vehicles on the balance sheet) and consolidating regulatory authority to better enforce existing rules could help to minimize the risk of another Bear Stearns’ occurrence. The current piecemeal structure allows aggressive dealmakers to exploit cracks in the system by creating an endless array of new financial instruments that fall outside of regulatory oversight. The participants in our financial system must cope with many challenges; however, figuring out which agency should have oversight for any specific financial instrument should not be one of them. Paulsen indicated in his speech that his blueprint should not be acted upon “this month or even this year.” Next year, of course, we’ll have a new president and all bets are off. But if I were asked to call the coin toss … As always, I welcome your comments.
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