Congress weighs next steps for financial regulation

WASHINGTON — As federal regulators continue to unveil new measures to reverse the global financial crisis, Congress on Tuesday began weighing what changes might be needed to restore confidence in the U.S. financial system and prevent future crises.

The House Financial Services Committee, which will be instrumental in drafting any regulatory changes, heard testimony from academic and industry experts who agreed on the need for new regulation, the merging of some regulatory agencies and writing rules to govern complex financial instruments.

Lawmakers must decide whether to start by patching holes on a leaking ship, taking a piecemeal approach, or to prepare broad legislation that amounts to building a new ship.

Joseph Stiglitz, a Columbia University professor and the 2001 recipient of the Nobel Prize in Economics, warned the committee that waiting on reform amounts would delay efforts to restore confidence in the U.S. financial system.

"We know the boat has a faulty steering mechanism and is being steered by captains who do not know how to steer, least of all in these stormy waters," Stiglitz said, in a stinging criticism of Wall Street executives. "Unless we fix both, there is a risk that the boat will go crashing on some other rocky shoals before reaching port."

One area of seemingly unanimous agreement Tuesday was to empower the Federal Reserve to guard against threats to the U.S. financial system.

In the crisis, the Fed has acted as the top regulatory cop, but in many areas it lacks sufficient authority. Fed Chairman Ben Bernanke said in a speech last week that he was powerless to prevent the bankruptcy of investment bank Lehman Brothers because of his limitations under existing law.

The Fed has pushed the limits of its authority with numerous creative steps to bolster markets since last March, when the financial crisis began snowballing. These include lending to investment banks, corporations and even foreign central banks, none directly under its regulatory umbrella.

On Tuesday, the Fed unveiled another new effort to restore confidence, this time shoring up the $1.7 trillion money market mutual fund industry by agreeing to backstop as much as $540 billion worth of lending.

The new Money Market Investor Funding Facility will allow money market institutions to sell their holdings of certificates of deposit and commercial paper, the short-term promissory notes issued by U.S. corporations. Because the credit markets have seized up, money market firms can't sell their holdings. The Fed hopes that by purchasing these debt instruments, it will unclog these markets and signal that they're safe.

Lawmakers on Tuesday appeared to agree on the need to reduce the number of financial regulators and increase their scope. Among the possibilities is merging the regulators of banks and thrifts into a single entity, and merging the Securities and Exchange Commission with the Commodity Futures Trading Commission to reflect that Wall Street now is deeply entrenched in markets for a wide array of products other than stocks.

"The number of regulators should be less than we have now, we clearly have a lot of duplication," said Alice Rivlin, a former Fed vice chairman and now a researcher at The Brookings Institution, a public-policy organization in Washington. "I do think we need a regulator of financial behemoths, sometimes known as bank holding companies, that is responsible for making sure they are adequately understanding and monitoring their own risk."

Lawmakers also supported the creation of a special select committee of Congress that could go beyond the usual turf wars and determine what caused the financial crisis and recommend changes.

Broad membership on such a congressional committee could bridge the current gaps that have resulted in the agriculture committees, not finance panels, having jurisdiction over the futures markets, where contracts for future deliveries of oil, natural gas and farm products are sold.

Wall Street investment banks, which fall under the finance committees, have pumped trillions of dollars into commodities markets. Some critics charge that this distorted these markets and pushed up the price of oil and a number of farm products to record levels earlier this year.

There also was unanimity behind bringing some minimum regulation to the over-the-counter derivatives markets. These markets are vast and "dark," or unregulated and non-transparent, for complex financial instruments that billionaire investor Warren Buffett famously dubbed "financial weapons of mass destruction."

These products derive their value from the underlying value of another instrument. Unregulated over-the-counter markets for derivatives, where transactions are between private parties instead of on a regulated exchange, are twice as large as the regulated markets are for them. In the oil market, these insurance-like instruments are called over-the-counter swaps. On products whose underlying value is derived from some form of debt, they're called credit-default swaps.

These swaps and derivatives were excluded from the last overhaul of commodity trading rules in 2000, and credit-default swaps were prominent in September's collapse of global insurer American International Group.

AIG was the leading issuer of swaps, but after paying out more than $18 billion on bets against mortgage bonds, it lost the confidence of investors. That prompted the Fed to step in with an $85 billion loan to prevent the potential collapse of the unregulated swap system.

"These (swaps) are areas where a broader regulatory approach would have served us well," Joel Seligman, the president of the University of Rochester in New York and an expert in securities law, told the committee.

The SEC and the CFTC are both vying for the right to regulate swaps. The Federal Reserve Bank of New York also has been working with the financial industry to create a transparent mechanism for settling contracts between buyers and sellers of swaps.


In coming months, as Washington tackles a regulatory overhaul of the nation's financial markets, there will be lot of terminology thrown around for complex financial instruments that to date largely have escaped regulation. Here's a glossary of some of these terms.

- Derivatives: Financial instruments that derive their value from the underlying value of another instrument. Investors buy these to help manage risk, often taking the opposite position in a derivative from what they've taken in the underlying asset.

- Exchange-traded derivatives: These are regulated derivatives. One example is a futures contract, which gives the buyer a right to purchase oil, corn or some other commodity at a certain price at a future date.

- Over-the-counter derivatives: These are traded in markets where there's no government regulation and they're bought and sold through contracts between parties. These markets have become bigger than stock or futures markets.

- Over-the-counter swaps: OTC swaps are instruments in which an investor enters into a deal to purchase oil contracts at a specified price from the swap dealer over a fixed period of time. If oil rises above this price, the swaps dealer loses. If it falls below the price, the investor has overpaid.

Swaps dealers are most often big Wall Street financial firms, which hedge their own deals through investments in the regulated futures market. As in the futures market, the majority of players are speculators who have no intention of ever taking physical delivery of oil or whatever is the underlying product.

- Credit-default swaps: Like OTC swaps, these are private contracts between parties but the underlying asset on these instruments is debt. The underlying debt can be pooled mortgages that are packaged into a bond, or other types of loans that are packed together and sold into a secondary market through a process called securitization.

The insurance-like swaps allow investors to take a position opposite to their exposure in the debt product they hold. The size of this unregulated market is estimated to be as much as $62 trillion. The lack of any sort of clearinghouse or settlement mechanism poses risks to the entire global financial system. New York state has moved recently to try to regulate some credit-default swaps.


Fed's money market announcement

Stiglitz testimony

Rivlin testimony

Seligman testimony


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