Treasury Secretary Timothy F. Geithner wants to create an independent regulator charged with ensuring that the companies involved in today's complex financial transaction don't ever bring the economy crashing down again.
Among the targets for reform in his plan unveiled today: credit default swaps and other types of derivatives that have been blamed for exacerbating the economy's troubles. And hedge funds, which have become important market players in the last few years, would now be required to register with the Securities and Exchange Commission.
One of the prime concerns is that some of these companies are so interconnected with the rest of the economy that if they fail, the domino effect could topple the entire financial system. That was the fear with AIG and Bear Stearns and Geithner hopes that the new regulator would be able to control that systemic risk.
Geithner outlined the plan in testimony today before the House Financial Services Committee, his second appearance in three days before the panel.
Geithner said that Wall Street and the financial system have "failed in basic fundamental ways."
"The system proved too unstable and fragile, subject to significant crises every few years, periodic booms in real estate markets and in credit, followed by busts and contraction," he said. "Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-term profits over long-term return."
To fix the system, Geithner said the government can't just make "modest repairs at the margin," but must write "new rules of the game."
"We can't allow institutions to cherry pick among competing regulators, and shift risk to where it faces the lowest standards and constraints," he said.
There was a push from some Geithner and some members of the committee to act now, while the economy was suffering and there is public support for reform.
"Too big to fail is the right size to regulate," said Rep. Al Green, D-Texas. "It is time for us to act."
"When we have this opportunity to make a difference there will be naysayers. We need naysayers … but we cannot allow the naysayers from allowing us to do what we know is the right thing for the American people," Green added. "Mr. Secretary I salute you for what you are doing. God bless you."
Geithner thanked him for the comments and then reiterated: "We have an opportunity now and we need to act."
Not everybody was so enthusiastic.
"This empowers federal regulators with incredible discretion," warned Rep. Spencer Bachus, R-Alab., the committee's ranking member.
Rep. Scott Garrett, R-N.J., cautioned that with a resolution authority in place, "We could really end up doing a heck of a lot more harm than good", adding "Forgive me if I'm still a skeptic."
"You realize how radical your proposal is?," asked Rep. Don Manzullo, R-Ill. in the day's most contentious exchange, just minutes before the hearing ended.
"It's not a radical proposal," Geithner replied.
"Oh, it's absolutely a radical proposal!" exclaimed Manzullo. "You're talking about seizing private businesses and you don't consider that to be radical?"
Rep. Joe Donnelly, D-Ind., asked why the government should allow Wall Street to produce certain types of investment vehicles.
"It just seems like gambling," Donnelly said.
Geithner said he isn't so sure they should be banned or could be but that the government should instead ensure that banks have more cash reserves in place against such bets so the system won't collapse if the go wrong.
Rep. Maxine Waters, D-Calif. also asked about eliminating some financial instruments.
"Why are credit default swaps good products?" she asked.
Geithner responded that: "People will always innovate around government restrictions." He said it is better to "ensure that the institutions are strong enough to weather a very bad storm."
More Cash Reserves
The financial crisis was caused in part because rating agencies and regulators simply did not understand or address the actions of the big banks and other players until they had already resulted in catastrophic losses.
Under the proposed new rules, investment companies would be required to have more cash on hand and take less risks.
The independent regulator Geithner is proposing would be separate from the Treasury Department and could come possibly from the Federal Reserve System. The aim is to end turf wars between the various government agencies tasked with overseeing the economy.
The regulator would have sweeping authority to examine any complex financial structure to assess its risks of going under and affecting the economy at large. It would oversee major insurance companies, hedge funds and financial derivatives markets.
The plan would also impose a uniform set of standards on large financial companies to limit their scope and risky activities.
The goal is to prevent another failure of a company like Lehman Brothers or insurer AIG and to limit exposure to the rest of the market if such firms were to topple.
Another goal is to prevent fraud such as those by admitted Ponzi schemer Bernie Madoff and accused scammer Allen Stanford -- grand-scale frauds that exposed major regulatory gaps and highlighted the need to strengthen enforcement and improve transparency for all investors.
New Rules Would Cover Companies Like AIG
The Obama administration is asking Congress to act quickly on its proposed reforms. Late Wednesday night, it sent Congress a 61-page bill that would give the government expanded powers to seize control of nonbank financial institutions. Rep. Barney Frank, D-Mass., the committee's chairman, has signaled that he could act on the measure as soon as next week.
The administration's tactic is in stark contrast to the Bush administration, which believed in less regulation and that the markets would set how much risk they should take on.
Obama's regulations aim to oversee companies not so much on the form they take -- bank, investment bank or insurance company -- but based on the type of transactions and business they conduct. A major criticism of the oversight structure to date is that insurance companies like AIG were involved in Wall Street's transactions but were supervised by traditional insurance regulators.
Two of the main targets for added oversight are credit default swaps and hedge funds.
Credit default swaps, which trade in a $60 trillion global market without government oversight, are contracts to insure against the default of financial instruments like bonds and corporate debt. They played a prominent role in the credit crisis that brought the downfall of investment banking giant Lehman Brothers in the fall and pushed AIG to the brink of collapse, forcing the government to provide more than $180 billion in support.
Hedge funds, vast pools of capital holding an estimated $1.5 trillion in assets, operate mostly outside of government supervision. As the market crisis deepened in the fall, hedge fund selling was widely cited as one of the reasons for increased volatility that pounded stocks and bonds.
U.S. law generally does not require hedge funds or other private pools of capital to register with a federal financial regulator, although some funds that trade commodity derivatives must register with the Commodity Futures Trading Commission and many funds register voluntarily with the Securities and Exchange Commission. As a result, there are no reliable, comprehensive data available to assess whether such funds individually or collectively pose a threat to financial stability.
House Committee to Vote on Blocking Bonuses
Finally, Geithner will unveil new standards for money market funds to reduce the risk of rapid withdrawals. Money markets have traditionally been seen as one of the safest and most conservative investments. They wouldn't make anybody rich, but they weren't supposed to ever decline in value.
As the financial crisis worsened and one fund actually lost value -- or broke the buck in money market terms -- there was a run on the entire money market industry. Investors pulled their money out of the funds, causing further pressures on the stock market.
There is also expected to be some action today on how to handle bonuses.
Before Geithner testifies, the House committee will vote on the markup of a measure to empower the government to stop future bonus payments at bailed-out financial institutions if Geithner and regulators determine that the employee compensation is "excessive."
The measure is a watered-down proposal compared to the lawmakers' legislation last week to put a 90 percent tax on bonus payments at bailout recipients after the $165 million bonus mess at AIG.
With reports from The Associated Press