With finance crisis, hands-off era over

The great financial shakeout of 2008 – one of the most dire US fiscal crises of modern times – is likely to change permanently the relationship between Wall Street and Washington.

Already Treasury Secretary Henry Paulson has overshadowed New York's titans of finance with his decisions as to which institutions will get government aid and which will not. If things don't get worse, history may credit Mr. Paulson with helping to pull the economy back from the brink, as financier J.P. Morgan did in the Bankers' Panic of 1907.

Beyond that, a long period of Washington laissez faire toward financial markets may well be at an end. The details of regulation could be different, depending on which candidate wins the White House this fall. But more US oversight seems inevitable.

"We need to restructure the system to reduce the chance of having another crisis," says Douglas Elmendorf, a senior fellow in economic studies at the Brookings Institution.

Financial regulators may win access to more internal information from financial institutions, allowing them to better judge the risks they are running. They may also look for ways to control derivatives, financial instruments backed by mortgages or other types of assets, which have become complex "to the point of absurdity," in Mr. Elmendorf's words.

There's a sense that Washington needs to modernize a system of financial oversight rooted in government entities founded after the Great Depression.

"We have an archaic financial regulatory system ... it really needs to be rebuilt," Paulson told reporters at the White House on Sept. 15. The US needs a balance between regulation and market discipline, added Paulson, who last spring proposed a package of tougher regulations for investment banks, including giving more oversight powers to the Federal Reserve.

The crisis management of the Treasury Department and the Federal Reserve appeared to have stabilized markets, at least for the short term. Though the Dow Jones Index fell over 500 points on Sept. 15, the sell-off was orderly and could have been worse, according to analysts.

But major Asian and European bourses also suffered sell-offs and the fate of the insurance giant American International Group remains in question, following the Lehman Brothers' bankruptcy and the sale of Merrill Lynch to the Bank of America.

By declining to use government funds to help Lehman, Washington ensured the financial crisis would enter a new and perhaps decisive phase. But it was the right step to take, said some analysts. While Bear Stearns collapsed quickly, Lehman's problems have developed over time. Any firm that stands to lose money due to interrconnections with Lehman may have only itself to blame.

Or, such firms may have been counting on a government bailout.

"To the extent that there were any major players in the market not prepared for Lehman Brothers' demise, that would be the clearest signal that moral hazard had begun to sink into the market. So it was the right decision to not step in with financial guarantees for Lehman," says Benn Steil, senior fellow and director of international economics at the Council on Foreign Relations.

Looking forward, Washington may need to set up a temporary new agency capable of buying and selling the toxic mortgage-backed assets that are dragging down Wall Street firms, said former Federal Reserve chairman Paul Volcker in a Sept. 15 speech. Such an agency would be similar to the Resolution Trust Corporation, the US-backed clearinghouse that helped move the nation through the savings-and-loan crisis of the 1980s.

But others say Washington shares some blame for the current crisis. Under longtime head Alan Greenspan, the Federal Reserve stood by while the housing market overheated, charges University of Maryland economic historian David Sicilia. Nor did the Fed talk about regulating derivatives or hedge funds until it was too late, in Sicilia's view.