Now, seven months after the start of the subprime mortgage crisis, financial markets are getting the equivalent of the post-Enron treatment. Regulators are trying to rein in the financial innovators. The result is likely to be more regulation and higher costs for business but also more disclosure, transparency, and oversight to help investors.
"Clearly the regulatory structure did not keep pace with the financial innovation that occurred in recent years," says Mark Zandi, chief economist at Moody's Economy.com. "This is an effort to catch up."
The latest plan – announced Thursday by the Bush administration – would affect a large swath of the credit market, ranging from mortgage lenders to the financial institutions that find innovative ways to sell those mortgages to sophisticated investors. Specifically, the proposal would boost oversight of all segments of the mortgage business, create licensing standards for mortgage brokers, and pressure credit ratings agencies, which decide the financial strength of companies, to improve their analysis.
"The objective here is to get the balance right," said Treasury Secretary Henry Paulson, who announced the plan in Washington. "Regulation needs to catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient, or cut off credit to those who need it."
The proposal announced by Mr. Paulson, who chairs the presidential working group charged with recommending ways to deal with the ongoing financial crisis, is one of several plans. On Thursday, Rep. Barney Frank (D) of Massachusetts proposed legislation that would allow the Federal Housing Administration (FHA) to insure and guarantee refinanced mortgages that banks and investors have taken losses on. Other committees in Congress also are deeply involved in examining everything from the pay structure of executives in the mortgage business to predatory loans.
Similar reforms are under review in Europe, where banks have also faced big losses tied to US mortgage loans. European Union leaders, at a summit this week, are considering how regulators, banks, and credit-rating agencies can better guard against shocks.
The new regulatory proposals come at a time when the Federal Reserve is trying to stabilize the credit markets. On Tuesday, the Fed announced it would swap up to $200 billion in US Treasury securities for other debt including mortgage securities.
Investors are somewhat sanguine about the efforts.
"I think it's a first step," says Doug Roberts, chief investment strategist at Channel Capital Research Institute, based in Shrewsbury, N.J. "There is not a short-term fix; this will go on for several years."
However, Mr. Roberts is pleased to see Paulson looking more deeply into the potential for systemic risk. "People have alluded to it but not dealt with it directly," he says. "Paulson is saying we have to constantly reevaluate risk."
One of the elements of the White House plan is to increase the regulation of companies that had fallen through the regulatory cracks but had been aggressively making loans. Last March, for example, the second-largest issuer of subprime mortgage loans – New Century Financial – collapsed. It has $35 billion in claims.
"It was not regulated by anyone," says Mr. Zandi. "It was nominally regulated by the [Securities and Exchange Commission], but that agency was not focused on capital adequacy."
The plan also tries to deal with failure of the credit agencies to adequately monitor the complex financial products being sold to investors. Critics have complained that the rating agencies get paid by the issuers of the securities. However, the agencies point out that if the ratings are paid for by investors, there is a potential for conflict as well. Paulson mainly wants the rating agencies to improve the quality of their analysis, particularly of complex investments called "structured products."
The Paulson effort received some grudging praise from Congress.
"The good news is they're beginning to put their toe in the water when it comes to government involvement to help the economy," Sen. Charles Schumer (D) of New York said in a statement. But he added, "The bad news is they're going to have to do a lot more than that to address the problem."
John Taylor, president of the National Community Reinvestment Coalition, says the Paulson effort is not going far enough. "I was glad to hear him say the market was complacent about risks," he says. "We need to clean up this market once and for all and that requires new laws."
He also says the administration and Congress need to expand emergency-loan programs for homeowners since foreclosures continue to soar. "They are up 60 percent over last year, which was a dismal year," says Mr. Taylor. "Paulson's proposals won't do anything relative to the current foreclosures."