Long, bumpy road ahead for Obama financial reforms

WASHINGTON Fri Mar 27, 2009 7:12pm EDT

U.S. President Barack Obama participates in an ''Open for Questions'' town hall on the economy in the East Room at the White House in Washington, March 26, 2009. REUTERS/Larry Downing

U.S. President Barack Obama participates in an ''Open for Questions'' town hall on the economy in the East Room at the White House in Washington, March 26, 2009.

Credit: Reuters/Larry Downing

WASHINGTON (Reuters) - The far-reaching reform of regulations governing U.S. financial markets, proposed by the Obama administration on Thursday, may mark a turning point for the economy, but a long political struggle lies ahead.

In congressional hearing rooms, in Capitol hallways where Wall Street lobbyists ply their trade, at global summits, and among ordinary Americans, basic questions will have to be answered about what kind of economy the United States wants.

The trend on Wall Street in recent years has been toward the formation through mergers of huge financial supermarkets, such Citigroup, Bank of America and other institutions now seen as "too big to fail."

New financial instruments were also invented without much regulation of either the risk-taking involved or the mechanics of trading them. While poor credit controls in the sub-prime home mortgage market contributed to the U.S. housing boom, the lack of regulatory supervision of new instruments, such as collateralized debt obligations (CDOs) and credit default swaps (CDS), may have exacerbated the property market crash.

Back in March 2008, then Democratic presidential candidate Barack Obama had warned, "A free market was never meant to be a free license to take whatever you can get."

The implication was that the central role of Wall Street -- efficient allocation of capital through competitive markets -- had somehow gotten lost in a scramble for wealth.

TWO PART PLAN

Geithner told Congress on Thursday the government needs new ways to handle the big-picture financial risks presented by firms that are "too big to fail" by setting up a systemic risk regulator to provide early warning of trouble.

The September 2008 bankruptcy of Wall Street investment bank Lehman Brothers, for example, caused disruption throughout U.S. and global financial markets, causing credit markets to seize up and liquidity to evaporate, accelerating the economic downturn started by the slump in the U.S. housing market.

In addition, Geithner argued, the government needs the power to take over and dismantle distressed firms in a more orderly way than, than has happened for instance in the erratic $180-billion taxpayer bailout of fallen insurer AIG.

"Someplace back in Economics 101, Wall Street was there to allow the citizen to participate in a capitalist society, a place where you purchased stocks," said William Attridge, chief executive of Connecticut River Community Bank, at a Senate Banking Committee hearing earlier this week.

"A majority of Wall Street now, or a good part of it, is basically a casino. The financial instruments are nothing more than gambling," he said, testifying on behalf of the Independent Community Bankers of America, an industry group.

APPROACH QUESTIONED

But some analysts and lawmakers question this approach, suggesting it could institutionalize mega-firms with an implied government protection from bankruptcy, put smaller firms at a competitive disadvantage, and leave taxpayers to bear the costs of any bailout.

"What we're going to do is guarantee that large firms borrow at a lower rate than smaller firms, which will be crowded out of the market," said Republican Rep. Ed Royce at a House committee hearing where Geithner testified.

Moreover, some lawmakers suggest that setting up a systemic risk regulator only masks failures among existing regulators.

Republican Rep. Don Manzullo said the Federal Reserve could have done more in years past to enforce laws already on the books against abusive mortgage lending -- a role that sounds a lot like "systemic" regulation -- and possibly have prevented the housing market bubble behind the present crisis.

"The reason I bring that up is that you are wanting to start yet another large, powerful federal agency ... But I just gave you an example of a federal agency that had the power to stop a lot of the subprime bleeding, but simply did not act."

BROADER QUESTIONS

The two initiatives also raise questions about the economic roles of government and the taxpayers, the power of financial elites versus ordinary Americans, and the accountability of existing regulators, say skeptical analysts and lawmakers.

There will be plenty of time to hash out these issues, said Jaret Seiberg, Washington policy analyst for institutional broker Concept Capital. "Neither of these plans are done deals as Congress must approve both ideas," he said.

He said Congress will be hard pressed to finish work on the plans before its August recess. "Yet the odds do heavily favor adoption of both initiatives," he added.

(Reporting by Kevin Drawbaugh)