Bush regulatory plan could do more harm than good

NEW YORK (Reuters) - A White House plan to overhaul the U.S. financial regulatory system could usher in an era of smaller investment returns and capital flight overseas as investors shy away from a tough new market cop.

The Bush administration proposals, unveiled on Monday, have quickly summoned bitter memories of Washington's last big reform binge -- Sarbanes-Oxley. A replay of that episode, which unfolded in 2002 in response to the collapse of Enron Corp, could kick the financial sector when it's down and prolong tight lending conditions, fund managers and market participants said.

The plan, giving the Federal Reserve more oversight powers and combining securities and futures-trading regulators was also seen as ancillary to the problems immediately facing investors: falling asset prices, increased market volatility and a very weak economy.

"There will be more regulation of the markets and that will slow already below normal growth and result in lower capital returns in asset prices," said Michael Metz, chief investment strategist at Oppenheimer in New York.

Metz said he still likes only U.S. stocks of companies that do heavy business overseas since foreign economies are relatively healthier.

Other investors feared the tighter regulation of Wall Street could drive foreign investors away from the United States, a phenomenon that many tied initially to the impact of Sarbanes-Oxley, which required a company's top executives to sign off on financial statements.

Such a scenario would be devastating for banks and brokerages increasingly dependent on foreign capital to stay afloat. It would also further undermine the U.S. dollar, which has fallen more than 6 percent in the last three months, the biggest quarterly decline since the fourth quarter of 2004

"We should have a sensible regulatory framework, but if we have a punitive one we could further the migration of world capital markets to outside of the U.S.," said Haag Sherman, chief investment officer of Salient Partners in Houston, a fund with $7 billion in assets under management.

"Regulation is always a step behind what's happening in the markets," said Sherman, who plans to be underweight U.S. stocks and overweight foreign securities in general.

SMALLER THE BETTER

The morass in lending markets has hit U.S. stocks like a rock. The Standard & Poor's 500 index has tumbled around 10 percent in the first three months of the year, the worst quarterly performance since the third quarter of 2002.

Bill Gross, chief investment officer of Pacific Investment Management Co, sees more government regulation forcing the finance-based economy to reflate, creating a world filled with more expensive, lower-yielding assets.

"The U.S. asset-based economy will morph into a more expensive hybrid that will reign supreme for years to come," he said in a note.

In the face of such poor markets, many investors have been slashing their leverage, borrowed money used to enhance returns.

Paul Nolte, director of investments at Hinsdale Associates in Hinsdale, Illinois, said he believes markets need less of two things: leverage and regulation.

"The marketplace needs to get smaller," he said.

He said the White House blueprint was the wrong approach to keeping markets stable since it would give too much oversight power to the Fed, a body whose governors are appointed by the U.S. president.

Critics of the regulatory plan were legion. The Democratic chairman of the U.S. Senate Banking Committee called it "a wild pitch" that doesn't solve the credit crisis. CME Group, the world's largest derivatives exchange, said the plan could cause "more harm than good."

Still, some on Wall Street tried to take a sober, realistic look at the plan, especially since there was little chance of the proposal becoming a reality during the Bush administration.

The era of cheap money that inflated the housing bubble certainly ended long before the White House plan and eventually engendered the current environment in which a financial system meltdown was narrowly averted when the Fed financed a proposed buyout of Bear Stearns Cos Inc by JPMorgan Chase earlier this month.

Any plan that could even remotely defuse current market tensions was welcome, said Thomas Lee, a U.S. equity strategist with JPMorgan.

"If you reduce systematic risk, you also reduce risk premiums," he said.

(Additional reporting by Jennifer Ablan)