Obama's Financial System Overhaul Would Give the Fed Broad Powers Over Wall Street

By Don Miller
Associate Editor
Money Morning

U.S. President Barack Obama took a swipe at Wall Street yesterday (Wednesday) as he unveiled a sweeping 85-page proposal to reinvigorate government regulation of the U.S. financial markets by giving the Federal Reserve new powers to supervise the economy.

The proposal is part of an effort by the Obama administration to restore confidence in the nation's financial system after last year's collapses of The Bear Stearns Cos. and Lehman Brothers Holdings Inc. (OTC: LEHMQ). The failures of those two institutions caused a credit-market seizure that froze bank lending and paralyzed consumer spending - resulting in a near collapse of the U.S. economy.

Those economic woes subsequently infected other economies throughout the world, forcing central governments from Washington to Beijing to rollout out hundreds of billions of dollars of stimulus packages.

President Obama's comprehensive plan contains reforms aimed at almost every facet of the financial system, including the asset-backed securities and credit derivatives that are widely blamed for nearly bringing down the banking sector.

Prior to releasing the proposals, President Obama singled out Wall Street for overreacting to government intervention in the financial markets. One of the administration's most-heavily criticized moves was the limits it placed on executive compensation.

 "Wall Street seems to maybe have a shorter memory about how close we were to the abyss than I would have expected," President Obama told Bloomberg News in an interview before the plan was released.

"When I hear some of the commentary that's been creeping up about, 'You know, it's time for government to get out of the economy. And what's the Obama administration doing?' I have to try to remind them - all we're doing is cleaning up after the mess that was made [by Wall Street]," Obama said.

Derivatives and Hedge Funds Under the Microscope

Obama pledged to bring more transparency to the murky derivatives market, which he called a system of "enormous risk."  The proposal also promises further regulation of mortgage-backed securities, which fueled the housing bubble and ignited last fall's credit crisis.

"Derivatives are a huge potential risk to the system," President Obama said. "We are going to make sure that they have to register, that they are regulated, that you have clearinghouses."

Derivatives are defined as "contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather," Bloomberg said.

According to an analysis of a draft of the proposal in Wednesday's Wall Street Journal, the plan would tighten regulations on many existing institutions already subject to government scrutiny, and bring some of the products and companies that previously operated outside of the banking system under federal control. Under President Obama's proposal:

• Hedge funds and other private pools of capital would have to register with the U.S. Securities and Exchange Commission (SEC).
• Thousands of financial institutions would be required to increase capital reserves to protect against unexpected losses, and companies would also have to keep part of the credit risk for loans they have packaged into securities.
• The government would have the power to take over and unwind a large financial company, a power the government was missing last year when the financial crisis was picking up steam.
• The Federal Reserve would be granted more powers over payments and settlements systems in U.S. financial markets to prevent a breakdown that officials fear could destabilize the economy.
• Any large, interconnected company that the government wants to take over and break up could be seized by the U.S. Treasury Department, if certain exigent conditions are met.

The plan clearly grants the central bank unprecedented new powers to conduct comprehensive examinations of almost any U.S. financial company, as well as any of that company's foreign affiliates.  It would also give the central bank oversight of any commercial company that owns a banking charter known as an industrial loan company, according to The Journal.

Rules Face Fight in Congress

The proposal now heads to Capital Hill where Congress must approve the changes. The plan is unlikely to pass in its present form, as it will likely be dissected by some legislators who believe that the White House is exceeding its legal authority.

In an effort to appease those opposing factions, portions of the plan actually do place new limits on the Fed's powers.

One notable provision of the administration's plan calls for the formation of a new consumer-protection agency, empowered to enact new rules related to mortgages, credit cards and other consumer products.  Those regulations were previously administered by the central bank.

In addition, the plan would require the Fed to gain approval from the Treasury Department before it makes drastic moves to stabilize the economy, which it did several times last year after it cited "unusual and exigent" circumstances, The Journal said.

But President Obama cited the overwhelming need for new powers at the Fed after ineffective government regulations contributed to the destabilization of the U.S. financial markets, as well as the crash of the American housing market.

The regulatory system either had gaps or overlaps with little accountability, he said at a press conference in Washington.

"Millions of Americans who have worked hard and behaved responsibly have seen their life dreams eroded by the irresponsibility of others and [by] the failure of their government to provide adequate oversight," Obama said.

The president said his plan to more closely regulate markets centers on having a "systemic regulator" overseeing the "entire financial system" and is designed to catch risky activity "before the crisis occurs."

U.S. Treasury Secretary Timothy F. Geithner, the chief architect of the administration's reforms, previously told an economic forum sponsored by Time Warner Inc. (NYSE: TWX) in New York that the government wanted a more stable, less volatile regulatory environment.

"We're going to try to eliminate gaps in the basic structure," Geithner told Bloomberg News. "We want to have a more boring system, a little less exciting, a little less drama."

Administration officials conceded they wanted the new rules to be stringent enough to prevent a reoccurrence of last year's financial meltdown, but not so strict that they stifle American ingenuity and innovation. Officials said they had stopped short of calling for all changes that could be seen as "desirable" and pushed only for those they see as "essential" to reform.

But skeptics pointed out that the system in its present form might be broken beyond repair.

In an analysis published in Tuesday's Money Morning, Contributing Editor Shah Gilani said that President Obama's proposals may not be comprehensive enough to fix the deeply entrenched problems plaguing the financial system. As a retired hedge-fund manager and longtime member of the institutional-investing community, Gilani understands the problems as only an insider would and says that what's really needed is a complete overhaul - and not the makeover that the administration is proposing.

We should not be lulled into a sense of false security by believing that the existing regulatory architecture can be fixed," said Gilani, who is also the editor of the The Trigger Event Strategist trading service. "What's being rolled out … is more about rolling over and pretending everything is now okay than it is about engineering real, substantive change."

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News and Related Story Links:

• Bloomberg:
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• Wall Street Journal:
  Draft Details New Rules for Markets.

• Wikipedia:
  Asset-Backed Securities.

• Money Morning:
  Wall Street vs. Main Street: The Regulatory Battle Begins Tomorrow.

• Money Morning News Analysis:
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• Bloomberg:
  Geithner Says U.S. Goal Will Be 'More Boring' Financial System.