TOPICS > Economy

Paulson Urges Oversight in Wake of Bear Stearns Bailout

March 26, 2008 at 6:35 PM EST
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Treasury Secretary Henry Paulson said Wednesday that investment banks may require the same government oversight that commercial banks face if they will borrow federal money. Economic analysts weigh the pros and cons of increased federal regulation.
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JUDY WOODRUFF: In the wake of the credit crunch, there has risen up a chorus of calls in Washington for greater regulation of investment banks, hedge funds, and other Wall Street players that don’t meet the traditional definition of a bank.

Those calls only grew louder after the Federal Reserve guaranteed financial assistance to ensure JPMorgan Chase could buy Bear Stearns and after the Fed recently announced that it would lend investment banks up to $200 billion if needed.

Today, Treasury Secretary Henry Paulson said for the first time that more regulation of those institutions may well be necessary.

HENRY PAULSON, U.S. Treasury Secretary: The circumstances that led the Fed to modify its lending facilities raises significant policy considerations that need to be addressed.

Insured depository institutions remain important participants in the financial markets, but this latest episode has highlighted that the world has changed, as has the role of other non-bank financial institutions, and the interconnectedness among all financial institutions.

These changes require us all to think more broadly about the regulatory and supervisory framework that is consistent with the promotion and maintenance of financial stability.

JUDY WOODRUFF: So should Wall Street firms be more tightly regulated by the federal government? We get two perspectives.

David John is a senior research fellow at the Heritage Foundation. And Dean Baker directs the Center for Economic and Policy Research.

Gentlemen, thank you both for being here.

I first want to ask you to explain briefly the difference between regular banks, where people keep their savings account, their checking accounts, and where they borrow money, and investment banks, David John?

DAVID JOHN, Senior Research Fellow, Heritage Foundation: Well, a regular bank, as you say, takes deposits from people like you and I, and those are insured by the federal government, and it has a fairly restrictive amount of business activities it’s allowed to undertake. It typically will do all the personal lending, credit cards, mortgages, and that sort of thing.

An investment bank, on the other hand, doesn’t do any of those necessarily, but it underwrites stocks and bonds and does investments, for instance investing for our pension funds or something along that line.

There’s a lot more risk in an investment bank, and there’s no insurance from the federal government.

Defining a model for regulation

David John
Heritage Foundation
[I]n the long run, we don't necessarily want to try to impose a regulatory regime that's meant for one type of institution on another, because they have two very different business models. And it just, frankly, won't work.

JUDY WOODRUFF: And what about the difference between the two, in terms of how much they're regulated by the federal government?

DEAN BAKER, Center for Economic and Policy Research: Well, the investment banks are largely unregulated. They do answer to the Securities and Exchange Commission, but they don't have nearly the level of regulation that commercial banks do.

Commercial banks have to maintain reserves against their deposits. The Federal Reserve oversees their books very carefully. And again, as David was saying, there's a limited range of activities that they can get involved with. In the case of investment banks, they can do almost anything.

JUDY WOODRUFF: Why isn't there now, already, more regulation of investment?

DEAN BAKER: Well, it's a very good question. I mean, the at least implicit assumption was that, you know, these are big actors. They know what they're doing. They're not going to get in over their heads. And, furthermore, if they do, that's their problem.

And basically what we have -- pretty much everyone saying, certainly the Federal Reserve Board, Ben Bernanke, saying, "No, it's our problem. They have gotten in over their heads, and we have to bail them out, because if we don't there are going to be huge repercussions for the financial system and the economy as a whole."

JUDY WOODRUFF: Well, what we heard today was the treasury secretary saying the world has changed and we need to take another look at this. David John, has the world changed?

DAVID JOHN: Well, the world has changed, but it's changed on a temporary basis. We do have a credit crisis. We had an even worse one about a week and a half ago. And that did have the Federal Reserve making moves that it hadn't made since the Great Depression.

But in the long run, we don't necessarily want to try to impose a regulatory regime that's meant for one type of institution on another, because they have two very different business models. And it just, frankly, won't work. You can't do one-size-fits-all.

Burden on taxpayers

Dean Baker
Center for Economic and Policy Research
[T]here has to be some quid pro quo here. I mean, people have to understand, we've given an enormous gift basically to the richest people in the country.

JUDY WOODRUFF: Well, let's talk about that, Dean Baker, because I know you happen to feel that some more regulation of investment banks is now appropriate.

DEAN BAKER: Well, there has to be some quid pro quo here. I mean, people have to understand, we've given an enormous gift basically to the richest people in the country. I mean, these are the people that draw $100 million pay checks every year, you know, with homes on the Hamptons and private jets, and all the rest of it.

And the Fed walked in, basically the government, the taxpayers are bailing these people out in two different ways. One, directly, the Federal Reserve Board is opening the discount window. They can borrow at 2.5 percent interest. That's a very nice deal.

JUDY WOODRUFF: And, again, that means they can borrow money at a reduced interest rate.

DEAN BAKER: Reduced interest, a low market interest rate. They're borrowing tens of billions, so that's a very nice gift to them.

The other gift, which is possibly even more important, is the guarantee that Fed Chair Ben Bernanke gave to them, where he said, "Don't worry. We're going to bail you out."

So Bear Stearns, you know, it turns out that their customers, Bear Stearns itself wasn't necessarily bailed out, but its customers are being bailed out. So if I'm concerned, "Is Goldman Sachs, is Lehman Brothers, is one of the big banks in trouble?" I don't have to worry, because they might be in trouble, but the Fed, the taxpayers, will come to help me out.

JUDY WOODRUFF: So what are you saying is the increased oversight or regulation that the federal government should exercise here?

DEAN BAKER: Well, a couple of things. First off, we have to know what's on their books. The Fed has to be able to go over their books the same way it does with commercial banks. We can't have them just running up liabilities to the hundreds of billions, trillions of dollars, with no oversight whatsoever.

JUDY WOODRUFF: And that's not being done now?

DEAN BAKER: That's not being done now. They basically do whatever they want. Secondly...

JUDY WOODRUFF: Well, let me -- David John, is that something that makes sense to you?

DAVID JOHN: Within limits. The Fed does need to know a bit more about how they do business and what's on their books, but that needs to be kept private, because, frankly, that's very valuable information that allows competitors to figure out strategies and things like that.

JUDY WOODRUFF: What about that?

DEAN BAKER: Well, I'm a big fan of transparency. I mean, we didn't get into this problem because we had too much transparency. So I think, you know, we don't have to know who exactly has what deal, but I think knowing the totals is very, very important.

And, again, I think if people knew the totals, if they know what the liabilities that Bear Stearns potentially had, they probably would have taken their business elsewhere.

Keeping money in reserve

David John
Heritage Foundation
If you require them to hold reserves on top of that, essentially you're reducing profit margins rather substantially. And really all you're going to see then is companies leaving the U.S...

JUDY WOODRUFF: All right. Another thing I know you were discussing today was reserve requirements. What would that involve?

DEAN BAKER: Well, some amount of money that you're basically putting up in the event that things turn bad. I mean, this is, in effect, what happens with the commercial banks, that they keep some amount of money on reserve. They don't get interest on that.

You know, this is -- in effect, they're covering the cost of, if there's a problem, they know the Fed will be there for them. Well, Bear Stearns, the other banks, you know, they're in a situation where they can turn to the Fed...

JUDY WOODRUFF: And this is not done now, again?

DEAN BAKER: No, that's right.

JUDY WOODRUFF: What about that, David John?

DAVID JOHN: Well, if do you that, essentially you're completely changing the business model. Investment banks are very highly leveraged. They take what capital they have and they put it in relatively risky and speculative areas.

If you require them to hold reserves on top of that, essentially you're reducing profit margins rather substantially. And really all you're going to see then is companies leaving the U.S. and doing their business in London and Hong Kong and places like that.

JUDY WOODRUFF: But I guess the question is, shouldn't these investment institutions be required to do something more if they're getting this much more additional help from the federal government, from the taxpayers?

DAVID JOHN: Well, what they're getting now is, the discount window that Dean referred to is open for six months. This is not a permanent level. And Secretary Paulson said today that every broker, and dealer, and investment bank shouldn't assume that they will be bailed out. He said, essentially, we're only going to do the ones that are the most crucial to the economy.

Holding banks accountable

Dean Baker
Center for Economic and Policy Research
I'd take a little bit out of their hide. These people made lots of money selling these credit default swaps. They made huge amounts of money on the fees. How about putting a cap, executive compensation of $5 million a year?

JUDY WOODRUFF: But they're getting help right now?

DAVID JOHN: They're getting help right now, but they're paying for it, also.

DEAN BAKER: Well, I'd say -- you know, the point here is that, when you get into trouble, the Fed is potentially there. Now, if we want to draw a clearer line, if we could draw a clear line, go, "Look, Bear Stearns, you're not a commercial bank. We're prepared to let you go under." Fair enough.

But, again, the banks have gotten so large, the investment banks have gotten so large that we're not prepared to do that. And, of course, Bear Stearns wasn't even the biggest.

So given that we have institutions that I think basically everyone recognizes we can't let just go under, it seems to me we are going to regulate them, we will bail them out, and that means they have to be subject to regulation.

JUDY WOODRUFF: So is it mainly what you described as the reserve requirement?

DEAN BAKER: Well, reserve requirement, getting the books open, and I actually would like to see a little more. I'd take a little bit out of their hide.

These people made lots of money selling these credit default swaps. They made huge amounts of money on the fees. How about putting a cap, executive compensation of $5 million a year? I know that will send them running and screaming, because for those people that's a week's salary. But I'd like to see some...

JUDY WOODRUFF: On the executives of these companies?

DEAN BAKER: Yes, exactly, exactly. I mean, I would like to see them pay a cost, because basically they got the taxpayers in a situation we never should have been in.

JUDY WOODRUFF: David John?

DAVID JOHN: Well, if do you that, they'll do their business from London, as I say, first and foremost. And the people who actually lost money substantially in the Bear Stearns were the Bear Stearns management.

A fair proportion of the stock was owned by Bear and its senior people. And their stock went from $171 on January 1st to $10 now.

JUDY WOODRUFF: So you're saying they've already paid a price?

DAVID JOHN: They've paid very substantially.

JUDY WOODRUFF: Why isn't that enough?

DEAN BAKER: Well, the Bear Stearns management paid a price, but that's, again, only part of the picture. A lot of those people made hundreds of millions of dollars last year, the year before, the year before that. So eventually things went bad and their stock went south, but they still are incredibly wealthy.

And, again, the point here is they're, in effect, selling something they don't own, because they're making -- in effect, they're offering insurance. That's what these credit default swaps are and they're not in a position, actually, to carry through on that commitment. They're relying on the taxpayers.

JUDY WOODRUFF: What about Mr. John's point, though, that these companies can just choose to take their business elsewhere, outside the United States?

DEAN BAKER: Well, I think we have to have -- yes, no, that's possible. I think the point here is we have to have a sound regulatory structure for the United States.

It doesn't make sense to say we should have an unsound regulatory structure because otherwise, you know, they'll go elsewhere. If they want to go elsewhere, there's nothing we can do about that.

DAVID JOHN: The United Kingdom has a very good regulatory structure in place that uses a vastly different type of regulation than we do. They say that, "This is the goal. How you get there is up to you." And that has proven to be a fairly decent structure, and many companies are leaving to go do business there.

JUDY WOODRUFF: Let me ask you both quickly, how does this get resolved? Is this something that's just up to the secretary of the treasury? Who's going to decide what happens here?

DAVID JOHN: Well, Congress, when it comes right down to it. But this is something they need to do slowly, because it's very complex and they really don't need to screw up the financial system accidentally.

DEAN BAKER: Well, obviously, it is up to Congress. My guess is, you know, with an election year, nothing much will happen. We'll probably get some voluntary regulations which will be a step in the right direction, but ultimately it will be resolved by the next president and Congress.

JUDY WOODRUFF: We did hear the treasury secretary today talk about a financial blueprint, so we'll see what that entails. Well, gentlemen, thank you both for being here, Dean Baker, David John. We appreciate it.