As Democrats close in on their goal of overhauling the nation’s financial regulations, several prominent experts say that the legislation does not even address the right problems, leaving the financial system vulnerable to another major crisis.
Some point to specific issues left largely untouched, like the instability of capital markets that provide money for lenders, or the government’s role in the housing market, including the future of the housing finance companies Fannie Mae and Freddie Mac.
Others simply argue that it is premature to pass sweeping legislation while so much about the crisis remains unclear and so many investigations are still in progress.
“Until we understand what the causes were, we may be implementing ineffective and even counterproductive reforms,” said Andrew W. Lo, a finance professor at the Massachusetts Institute of Technology. “I understand the need for action. I understand the need for something to be done. But what I expect from political leaders is for them to demonstrate leadership in telling the public that we need to proceed about this in a much more deliberate and rational and thoughtful way.”
Senate Republicans echoed some of these concerns as they delayed debate on the legislation last week. Democrats agree that significant issues remain to be addressed. But they say that the government must press forward in responding to the problems that already are clear.
The bill, which was introduced by Christopher Dodd, D-Conn, chairman of the Senate Banking Committee, would extend oversight to a wider range of financial institutions and activities. It would create a new agency to protect borrowers from abuse by lenders, including mortgage and credit card companies. And it seeks to ensure that troubled companies, however large, can be liquidated at no cost to taxpayers.
A diverse group of critics, however, say the legislation focuses on the precipitators of the recent crisis, like abusive mortgage lending, rather than the mechanisms by which the crisis spread.
Gary B. Gorton, a finance professor at Yale, said the financial system would remain vulnerable to panics because the legislation would not improve the reliability of the markets where lenders get money, by issuing short-term debt called commercial paper or loans called repurchase agreements or “repos.”
The recent crisis began as investors nervous about mounting subprime mortgage losses started demanding higher returns, then withholding money altogether. The government is now moving to prevent abusive mortgage lending, but Gorton said investors could just as easily be spooked by something else.
The flight of investors is the modern version of a bank run, in which depositors line up to withdraw their money. The banking industry was plagued by runs until the government introduced deposit insurance during the Great Depression. Gorton said the industry had now entered a new era of instability.
“It is unfortunate if we end up repeating history,” Gorton said. “It’s basically tragic that we can’t understand the importance of this issue.”
Treasury Secretary Timothy F. Geithner agreed in testimony before the House Financial Services Committee in April that “more work remains to be done in this area,” but he said that regulators could address the issue without legislation. The government plans to require lenders to hold larger reserves against unexpected losses and to require that they keep money on hand to meet short-term needs.
David A. Skeel Jr., a corporate law professor at the University of Pennsylvania, said it would be a mistake for Congress to leave the drafting of these standards to the discretion of regulators.
“Regulators working right now will be tough,” Skeel said. “But we know from history that as soon as this legislative moment passes, the ball is going to shift back into Wall Street’s court. As soon as the crisis passes, what inevitably happens is that the people that are paying the most attention are the banks.”
A second group of critics say the government helped to seed the crisis through its efforts to increase home ownership, including the role of Fannie Mae and Freddie Mac in buying mortgage loans to make more money available for lending. The companies are now owned by the government after incurring enormous losses on loans that borrowers could not afford to repay.