The date is March 14, 1907. The markets are down 50 percent. Faulty stock and real estate speculation have caused the failure of major lender Knickerbocker Trust Company. The panic is spreading to other New York banks and even across the country. John Pierpont Morgan organizes a group of private bankers with the Secretary of the Treasury to buy $25 million of failing bonds. The Panic of 1907 will soon end. While according to a New York Times article. it was a wide ranging relief measure, the article went on to state, "It is the Administration's desire that this should not be regarded as a precedent ... [Treasury] Secretary Cortelyou is hardly warm in his seat yet and has not had a chance to make a study of financial conditions."
Three years later, J.P. Morgan, John D. Rockefeller and other banking bigwigs met on Jekyll Island, Georgia with Senator Nelson Aldrich, head of the National Monetary Commission and father-in-law to Rockefeller's son. The group emerged with the Aldrich Plan to create a central banking system that would help stabilize the markets. This plan evolved into the Federal Reserve Act of 1913, creating the system of central banks we now affectionately call "The Fed."
Fast forward a century. The year is 2008. A housing bubble pops, causing daisy chains of poorly-valued debt instruments to go bad. Clients of major Wall Street broker Bear Stearns take their business elsewhere, and the firm faces a liquidity crisis. The Federal Reserve and its new chairman Ben Bernanke, along with JPMorgan (the company), organize a $30 billion bailout to defuse a possible chain reaction.
The story is the same. However, innovation in financial services in the past 100 years has made all the factors infinitely more complex. When the runs of 1907 were caused by simple railroad bonds, the government warned that its unprecedented steps were just that -- not a standard recourse. However, today's bankers trade securities that tie everyone together so much more, yet everyone understands them even less. Overall, the downside risk is greater, and after this year's scare, people want protection in the form of regulation.
But how much is enough, and how exactly should the banks be watched over? There are two ways the Fed or other government entities could get involved.
The Fed and Treasury could accept their action with Bear Stearns this year as a precedent, and simply limit the downside to a market failure by supporting future bailouts. This plan of action would be minimally invasive and would let banks and other securities firms continue business as usual and be responsible for learning their own lessons.
However, this poses the risk of significant moral hazard: if banks start to depend on the Fed to provide help when they make mistakes, they could start taking on untenable amounts of risk. The consequences of a system-wide failure could eventually be beyond the Fed's control. Further, a Fed bailout shifts the cost away from the private banks and onto the taxpayer, which many believe is unfair.
On the other hand, the Fed could take a very active role in making sure the banks do not take on too much risk. Agencies could closely monitor financial records and charge fines for not meeting certain minimum requirements. As of now, the Securities and Exchange Commission, a separate entity, just makes sure securities firms are following the rules. Any active oversight role for the Fed would be a tremendous change.
While a third-party risk manager would ensure banks are operating more conservatively, there could be a negative impact in the long term. "You [wouldn't] have the same regulations in London, in Tokyo, and I think a lot of the investment banking business [would] move out of New York," explained Edwin Burton, University professor of economics. "We [would] have the toughest regulatory environment in the world." Banks would see business environments abroad where they can make more complex trades, lend more and simply make more money. This could drive business out of the United States, putting another strain on the economy. For the first time ever in 2007, the IPO market -- Initial Public Offering, the first time a company offers stock to the public -- was smaller than the amount of money raised from private investors. This could already signal a shift of business away from the U.S.
Balancing the two negative side effects is a delicate task. On March 31st, Treasury Secretary Henry Paulson unveiled a sweeping plan to overhaul government regulation of financial institutions. His plan involves merging or closing several agencies -- including the SEC -- and replacing them with a consolidated group of insurers and regulators. Additionally, the Fed would become the ultimate regulator of market stability, with oversight and punitive powers over every type of financial firm. A new Mortgage Origination Commission would oversee mortgage lending and securitization, the process that created the subprime securities that went bad this past summer.
The impact on the public could vary. While maintaining or reducing regulation would be easiest, the possibility of a surprise Depression-size downturn is downright terrifying, and banks could hypothetically lose sight of risk enough to let that happen. Tighter regulation, though, could slow economic growth and make it harder to borrow. "In the past, people with poor credit were able to get loans," Burton explained. "In the future, they won't." Students already having trouble paying their loans could face even more down the road.
Such legislation would have to pass through Congress in or after an election year, though. The plan is inherently partisan, with Republicans favoring less regulation and Democrats demanding more, so the debate would likely drag on very slowly towards a compromise. According to The Wall Street Journal, Senator Barack Obama has already called the Treasury's blueprint as "inadequate."
The trend to increase regulation is gaining momentum. On April 3rd, the Fed placed officials at the five largest brokerages to monitor their financial conditions. A special lending window usually only open to commercial banks is now available to broker-dealers.
Wall Street has welcomed the Fed's move to save Bear Stearns, and banks see Paulson's plan as a more progressive, streamlined system. Burton, on the other hand, took a different position. "Why do they think the financial system would fail if Bear Stearns were to fail?" he said. "The Fed could have helped temporarily; [Bear Stearns] would have been on their own and they would have been fine." According to Burton, an industry is not very vibrant if it never has a bankruptcy. "Firms are supposed to take risks," he said.
One hundred years after the Panic of 1907, the United States finds itself in a very similar situation. While the Treasury claimed it did not want to set a precedent with its first bailout, that advice clearly went unheeded. We now face the effects of the Bear Stearns deal and impending legislation that could change the face of business in the U.S. The next decade will show just how much trust we can put in the markets.
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