Paulson Calls For Regulatory Changes To Deal With Failing Firms
In a speech today, Treasury Secretary Henry Paulson called for new regulations to help liquidate failing firms without it affecting overall market stability.
“For market discipline to constrain risk effectively, financial institutions must be allowed to fail,” Paulson said in excerpts of a speech he will deliver in London.
“It is clear that some institutions, if they fail, can have a systemic impact, so we must give regulators the authorities to limit that impact and facilitate an orderly failure,” Paulson said.
Why are these regulatory changes needed? Well back in March, the Fed intervened when it looked like Bear Stearns was in danger of failing, financing a buyout from JP Morgan and putting to risk potentially $30 billion in taxpayer dollars.
Through it’s excessive risk taking in the residential mortgage market, Bear Stearns deserved to fail but it couldn’t be allowed to due to the impact it would have on other financial firms. Financial firms are tightly interconnected these days through counterparty risk in the credit derivatives market, a largely unregulated market that has had explosive growth in the past decade.
It is a massively leveraged market that has the potential of causing financial Armageddon according to some well known industry leaders. Although firms are slowly de-leveraging, there will still be the potential of a failure cascade as the credit crisis is far from over.
Over the past few weeks speculation has run wild on Wall Street that Lehman Brothers would meet the same fate as Bear Stearns and need to be sold at a discount, although those rumors have abated somewhat recently. While this is one potential trigger that has been avoided, the danger will likely exist as long as home prices keep falling and firms face the prospect of more writedowns.
