Trial by Fire

Story Highlights:

• In light of today's comments by Treasury Secretary Henry Paulson, increased regulation is a market risk worth watching.
• Paulson called for new legislation and regulation—possibly a negative for markets if too draconian or constrictive.
• But the overall tone emphasized the need to take personal responsibility and allow natural market turbulence to spur industry-led adjustments.

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Free markets thrive on mistakes. Through trial by fire, market participants become smarter, stronger and better able to deal with the rigors of the marketplace. Yet the knee-jerk reaction by government to any problem (real or perceived) is to revoke privileges and regulate, regulate, regulate—as if we're witless children in need of constant supervision.

So far, politicians' protectionist rhetoric has failed to materialize, and the Fed's recent moves to bolster liquidity in capital markets have been generally helpful without being intrusive. (See our past commentary "Pawning Stocks," 3/12/2008, for more.) We really haven't seen anything particularly ridiculous from the Beltway since Sarbanes-Oxley. But like Maude Flanders breaking in on Bernanke and the Fed to shrilly query, "Will someone please think of the children!?" recent headlines shout it's high time our elected officials saved us. Coupled with Bernanke's call for action in his Congressional testimony last week, Treasury Secretary Paulson's comments this morning make harmful, potential regulation a threat worth watching.

Thus far, Paulson has seemed staunchly opposed to excessive government intervention. Today he presented a policy statement and recommendations for action from the President's Working Group on Financial Markets (PWG). The PWG includes representation from the Treasury Department, the Federal Reserve, the Securities and Exchange Commission, and the Commodity Futures Trading Commission and was called upon last August to examine perceived trouble in financial markets. (Presidential committees are always a bit of a charade. Of course they recommend action—they exist expressly to recommend action!)

Remarks on Recommendations from the President's Working Group on Financial Markets
By Secretary Henry M. Paulson, Jr., Department of the Treasury

Highlighting themes of individual responsibility, the normalcy of market cycles, and a market-driven solution, Paulson's comments seemed more a private sector call to action than a request for legislation. He urged investors to conduct more independent analysis, rely less on ratings, and demand better information outlining investment risk—emphasizing better industry leadership and standards will come only by fire. And we like trial by fire—less messy government intervention that way.

Paulson also expressed the need for stronger financial infrastructure to meet increased innovation and intricacy in financial markets—both of which he noted "…have made more flexible and lower-cost capital available to consumers and companies, and stimulated competition." And all sounded great! But his rhetoric took a surprising U-turn as he called for stronger oversight of mortgage originators (brokers), sterner nationwide licensing standards, and higher capital requirements for lenders.

The PWG's recommendation for increased oversight is frighteningly reminiscent of Sarbanes-Oxley—a reactionary policy whose costs have far outweighed benefits in our view. Similarly, stronger licensing standards could hinder efficient business operation. And higher government-mandated capital requirements would only exacerbate a problem the government is purportedly trying to fix—rather than easing liquidity, they'd be making credit more scarce. What happened to Paulson's trial by fire? This is trial by coddling—that rarely works.

Instead of having the government make blanket regulation, individual businesses should be allowed to weigh risk and reward and decide what's in their own best interest for long-term survival. Politicians seem to forget: Businesses aren't in it to go belly-up with all expediency—they actually want to stick around for awhile.

Nonetheless, the overall tone of the speech, while calling for some heavy legislation and regulation, seemed to place heavier emphasis on personal responsibility and natural market turbulence spurring industry-led adjustments. Further, its likely little legislation of import will pass this year since Congress remains gridlocked and focused on elections. That makes the majority of the PWG's recommendations a fantasy—thankfully.

In Paulson's own words, the objective is "to help restore investor confidence but not go so far to create new problems, make our markets less efficient or cut off credit to those who need it." We hope he stands by that in the months to come but will remain watchful of major government initiatives to stifle the healthy operation of free markets.