Let Them Sink?

Yesterday (Monday, 3/31), the Treasury Department laid out a new policy for dealing with financial-industry problems. It wasn’t a get-tough policy, and didn’t want to be. Treasury Secretary Henry Paulson, a former Wall Street guy, clearly doesn’t have his heart in this.

And why should he? He can only guess where things are heading.

If Bear Stearns’ investors were (partially, at least) saved by a deal using Federal Reserve cash, then investments like collateralized debt obligations and other curious fruit from the shadow banking system should be regulated. Which they aren’t much now.

The counterargument goes: If these investments are regulated, then innovation and “creativity” will be stifled. And that, in turn, will stifle investment in general and overseas bankers will have an edge.

I wonder about the factual basis of this. Does something get to be called an “innovation” if few people (if any) really understand how it works?

And what do these kinds of investments actually do for the economy? What do they do to build it? Do they create any real value? Are they building factories or infrastructure or anything else that’s really needed?

Or are they simply manipulating imaginary piles of money and getting into billions of dollars in debt for the global “Niagara of capital” that hungers for massive returns?

That hunger drove the drive to develop subprime mortgages, pushing people into buying houses they really couldn’t afford.

I suspect that Paulson believes that these various markets—mortgages, exotic investments—should be self-regulating. If you take on too much risk—including spending money you didn’t really have, why should those who didn’t bail you out? You overextend, you pay the price. Good money drives out bad. In theory.

What’s more, many have argued that the Fed’s backing is keeping Wall Street from doing the hard work of getting its house in order. What’s more, the Fed is venturing into uncharted waters. It may work out. Or there may be sharks and undertows lurking.

As for the financial services regulation the Fed’s recent actions regarding Bear Stearns have partially prompted, Paulson’s proposal is pretty paltry—he knows “something must be done,” but he doesn’t want the government doing it. Perhaps intentionally, his proposal isn’t likely to make it through Congress.

Was the Fed’s action in “saving” Bear a good idea? We won’t know for a while. It was an open-eyed risk on Fed Chairman Ben Bernanke’s part. Nor do we know whether helping people deal with their bad mortgages would be wise.

But the point remains: If mortgage-backed securities that have been tainted with subprime deals can sicken the financial services industry, that can mean an unnecessarily weakened economy for everybody. And the federal government certainly should have some say in regulating such “creativity.”

If financial firms are willing to get federal backing, then the Fed—that is, the public—must have a say in how much risk they’re running. End of story.