Regulation to the Rescue

While the Fed tries to stabilize the financial system, measures are needed to prevent mortgage market abuses.

THE REPORT of the President's Working Group on Financial Markets is a depressing document. Over the course of 20 pages, it describes the genesis of the current financial crisis in the years between late 2004 and 2007. Lenders pushed tens of billions of dollars in potentially high-interest mortgage debt on people ill-equipped to handle it. They then peddled these loans to investors around the world in the form of securities whose true risks and benefits no one really understood. The whole business was predicated on rising housing prices, so when home prices finally softened, mortgage-backed bonds, which were being used as collateral for all sorts of commercial lending, lost value and became unmarketable. Financial panic spread, credit markets froze -- and now the U.S. economy is staring a recession in the face.

Yesterday's Federal Reserve rescue of Bear Stearns, which has been hammered by subprime losses, is just the latest reminder that the trouble is deep -- and far from over. Investors have been pulling their cash out of the firm by the billions amid rumors that it was about to go belly up. The Fed's unusual move, which involved putting up some of the central bank's own money along with that of JP Morgan Chase, came on the heels of an

industry-wide rescue package that offered $200 billion in loans to banks and investment houses in exchange for risky mortgage-backed collateral. The Fed says that it will provide enough liquidity to ensure "the orderly functioning of the financial system." It's a bold promise; one almost wonders if even the central bank has enough money to keep that pledge.

The lenders and securitizers aren't the only ones to blame for things having reached this point: Some borrowers speculated with subprime credit, and credit rating agencies blessed mortgage-backed bonds after no due diligence or, at times, because of their self-interest in having the securities sell. And, least excusably, federal regulators did not act on warnings from consumer groups and experts such as the late former Fed governor Edward M. Gramlich. Untangling the short-term financial meltdown is difficult, fraught with the risk that, even as they may prevent an unjustified collapse in investor confidence, bailouts will simply encourage more of the same bad behavior or raise the cost of an inevitable shakeout. But, for long-term policy, the lessons of the crisis are clear: Financial regulation has to be tougher.

In that respect, the policy recommendations of the President's Working Group deserve not only to be marked tardy but also to be graded as incomplete. The group wisely promises greater transparency on the part of credit rating agencies, enforced by the Securities and Exchange Commission -- how, exactly, remains to be worked out. It endorsed nationwide mortgage broker licensing -- as a House-approved bill already would require. The report blessed a European practice under which mortgage lenders hold equivalents of their securitized loans in their own portfolios, so that they share the risk with investors -- but the Federal Deposit Insurance Corp. must still fill in the details.

A creative, flexible financial system is indeed an engine of economic growth. Bush administration officials express an understandable desire not to burden the capital markets with excessive regulation. But where the subprime experience is concerned, too much government supervision does not appear to have been the problem.