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A New Architecture For the Financial World

By Neil Irwin and David Cho
Washington Post Staff Writers
Monday, September 15, 2008

The U.S. financial system this weekend faced its gravest crisis in modern times, as regulators resorted to triage on Wall Street to contain the spreading damage from a meltdown in the housing and mortgage market.

Two of the world's biggest investment banks, Merrill Lynch and Lehman Brothers, appeared almost certain to disappear, Merrill into the arms of banking behemoth Bank of America and Lehman into bankruptcy. American International Group, once the country's largest insurer, was seeking a financial lifeline. This came just seven days after the government took over housing finance giants Fannie Mae and Freddie Mac.

For all the drama of the weekend, these were the first steps -- but far from the last -- in finding a fundamentally new architecture for the financial world. The titans of Wall Street have, over the past 72 hours, been forced to reckon with the reality that the financial sector they built is, in its current form, too big, uses too much borrowed money and creates too much risk for the broader economy.

In a weekend of intensive and almost nonstop meetings behind the massive stone facade of the Federal Reserve Bank of New York, Treasury Secretary Henry M. Paulson Jr. and New York Fed President Timothy F. Geithner oversaw a series of meetings that essentially forced the chief executives of every major firm to grapple with a crisis of their own making.

The work proceeded along parallel tracks. Paulson and Geithner were trying to find a buyer for Lehman Brothers. But from the beginning, they were also running meetings to try to game out the problems that could result if Lehman did fail. This morning will offer an acid test of whether that contingency planning was enough.

However things go on Wall Street and financial capitals around the world today, the reworking of the global financial system will continue apace.

Among the issues likely to be scrutinized: How much of a day-to-day role should the government and regulators take in financial markets? Which agencies should oversee financial institutions? Should the basics of the financial world be rethought?

Paulson has offered a blueprint to overhaul this financial regulation, and Congress plans to take it up next year. The deepening of the financial crisis will almost certainly make that effort more pressing.

Wall Street firms have been allowed to grow with relatively few restrictions; the regulator that oversees their financial soundness, the Securities and Exchange Commission, is historically more focused on protecting investors than preventing a run on a bank. Indeed, the investment banks -- there were, as of March, five major ones, but after this weekend there now appear set to be only three -- agreed voluntarily to that "prudential supervision."

The Federal Reserve, the agency that has more explicit focus than any other on rooting out risks to the financial system, has little authority over institutions that aren't commercial bank holding companies.

Regulators of all stripes have had difficulty getting the information they need to fully understand the risks that financial firms are taking. The $50 trillion corporate derivatives market is a model of obscurity. The same could be said of many structured debt products, which slice up mortgages, credit card debts, or corporate loans in such ways that understanding how risky they are requires a PhD in mathematics.

Indeed, it is increasingly clear that Wall Street chief executives themselves didn't fully understand the risks they were taking on during the boom years of this decade; they have seemed as blindsided as any regulator.

The problems on Wall Street may go deeper. Financial firms have expanded vastly in the past decade, hiring tens of thousands of bright business school graduates to engineer new financial products, find ever more complicated ways to manage other peoples' money, and dream up new ways to combine, divide, and recombine corporate America.

Some large portion of that work, it now appears, wasn't really creating any value for the company's clients or for the U.S. economy. No matter how many times crummy mortgage loans are recombined into clever packages, they're still crummy.

In a perfect world, those excesses would be corrected by a gradual, orderly decline, in which a few firms get bought out by competitors, some modest layoffs occur, and Wall Street cuts back on its hiring for a few years.

In the real world, that correction is occurring before our eyes, through a series of convulsive weekends in which the entire financial world appears at risk of coming off the rails.

So far, the conflagration has only singed the broader U.S. economy. Gross domestic product grew at a 3.3 percent annual rate in the second quarter, and the unemployment rate has risen sharply this year but, at 6.1 percent, is not as high as it has been in past bad economic times. The question that remains is: How much more of Wall Street's problems can the rest of America take?

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