The stagecraft was impressive. The new Financial Stability Oversight Council held its second meeting Tuesday behind a large horseshoe-shaped table in the opulent Cash Room, the Carrara-marbled heart of the Treasury Department.
Four American flags backed up the elite council's chairman, Treasury Secretary Tim Geithner, as he declared that he and his fellow members had “begun to build this council into a lasting institution.” To Geithner’s right sat Federal Reserve Chairman Ben Bernanke; to his left, Sheila Bair, head of the Federal Deposit Insurance Corporation.
But there was a jarring disconnect as soon as Geithner turned to the first order of business, the mortgage foreclosure crisis. Outgoing Assistant Treasury Secretary Michael Barr delivered a report on the “widespread and inexcusable breakdowns” in the system, saying that regulators were expected to complete their “on-site field work” by the end of the year and to draft a report by late January.
What's odd is that many of the council members have already been saying for weeks that the mortgage mess posed no grave threat to the financial system. And Barr, in a short interview with National Journal after the meeting, said there was little ”evidence” thus far that the untold number of mortgages with erroneous and often fraudulent documentation could cause another financial meltdown. He echoed Phyllis Caldwell, head of Treasury’s homeownership preservation office, who told the Congressional Oversight Panel last month that "at this point in time there is no evidence that there is a systemic risk.”
Yet the Congressional Oversight Panel itself recently issued a report warning about just that possibility. "Clear and uncontested property rights are the foundation of the housing market," the report said. "If these rights fall into question, that foundation could collapse." Former Sen. Ted Kaufman, D-Del., the chairman of the panel, said the effects of the mortgage imbroglio were still unknown, but “if investors lose confidence in the ability of banks to document their ownership of mortgages, the financial industry could suffer staggering losses."
The disconnect points to a deeper conflict for the new council. On the one hand, its purpose is to monitor "systemic risks'' in the financial system and deal with them before it's too late. At the same time, though, the council consists largely of banking regulators, who have labored for decades to maintain confidence in banks and prevent panics.
The eagerness with which FSOC members sought to reassure the public about foreclosure problems—even before its own report is complete—may be evidence of a fatal flaw in the design of the council, according to some critics.
Indeed, the very ponderousness of Tuesday’s meeting and the expectations attached to the FSOC—which was enshrined in last summer’s Dodd-Frank financial reform law—could undermine its function. Because the views of its powerful members are so closely watched and they know it, FSOC would seem to carry an institutional bias to deny systemic risk so as not to panic the markets. But that sounds perilously like the sort of ostrich-like regulation that led up to the financial crash of 2007-09.
“In order for systemic risk regulation to work, regulators have to be willing to call a systemic risk ‘a systemic risk,’” Damon Silvers, a member of the Congressional Oversight Panel, told National Journal. “Otherwise the structure we have just created won’t function.”
Treasury Department spokesman Steve Adamske flatly denied that the Council had an interest in masking any problems with systemic risk, especially in connection with the foreclosure mess.
"It's absolutely false," Adamske said. "There is a predatory lending rule that will be written, rules on risk retention on mortgages, derivatives legislation—all those things will contribute to lowering systemic risk,” he said. As to the statements by Caldwell and other officials that seem to render conclusions before all the evidence is in, Adamske said that was an erroneous interpretation. “We have to work in terms of the evidence we have,” he said.
Even so, similar questions surround the other major order of business taken up by the FSOC on Tuesday: designing rules to determine which financial institutions and “financial market utilities”—exchanges and clearinghouses for trading—are “systemically important,” and therefore subject to greater regulatory scrutiny. Banks and nonbanks have sought to escape that designation, or at least to minimize its regulatory effects. The lobbying “has been intense,” one FSOC member, Debbie Matz, chairwoman of the National Credit Union Administration, told National Journal. “You do get everybody’s perspective.”
The designation “systemically important” could create a brood of market-favored institutions thought of as too big to fail—precisely the opposite of what Dodd-Frank sought to promote. The FSOC process could thus begin to bifurcate the financial system. Even though the new law calls for liquidating "systemic" firms if they get into trouble, the market itself could decide otherwise. The problem could grow worse if the same systemically important banks end up controlling or at least dominating the new “utilities” like clearinghouses, at the same time that higher capital requirements create barriers to entry for new firms. This consolidation of the elites could make it “way tougher to kiss somebody off when they get in trouble,” said a former Fed official.
Perhaps none of these worst-case fears will come to pass. Supporters of the new council point out that the group is only beginning to get off the ground. Whatever its faults, they add, it is certainly better to have Washington investigating and watching the system than not. The third meeting is in January. Stay tuned.