Seven Questions: William H. Donaldson

First it was the U.S. Federal Reserves $30 billion loan to Bear Stearns; then it was the Congresss $700 billion bailout for the banks later in the year; and now the Federal Reserve is committing $800 billion to thaw frozen credit markets. While the U.S. government throws money at every new crisis, big questions remain about how to reform the fundamentals of the financial system — the structure, the rules, and the players.

Perhaps the most important rule-making authority for U.S. financial markets is the Securities and Exchange Commission, which regulates the financial instruments that Wall Street trades. Foreign Policy‘s Jerome Chen spoke with William H. Donaldson, who served as chairman of the SEC from 2003 until 2005, to sort out the bailouts, the regulations, and the fallout. Donaldson, who has raised questions about the transparency of the federal bailout, says the government will have to grant broader powers to the SEC so that no part of the financial industry, particularly hedge funds, will escape regulation.

Foreign Policy: Chairman of the Federal Reserve Ben Bernanke has justified leaving some dealings of the bailout confidential in order to protect companies stocks. What are the most important pieces of information regarding the bailout that should be disclosed to the public?

William H. Donaldson: We have read that the banks — instead of lending — are sitting on top of that capital. I think the question is, what were the terms for [the government] to put money in? Who was monitoring those terms? And how well are [receiving] institutions abiding by the terms? I cant believe that the outlining of the general terms by which capital is being put in — without being bank-specific — can hurt anybody. I think its very important for people to understand what sort of a deal the government has made.

FP: Are members of Congress justified in feeling that Treasury Secretary Hank Paulson has duped them by employing the $700 billion in ways other than the original intent of the bill to purchase bad assets?

WD: Clearly theres been a lot of opaqueness and informality as to whats going on behind the scenes. But I dont think its malice of forethought [on Secretary Paulsons part]. I think you have changing circumstances. This is a high-pressure environment, and the interpretation of [that] environment can change. I dont think its a bait-and-switch kind of thing. I think it was a sincere attempt [on Paulson and Bernanke’s part] to say what they thought they were going to do and exercise a change of direction based on further analysis.

FP: Many officials have recently experienced what might be called a religious conversion with regard to regulation of the financial markets. Can you compare how your thinking about regulation now differs from your thinking when you were at the SEC?

WD: We attempted, when I was there, to look ahead and bring some regulation or at least oversight to certain vulnerable areas in the economy, most particularly the registration of hedge funds — these pools of capital that were operating outside of any oversight or regulation. Who knows what impact these hedge funds are having on the marketplace? We dont even know what the total dollar amount [contained in hedge funds] is, much less what their internal procedures are, and much less their external impact on the marketplace.

The court of appeals in Washington, D.C., said we did not have the authority to bring hedge funds under the Investment Advisers Act. The reason they were not under the Investment Advisers Act was a rule made by the SEC itself in the past, which allowed hedge funds to not register. We reversed that [rule], and the court said we did not have the right to do so. The SEC needs to find some way to provide oversight [where] they do have authority, and if they cant find [that ability], then either the SEC goes to Congress or Congress must come to the SEC and say we want you to have this power.

FP: Given Treasury Secretary-designate Tim Geithners central role in orchestrating Secretary Paulsons responses to the financial crisis, is there reason to be concerned about how he will tackle the crisis once the new administration enters office?

WD: I have great confidence in the Obama administration and I think [Geithners] appointment as the secretary of the Treasury is an excellent one. I’m sure that [Obama’s economic team] will carry out his avowed priority item — to strengthen regulatory oversight such that regulation is effective but not inhibiting.

The crisis is an evolving — and unfortunately escalating — situation, and I think what Obama has announced indicates a much more all-encompassing, massive approach to the escalating problems, as opposed to the piecemeal approaches that have come along [so far]. I think its safe to say that the piecemeal approach has not worked; we’ve had to keep adding to it.

FP: What are the issues that should be tackled in a new holistic approach to managing the crisis?

WD: We need to identify the cascading weaknesses that have caused the credit freezing, and we need to address those weaknesses in a broad and all-encompassing way. Second, we have to be clear that the injection of government monies into the private sector is temporary. I think we need to be assured that there are safeguards [so] that when the crisis passes, the government will be out of the business world in terms of direct investment as quickly as possible.

FP: Given that the government acknowledged Citigroup’s too big to fail nature, should the SEC have reinstated the short-selling ban, which expired Oct. 8, as this was an extraordinary circumstance?

WD: Short-selling is a legitimate function in our marketplace. It’s an important risk-modifying, hedging capability. Whats illegal is naked short-selling and manipulative short-selling, and [regulators have] tried to crack down on that. The other aspect to it is the elimination of the so-called uptick rule [which prohibits short-selling unless there is upward movement in the price of stock]. I believe that was a mistake. The uptick rule was an important kind of circuit breaker in terms of preventing manipulative or uninterrupted downward pressure.

FP: How do you see the role of the SEC evolving in the coming months?

WD: As a result of the Commodity Futures Modernization Act, derivatives were exempted from oversight by the Commodity Futures Trading Commission (CFTC), by the SEC, and by the Federal Reserve. One of the reasons you had an explosion in the credit-default swaps was that there was a hole in the regulatory coverage. I think all types of securities out there — and any securities devised in the future — should fall under some regulatory oversight. That could be accomplished by putting the CFTC and SEC together into a new agency. Whatever that new agency may be, it must have investor protection and true disclosure as its primary raison dtre. It’s been proven that we’ve got to have a measure of regulation. Allowing totally free markets to operate uninhibited is like suggesting we have no stoplights at an intersection.