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U.S. to Revamp Credit Rules,
Drawing From Crisis Lessons
Paulson Plan Seeks
To Tame Excesses
In Mortgage Market
March 13, 2008; Page A1

WASHINGTON -- The nation's top economic policy makers plan to release today their broadest blueprint yet for avoiding a recurrence of the credit crunch now threatening the economy.

Their recommendations extend to nearly every niche in the credit markets -- from mortgage brokers to the Wall Street firms that package home loans into securities, to the credit-rating firms that assess the risk of those securities, to the regulators who police the system.

Amid the housing market's deepening slump, mounting defaults by cash-strapped homeowners and an upswing in foreclosures have made investors wary of mortgage-linked securities and have made those securities increasingly difficult to value and trade. That's led to turmoil in global financial markets.

"We aren't singling out any group of market participants, because...there were mistakes made by all," including regulators, Treasury Secretary Henry Paulson said in an interview yesterday, a day in which the stock market's euphoria over the Federal Reserve's latest initiative to free up the flow of credit gave way to some caution.

The Dow Jones Industrial Average shed 46.57 points to close at 12110.24, giving up gains as oil prices rose again. Oil ended the day up $1.17 at $109.92 in New York Mercantile Exchange trading. The dollar weakened. But the gap between yields on mortgage-backed securities and U.S. Treasury yields narrowed, as the Fed had hoped they would.

"Regulation needs to catch up with innovation and help restore investor confidence," Mr. Paulson is planning to say today in a speech at the National Press Club, "but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it."

Mr. Paulson told The Wall Street Journal that the recommendations of the President's Working Group on Financial Markets, which he leads, include strengthening state and federal oversight of mortgage lenders and brokers. The group will also recommend implementing what he termed "strong nationwide licensing standards" for mortgage brokers, a move that will probably require legislation.

The group also will propose directing credit-rating firms and regulators to differentiate between ratings on complex structured products and conventional bonds. In addition, it wants rating firms to disclose conflicts of interest and details of their reviews and to heighten scrutiny of outfits that originate loans that are enveloped by various securities.

Another recommendation from the panel is to push issuers of mortgage-backed securities to disclose more about "the level and scope of due diligence" and about the underlying assets of the securities. The panel is also seeking disclosure of whether "issuers have shopped for ratings" -- that is, have had to go to more than one credit-rating firm before getting the triple-A stamp of approval.

And the panel will urge global bank regulators to revisit the latest version of bank capital requirements, known as Basel II for the Swiss city where they were negotiated, so that banks that take on risks hold sufficient capital. The panel also wants regulators to complete updated standards for how banks manage liquidity.

Many of the recommendations parallel those made by others, but the endorsement by top officials carries significant weight. They reflect a consensus of the Working Group, which includes the heads of the Federal Reserve Board, the Federal Reserve Bank of New York, the Securities and Exchange Commission and the Commodity Futures Trading Commission. Each agency has considerable sway over banks, investment houses and investors.

"We are going to be mindful when we implement it to not create a burden," Mr. Paulson said. "But we think it's very appropriate to lay out some of the causes and some of the steps that need to be minimize the likelihood of this happening again."

The aim is to alter rules and incentives that led to excesses that are now painfully evident: years of lending and investing at prices that didn't fully recognize the risks by institutions with inadequate capital cushions, the development of financial instruments so complex that even the most sophisticated investors didn't understand them, and a deterioration in lending standards.

The proposals won't be the last word. Discussions are continuing, but President Bush has given some indications of his strategy for dealing with the housing and mortgage crises. In an interview yesterday with Nightly Business Report on PBS, Mr. Bush was asked if he was ruling out using taxpayer money to aid struggling homeowners. "No, I haven't said that. I just need to hear what the good plan is -- and without having lasting long-term damage to the economy," he said.

"I have heard about using taxpayers' monies to buy empty houses, which I think would be a huge mistake," Mr. Bush added.

"That plan doesn't help homeowners. That plan helps lenders. And we want to help homeowners."

The Treasury already has a number of private-sector advisory panels at work on the credit crunch, and plans to create more -- including one focused on credit-rating firms -- and will elaborate in the coming weeks on its proposals for reorganizing the federal bank regulatory apparatus. Congress has ideas of its own and so, inevitably, will the next president. Democrats are almost certain to say that Working Group plan doesn't go far enough.

If markets and the economy continue to deteriorate, the administration and regulators may discover their proposals weren't ambitious enough. But any further delay by the administration in publicizing its thinking about how to avert future crises might have left it at risk of losing the initiative, allowing Democrats, Wall Street or others to seize center stage in the debate about how to change policies, rules and practices.

Most of the Working Group's recommendations wouldn't require legislation -- except for an as-yet undetailed proposal for regulating mortgage brokers -- but could be implemented by regulators or the industry. Mr. Paulson, a former chief executive of Goldman Sachs Group Inc., warned that if the industry is slow to act, regulators would be more forceful, issuing new rules and seeking new authority, if needed, to provide guidance and evaluate progress.

In some areas, regulators intend to become more assertive immediately. The recommendations call on bank supervisors to give much more scrutiny to the due diligence, risk management, and risk awareness policies at banks. Regulators will be pushed to work more closely with the Financial Accounting Standards Board to revisit accounting issues and make sure that exposures at financial companies are properly measured "across business lines."

The Working Group also called on regulators to be less reliant on credit-rating firms' evaluations of risk.

Mr. Paulson, in remarks prepared for delivery today, repeated his call for financial institutions -- not only banks but also government-sponsored mortgage giants Fannie Mae and Freddie Mac -- to raise more capital and to revisit "dividend policies," a thinly veiled suggestion they consider reducing dividends to conserve capital, so they can "continue to lend and facilitate economic growth."

In a meeting with investors yesterday, Freddie Mac Chief Executive Richard Syron said his company wouldn't raise capital unless that would benefit shareholders. In the long run, he said, "We expect to thrive for the benefit of our shareholders -- and for the country."

Some of the Working Group's recommendations resemble those in legislation passed in November by the Democratic-controlled House of Representatives. For example, the House bill would also mandate a national registration system for mortgage brokers. One significant difference is the treatment of firms that packaged many of the mortgage-backed securities now deteriorating in value.

The House bill would assign liability to certain Wall Street firms and others (though not trusts or investors) who created mortgage-backed securities using loans which borrowers didn't "have a reasonable ability to repay." The Bush administration's proposal doesn't push legal liability onto Wall Street firms or the secondary market, but it does try to pressure them to act more prudently.

"The idea that investors can abdicate their responsibility and that they can be overly reliant on ratings is something that really didn't wash in the past and won't wash in the future," Mr. Paulson said in the interview. "They need to do independent analysis, and they need a better understanding of risk. There is not a free lunch."

The Working Group's recommendations were hashed out over seven months by the different government bodies, including two lengthy meetings among top officials from each agency. On Saturday, March 1, Mr. Paulson and Federal Reserve Chairman Ben Bernanke huddled for half of the day with staffers to review details.

For much of the past year, the loudest complaints in Washington about the mortgage crisis were from consumer groups and Democrats who urged more aggressive government intervention to prevent home foreclosures. But this year, much of the consternation has come from financial institutions overwhelmed by losses and write-downs.

U.S. and foreign regulators have launched multiple initiatives to try to quickly document lessons learned from the current market turmoil. A review released last week by bank supervisors from the U.S. and four other countries called for enhanced and tested risk-management policies at big financial institutions. The Basel Committee on Banking Supervision is developing new guidelines to encourage banks to have better contingency plans for liquidity. And U.S. officials are working with their counterparts in the international Financial Stability Forum, chaired by Italian central banker Mario Draghi.

Mr. Paulson also is planning to encourage the development of a domestic market for "covered bonds," bonds issued by banks that are secured by mortgages. Popular in Europe, these could be an alternative to securitization. When mortgages are securitized, they generally leave bank balance sheets and banks don't hold capital against them; covered bonds remain on bank books, and banks must set aside capital to back them.

Write to Damian Paletta at damian.paletta@dowjones.com3
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