By Heidi Przybyla
Nov. 19 (Bloomberg) -- During the height of the financial crisis in late September, some of Barack Obama's campaign advisers pushed him in a conference call to distance himself from Treasury Secretary Henry Paulson. The former Goldman Sachs Group Inc. chief executive officer, they warned, was too close to President George W. Bush and Wall Street.
Obama, 47, rejected the idea. At one point, he talked to Paulson everyday for two weeks.
As the president-elect faces a once-in-a-century opportunity to remake the regulatory apparatus governing Wall Street, some of Obama's fellow Democrats and investor groups are urging him to bring sweeping changes to banks, hedge funds and executive pay. His closest economic advisers, men like Robert Rubin, Lawrence Summers and Paul Volcker, may recommend otherwise: go slow. If Obama takes their counsel, the 44th president, who succeeds Bush on Jan. 20, may not clamp down all that hard on a financial industry whose excesses have pushed the nation -- and much of the world -- into a recession.
``This is a group of people that understands the markets, respects the free-market system and understands government has an important role to play,'' says Eugene Ludwig, a former U.S. comptroller of the currency who is himself an Obama adviser. ``But there are limits on what government can or should do.''
Both Franklin Delano Roosevelt in the 1930s and Ronald Reagan five decades later saw an economic crisis as an opportunity to make major changes. Roosevelt, in response to the Great Depression, created Social Security and federal deposit insurance. During the 1981-82 recession, Reagan set out to reverse the centralization of power in Washington that was at the heart of the Roosevelt revolution; he ushered in a quarter-century of deregulation.
Reagan the Radical
``Most politicians are incrementalists,'' says presidential historian Richard Norton Smith at George Mason University in Fairfax, Virginia. ``Reagan was no incrementalist. He took advantage of the dire circumstances he inherited, and he saw them as justification for significantly, if not radically, different policies.''
On the campaign trail, Obama regularly condemned the lack of regulation of the financial industry. ``The last thing we can afford is four more years where no one in Washington is watching anyone on Wall Street,'' the candidate said during an Oct. 31 rally in Iowa.
In his first interview since his victory, he struck a more moderate tone. ``I think we have to restore a sense of trust, transparency, openness in our financial system,'' he told CBS television's ``60 Minutes'' on Nov. 16. ``The answer is not heavy- handed regulations that crush the entrepreneurial spirit and risk- taking of American capitalism. That's what's made our economy great. But it is to restore a sense of balance.''
Showdown in Congress
Even if Obama was tilting either toward state intervention or unfettered markets, he would now be likely to tack to the center - - in a country where a new economic shock arrives almost daily.
``How can you be an ideologue in an environment like that?'' says Pablo Spiller, a professor at the Haas School of Business at the University of California, Berkeley. ``The conditions are so dire, there is no way you can speak to one policy. Would you have imagined that Mr. Bush would have taken stakes in banks? The answer is no.''
A light touch by Obama in rewriting the rules for Wall Street would likely lead to a showdown with his own party. The Democrats strengthened their majorities in the November election by at least 20 seats in the House and at least six in the Senate -- backed by voters outraged over the $5.8 trillion plunge in the stock market from Jan. 1 through Nov. 4.
Executive Pay Limits
``Obama and the whole party will be answering to a lot of people looking to make some dramatic changes,'' says Representative Scott Garrett, a New Jersey Republican and member of the House Financial Services Committee.
Executive compensation exemplifies all that's wrong with Wall Street for many Democrats, including Representative Henry Waxman of California. During an October hearing of the House Oversight and Government Reform Committee, Chairman Waxman lashed out at Richard S. Fuld for making what he estimated was $484.8 million since 2000 as head of now bankrupt Lehman Brothers Holdings Inc.
Garrett says some Democrats are talking about imposing compensation caps with specific dollar amounts on banking executives. That's more severe than the tax penalties on severance pay and the ban on golden parachutes enacted under the $700 billion Treasury Department bailout in October.
Obama's Plan
Obama himself has stopped short of calling for firm limits on paychecks. In May 2007, he endorsed annual, nonbinding shareholder votes on whether pay packages are appropriate.
``Public discussion and debate over executive compensation packages would force corporate boards to think twice before signing over millions of dollars,'' Obama wrote to the Senate Committee on Banking, Housing and Urban Affairs.
In the president-elect's first press conference after his electoral college victory of at least 365 to 162 over Senator John McCain, he said the pay provisions in the bailout program would be reviewed to make sure executives at banks receiving taxpayer funds were not unduly rewarded.
``This is going to be no honeymoon,'' says Donald Langevoort, a former Securities and Exchange Commission attorney who teaches securities regulation at Georgetown University in Washington. ``People like Bob Rubin and others are well aware that we live in a global economy, and if you regulate too hard, you accomplish nothing and just watch economic activity move somewhere else. It's going to take a lot of political skill to navigate that clash.''
Wall Street Connections
The president-elect has monitored Wall Street's meltdown with the help of industry insiders in New York. During the campaign he regularly traded text messages with Robert Wolf, CEO of UBS Americas, a subsidiary of UBS AG; Timothy C. Collins, head of buyout firm Ripplewood Holdings LLC; and Mark Gallogly, managing partner of Centerbridge Partners LP, a private equity shop.
On Sept. 14, as Lehman Brothers was imploding, Jason Furman and other advisers were on a senior staff call with Obama. Furman, 38, a Harvard University-trained economist who served as Obama's top economic adviser during the campaign, began explaining the bank's demise.
``I started my briefing at square one, and he immediately cut me off and started asking a much more detailed set of questions, because he had spent the weekend on his own cell phone,'' Furman says.
Public Citizen, a consumer advocacy group in Washington, says Wall Street has gained a disproportionate influence over the new administration's regulatory agenda because its employees contributed so much to the Obama campaign -- a record $12.7 million compared with $8 million for McCain, according to the Center for Responsive Politics in Washington.
Rubin Defeats Regulation
Individuals working in securities and investment companies were the third-biggest contributor to Obama by industry, after the education and legal fields. Goldman Sachs employees gave $874,207 to him, the second-highest amount for any organization, behind the University of California.
Rubin, one of Obama's closest economic advisers, was a proponent of deregulation as President Bill Clinton's Treasury secretary from 1995 to `99. Summers, a Harvard economist who worked under Rubin in the Treasury before replacing him as secretary, joined his boss in defeating an effort to rein in over- the-counter derivatives in 1998.
Brooksley Born, then commissioner of the Commodity Futures Trading Commission, wanted to examine regulating the derivatives, including credit-default swaps, saying they posed ``grave dangers'' to the economy. Federal Reserve Chairman Alan Greenspan and Rubin issued a rebuke, saying in a statement that they seriously questioned the scope of the CFTC's jurisdiction in this area.
Repealing Glass-Steagall
Summers called Born and said he was with bank representatives in his office and they believed that the regulation would lead to an economic crisis, according to a person familiar with the situation who asked to remain anonymous. Summers declined to be interviewed for this article.
Summers and Rubin also helped secure passage of the 1999 Gramm-Leach-Bliley Act, aimed at spurring competition in banking. The law repealed the 1933 Glass-Steagall Act, which had prohibited commercial banks from offering investment and insurance services. Summers, 54, helped craft the legislation, and Rubin urged Congress to pass it and Clinton to sign it.
In 1999, Rubin left the Treasury to serve as a self-described consigliere at Citigroup Inc., whose CEO, Sanford Weill, had pushed for the repeal of Glass-Steagall. Freed to act as an underwriter, Citigroup became the second-largest seller of collateralized-debt obligations, which are packages of bonds and loans including mortgage-backed securities.
Summers' Baggage
The CDOs and CDSs, which act as insurance on debt, would contribute to $67.5 billion in writedowns and credit losses at Citigroup from 2007 through Nov. 17, 2008. Shareholders say Rubin, who has made $150 million at the bank, should've curtailed its exposure to subprime mortgages.
``Rubin's fingerprints are all over this collapse,'' says Leo Gerard, president of the United Steelworkers. ``My only hope is that some of these guys who helped cause this problem recognize the mess they made and accept some responsibility for fixing it.''
Rubin, 70, said in June that he wasn't in a position to know details in traders' books. In November, he pulled himself out of the running for a job in the Obama administration. He didn't respond to a request for an interview.
Summers, Rubin's former protégé, has his own baggage. He stirred controversy as president of Harvard, a post he took two months after resigning as Treasury secretary at the end of Clinton's term in 2001.
Credit Default Swaps
Faculty members criticized his autocratic style and his comment that women may lack an aptitude for math and science. Summers resigned in 2006, after receiving a no-confidence vote by the faculty. He's now in contention to be Obama's Treasury secretary.
``One problem with Summers is, he's a deregulator, which is not what the banks need right now,'' says Steffen Schmidt, a political science professor at Iowa State University in Ames, Iowa. ``I would not choose him for Treasury.''
Even with all of the clashing opinions within Obama's party, a consensus has built on several issues. One is the need to regulate CDSs. Democrat Barney Frank of Massachusetts, who's chairman of the House Financial Services Committee and the point person in Congress on Wall Street regulation, is seeking federal oversight of the derivative market. So is billionaire Warren Buffett, another Obama adviser.
Rubin told Bloomberg Television in October that he wishes he had advocated for a clearinghouse for the swaps, which would have helped reduce today's turmoil.
Super Risk Regulator
American International Group Inc.'s brush with bankruptcy in September was due largely to its holdings in the swaps. The Treasury has pumped $150 billion into the insurance giant to prevent a collapse that would further roil financial markets.
The Fed is seeking to become the lead regulator for clearing trades in the $33 trillion CDS market, according to people with knowledge of the proposal. The Fed, SEC, Treasury and CFTC are hammering out the framework for oversight of clearinghouses that would absorb losses should a dealer default.
The most far-reaching idea to gain support from Obama advisers, Frank and Paulson is the creation of a super regulator to control risk -- although the form it will take is a matter of debate. The regulator might set requirements for holding capital in banks, hedge funds and private equity firms and try to prevent financial implosions that would disrupt global markets.
Volcker, who served as Fed chairman from 1979 to `87, testified at a congressional hearing in May that the central bank would probably be the place to put a chief supervising regulator.
Lax Oversight
``We need more uniformity, and it looks like the Federal Reserve seems to be the logical candidate,'' Volcker, 81, said.
The Consumer Federation of America says consolidating power in the Fed, which isn't accountable to Congress, is a recipe for lax oversight. Barbara Roper, head of investor protection at the federation, says the proposal is a spinoff of a blueprint that Paulson released in March.
``The Paulson plan was conceived of as a way to `streamline,' which is code for `reduced regulation,''' Roper says. ``You can't just assume that because Barack Obama is a Democrat that he's going to come in and fundamentally change that approach.''
Lynn Turner, who was the SEC's chief accountant under Clinton, says the Fed's poor regulatory record should disqualify it for an expanded role.
Fight `Like a Tiger'
``The Federal Reserve had the power to stop banks from making the bad subprime loans but had adopted a policy encouraging cheap debt,'' Turner says. ``They were supposed to supervise the lending by many of the banks now in trouble and yet seemingly did nothing. I wonder why when they didn't do the job they were supposed to be doing, one would give them even more responsibility.''
Lyle Gramley, a Fed governor from 1980 to `85, says the central bank considers itself best suited for the risk regulator job after bailing out Wall Street and would resist congressional efforts to create a new agency. ``The Fed's going to fight that like a tiger,'' says Gramley, a senior economic adviser at Stanford Group Co.
While Democrats and even some Republicans agree that hedge funds must be regulated, they differ on how strict those rules should be.
Senator Charles Grassley, an Iowa Republican, said in October that he would reintroduce legislation to require hedge funds to register with the SEC. It would likely require hedge funds to submit to routine inspections and disclose the amount of assets they manage and their numbers of employees and investors.
Obama's counselors say they may recommend that the president- elect go even further by imposing rules on the amount of capital the firms must hold, according to an adviser familiar with the matter who asked not to be named.
Paulson, Simons, Soros
On Nov. 13, five billionaire hedge fund managers including John Paulson, James Simons and George Soros made an unprecedented appearance before Congress to defend their industry's practices.
Thomas Davis of Virginia, the top Republican on the House oversight committee, said regulation was needed because institutional funds and public pensions now have a huge stake in hedge funds.
``That means public employees and middle-income senior citizens, not just Tom Wolfe's `masters of the universe,' lose money when hedge funds decline or collapse,'' he said.
While investor Philip Falcone said hedge funds should disclose more information to regulators, Kenneth Griffin, founder of Citadel Investment Group LLC in Chicago, disagreed with the call for controls.
``We've not seen hedge funds as a focal point of the carnage,'' said Griffin, whose funds dropped 38 percent this year through Nov. 4.
Assault on Capitalism
Many Republicans warn that the drive to rein in the financial industry may go too far and inflict further pain on the economy.
Representative Tom Price, a Georgia Republican, calls the government's bailout of banks and help for homeowners facing foreclosure an assault on capitalism.
``It's a marked turn toward a nefarious ideal that problems can be solved by centralized decision making here in Washington,'' Price said before the financial services committee in October. ``Moving ahead, Congress must be sensible. The end result must promote economic growth, not stifle opportunity.''
Obama may be planning more profound regulatory changes than his advisers have revealed so far, says Julian Zelizer, a history and public affairs professor at Princeton University in Princeton, New Jersey.
``If he surrounded himself with the left, it would be much harder to push regulation,'' Zelizer says. ``Now he can claim the support of Summers or Rubin. They will offer him some support and cover from the financial community.''
Just by being elected, even before he sets foot in the White House, Obama has changed the course of history. And starting in January, he'll have a rare chance to overhaul a financial regulatory system that failed to prevent the worst crisis in decades -- if he chooses to seize the opportunity.
To contact the reporter on this story: Heidi Przybyla in Virginia at hprzybyla@bloomberg.net
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