Paulson Proposes a Regulatory Overhaul

Updated from 12:44 p.m. EDT

The Bush Administration unveiled a sweeping plan to overhaul the regulation of U.S. financial markets on Monday that would give the Federal Reserve broad, new powers to oversee market stability.

The proposals amount to the first salvo in what is expected to be a long and contentious debate over the government's role in financial markets in light of the U.S. housing and credit crisis. Shaky credit tied to mortgages has sent financial markets into turmoil by leading to large asset writedowns at banks and dried up liquidity, all of which led to the swift demise of a major investment bank, Bear Stearns(BSC).

Initial criticisms of the plan will likely focus on the Fed's perceived failure to use its existing regulatory powers to dampen the housing bubble, as well as the Bush Administration's longstanding contention that financial markets are over-regulated, sending investors to friendlier markets overseas. Moreover, the proposals come at a time when the crisis is already raging, and Democrats are calling on the federal government to focus directly on consumers that are being hurt by its fallout.

Cramer: Paulson Plan Is Hooey

Fueling those critics, Treasury Secretary Hank Paulson's speech that laid out the administration's proposals coincided with the resignation of Housing and Urban Development Secretary Alphonso Jackson. At the center of the mortgage storm that's plaguing financial markets, Jackson has been accused of steering lucrative housing contracts in the Virgin Islands and New Orleans to friends -- charges that he has denied.

Two senior Democratic senators have called on Jackson to resign, but he explained his departure as an effort to spend more time with his family.

In this environment, Paulson acknowledged that the administration's regulatory proposals for the financial system are part of a long-term effort that will extend beyond the presidency of George W. Bush, which ends at the beginning of 2009.

"Once we are through this period of market stress, we need to begin the serious work of modernizing and reforming the structure, which will require a great deal of discussion and many years to complete," said Paulson.

Former Fed governor Lyle Gramley, now a senior economic advisor with the Stanford Financial Group, says the administration's plan has merit, but it's unlikely to be embraced amid the intense partisanship that has paralyzed Washington, D.C. in recent years amid spiraling budget deficits and controversial wars continuing in the Middle East.

"It's going to involve a lot of turf battles, so it's going to be very difficult to get through Congress," says Gramley. "That said, there is widespread recognition that we've leaned too heavily on market discipline and it has really let us down. We've got to try to get involved with more regulation of financial institutions like investment banks, hedge funds and private equity firms. There will be a great deal of sympathy for creating a market stability regulator, and the notion that that should go into the Federal Reserve is the correct one."

The Fed inspired a chorus of demands for a new regulatory framework earlier this month when it abandoned its traditional role as a lender of last resort for depository institutions, like commercial banks, and rushed to the aid of Bear Stearns as it faced a bankruptcy that could have trigged a systemic breakdown in the financial system. The Fed's backstopping of nearly $30 billion in shaky mortgage-related debt to prop up the fire sale to JPMorgan Chase(JPM) marked the most dramatic encroachment into financial markets by the central bank since the Great Depression.