Lehman Brothers, Merrill Lynch and American International Group (AIG) have at least one thing in common: They owned depositories but were not overseen by the Federal Reserve Board.

Each own a thrift but opted not to use the holding company structure laid out in the Gramm-Leach-Bliley Act of 1999. That left oversight to either the Office of Thrift Supervision (OTS) or the Securities and Exchange Commission (SEC), neither of which has as much power as the Fed's authority over financial holding companies.

That's a legacy of the Gramm-Leach-Bliley Act of 1999, which created the financial holding company structure and put the Fed in charge of policing these companies. But most nonbanking companies did not want to subject themselves to Fed oversight, so those that wanted to own a depository institution did so through the thrift charter.

At a congressional hearing last Thursday on the housing crisis, lawmakers were expected to investigate the issue, including whether a stronger holding company regime could have prevented the companies from unraveling.

"If there had been safety-and-soundness regulation of the holding companies, in principle there shouldn't have been these difficulties," said Lawrence White, a professor at New York University's Stern School of Business.

Because it owned a thrift, AIG automatically had the OTS serve as its consolidated holding company regulator. Though both Lehman and Merrill also own thrifts, and are technically considered thrift holding companies, both opted for the SEC to be considered their consolidated holding company regulator.

Observers said both those agencies lacked sufficient authority and resources to oversee the parent companies. The OTS, for example, is largely focused on a parent company's potential to jeopardize a thrift - something that was not at issue in AIG's case.

"The holding company authority idea was always that you wanted to make sure that involvement of the regulated entity ... with the holding company didn't endanger the insured institution," said White, a former member of the Federal Home Loan Bank Board.

The system was never designed to ensure control over the parent company, he said. "The idea that the regulator was going to be able to control the activities of the holding company was really never a realistic possibility."

The Fed sets capital requirements for all financial holding companies, but the OTS has decided to set those on a case-by-case basis. Also, the Fed has regulatory authority over the entire holding company and all its affiliates. The OTS has power only over entities that directly affect the thrift, said L. Richard Fischer, a partner at Morrison & Foerster.

Karen Shaw Petrou, managing director of Federal Financial Analytics, agreed with that assessment.

"There's the Bank Holding Company Act, which defines any number of expressed Federal Reserve authorities, requirements, restrictions, authorities, with regard to the bank holding company," she said. In contrast, there are only "limited references" to the thrift holding company powers "and expressed provision in law that bars the OTS from reaching into the holding company."

The central bank also has more experience in overseeing diversified financial services holding companies, such as Bank of America Corp. and Citigroup.

The SEC has allowed the largest broker-dealers to use an umbrella structure known as "consolidated supervised entities" oversight. The regime was established as foreign regulators required investment banks to be subjected to consolidated supervision.

Yet the legal status of these entities here is unclear. As lawmakers have considered legislation to reform regulation of industrial loan companies - a number of which are owned by investment houses - some, including Sen. Richard Shelby, R-Ala., have balked at provisions that would effectively ratify the structure in the United States. Shelby then said Congress needed to study the structure further before approving it.

Since the housing crisis began to deepen this year, a growing chorus of lawmakers have urged giving the Fed more power over all firms of systemic importance to the economy. The latest government steps only give more impetus to that, observers said.

"I believe we need to restructure the financial system," said Ernest Patrikis, a former general counsel at the Federal Reserve Bank of New York, who is now a partner in Pillsbury Winthrop Shaw Pittman. "I pose the question of whether the Fed should get the top 25 systemic entities in the country: commercial banks, investment banks, private funds, hedge funds, insurance companies. There's a criteria, and the Fed should get the top 25."

Others agreed with that assertion.

"It seems to me that if one of the purposes of that safety net is to maintain the stability of the financial system, you have to look at bringing those other players into that safety net," said Oliver Ireland, a partner at Morrison & Foerster and a former Fed lawyer.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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