Financial Reform or Foundation for the Next Crisis?

July, 2010

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act that he says will end many of the practices that led to the worst recession in the U.S. since the Great Depression. This is Obama's second major domestic reform of the year, after health care.

The stated purpose of this legislation is to:

• Protect Consumers from abusive financial services practices
• Rein in Wall Street by improving accountability and transparency in the financial system.
• End "Too Big" to fail and taxpayer funded bailouts

The Senate Committee on Banking, Housing and Urban Affairs added to this "We must create a sound foundation to grow the economy and create jobs."

Is it possible to achieve such lofty goals and what will be the unintended consequences?

For a summary of the bill click here

Potential Impact

This law is ambitious, but despite its 2,319 pages, is only a template. A vast number of details are left to regulators, such as the 67 studies to be conducted and some 243 new detailed rules to be written. How regulators write these rules (estimated to take two years or more) and how they and future administrations decide to enforce them will dictate the impact on financial institutions, businesses and, ultimately, consumers. I believe this legislation is on a spiraling path towards more government oversight and control, and ever more bureaucrats.

Not only is it important to understand what is in this bill, but what is noticeably absent. It does not address the problems faced by Fannie Mae and Freddie Mac, despite the fact that these two entities helped fuel the housing bubble and were recipients of $150 Billion in Federal bail-out monies. The Farm Credit System, a group of banks and cooperatives that lend money to farmers and rural land owners, will not be subject to the oversight other banks will have thanks to their lobbyists and the help of the Senate Agriculture Committee. (While the Farm Credit System has not made the front page during the current crisis, they did receive a government bailout back in 1987, to the tune of $1 billion. Of course, that seems like chump change now.) Additionally, car loans are exempt from the new law despite the fact that such loans are notoriously subject to abuse; such an exemption is all the more notable, given the sizable bailout of the car manufacturer industry.

The new law is intended to help prevent another financial system crisis of the magnitude we experienced in 2008. Unfortunately, no bill can anticipate every possible crisis and its causes. There have been many financial crises in the past, of varying severity, and there will be others, either in spite of or as an unintended consequences of certain rules contained in this legislation. After all, many point to the government policies put in place to stimulate the economy through housing in the wake of the tech bubble as the cause of this crisis. The pressure was on Washington to do something about the 2008 financial crisis, so they moved at record speed to pass a broad-reaching and complex set of laws. In my opinion, this legislation is a knee-jerk response to the high degree of anxiety felt by Americans and is not well thought out. We can only hope that this legislation will not be the cause of the next crisis.

That said, I believe there are some good reforms in the law, such as the establishment of exchanges for derivatives. The increased standardization should bring down the cost of trading and increase volume, so the falling profit margins will be offset by volume. Moreover, with contracts cleared centrally, the current required reserves will be reduced.

The resulting increase in jobs from this legislation will be from a growing bureaucracy, more lobbyists and compliance staffs. The two major agencies created by this bill, the Consumer Financial Protection Agency and the Financial Stability Oversight Council, are only a start. The additional offices added to existing agencies (Office of Financial Research, Office of Housing Counseling, Federal Insurance Office, Office of Minority & Women), the 67 studies and the 243 detailed rules would expand government employment considerably. Additionally, as the bureaucrats begin writing the rules, the lobbyists will be out in force to help shape the outcome. Of equal concern will be the increase of corporate accountants and attorneys to keep track of and comply with the new rules. Unfortunately, this type of job growth is counter-productive to the growth of the economy, as increase in spending by the government must come from the taxpayers (hence higher taxes). In addition, businesses will incur higher compliance cost—which, of course, can reduce productivity, increase overall costs passed on to consumers, and reduce profitability to its shareholders. How high can the costs rise?

At the Economic Club of Washington on June 22, Chairman of the Business Roundtable and Verizon Communications CEO, Ivan Seidenberg expressed his opinion about what is coming out of Washington: "In our judgment, we have reached a point where the negative effects of the proposed policies are simply too significant to ignore...By reaching into virtually every sector of economic life, government is injecting uncertainty into the market place and making it harder to raise capital and create new businesses."

In my opinion, while some aspects of this bill will result in much-needed improvements, its ambiguous, over-reaching rules and regulations will significantly hamper the recovery of our economy. Ronald Reagan once said that the closest thing to eternal life on Earth is a federal program, as "they never end."

While we do expect the economy to recover, the impact of this legislation will impede its pace and, more importantly, prevent it from reaching its potential. We will need to be watchful in the coming months and years as this legislation is implemented, changing the rules of the game to create opportunities in certain areas while ending them in others. As investors, we must be vigilant in identifying the companies and industries that benefit, along with those who will suffer...for every cloud has a silver lining and it's our job is to find it.

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2010 Financial Reform Bill

AKA Dodd-Frank Wall Street Reform and Consumer Protection Act

Protect Consumers

New Consumer Protection Agency

The Consumer Financial Protection Bureau (CFPB) will be formed in one year with broad powers to write rules and ban certain financial products. Its jurisdiction will include mortgages, credit cards, student loans, payday lenders and debt collection, while car loans and loans through the Farm Credit System are exempted. The CFPB will also oversee the enforcement of federal laws intended to ensure the fair, equitable and nondiscriminatory access to credit for individuals and communities. The CFPB will be under the Federal Reserve, with a director appointed by the President and confirmed by the Senate, although the Financial Stability Oversight Council can override CFPB. The CFPB is also charged with creating an Office of Financial Literacy, with a toll-free hotline for consumer complaints.

Mortgage regulations

Within two years, there will be more mortgage protections by holding mortgage brokers and loan originators responsible for ensuring that borrowers can afford their mortgage and get the right product for their needs. Lenders will be required to verify the income and assets of borrowers. The law prohibits financial incentives for selling more expensive loans and bans prepayment penalties on all but the most basic mortgages; in addition, any prepayment penalty mortgage must also be presented with a non-penalty alternative. Variable-rate loans must include disclosures as to the maximum a borrower could end up paying. Lenders who sell off riskier loans to investors must retain a 5% ownership stake.

Within a year there will be new home-appraisal rules, with the aim of ensuring appraiser independence. There will also be a study of reverse-mortgage loans, to determine whether stronger consumer protections are needed.

Housing Counseling

Establishes an Office of Housing Counseling within HUD to promote homeownership and provide housing counseling.

Credit and Debit Cards

An individual will be able to access their credit scores for free if turned down for a loan or a job, in addition to the credit report available once a year from the three big credit bureaus (at Annual CreditReport.com).

The Federal Reserve is charged with creating rules to cap the fees that debit card issuers can charge merchants. The hope is that retailers will offer discounts for debit card use. More likely, however, is that banks will raise other fees as their profit margins on these products get squeezed. In addition, merchants may set a $10 minimum purchase for credit card use. And colleges and federal agencies will be allowed to set maximums for credit card charges they accept.

Student Loans

Private student loans from banks as well as student loans from for-profit career colleges will fall under the oversight of the CFPB. Private loans often carry variable rates with no cap, and lack the consumer safeguards that federal student loans provide, such as deferment options, forgiveness programs and affordable repayment plans. Within the CFPB, a Private Education Loan Ombudsman will give students a central place for help with private student loans.

Rating Agencies

The SEC has two years to produce a study to mitigate conflicts of interests at the biggest rating agencies; otherwise, a board will be created to match rating agencies with debt issuers. Investors are allowed to sue credit rating agencies if they recklessly failed to review information used in developing a rating.

Deposits

Federal deposit insurance limits will be permanently raised to $250,000 per account. The prohibition against paying interest on demand deposits is repealed.

Executive Compensation

The SEC is directed to enact new "say on pay" rules for public company compensation and golden parachutes. The new rules are expected within six months and enable shareholder to have an advisory vote on such pay practices. It will also require companies to provide charts comparing stock performance with executive compensation over a five-year period and require corporate compensation committees be comprised solely of independent directors, with the authority to hire consultants. The "pay czar" will have the authority to ban what is deemed to be inappropriate compensation practices and to require financial firms to disclose any compensation structure with incentive-based elements.

Too Big To Fail

Agency heads to monitor risk

Chaired by the Treasury Secretary, the Financial Stability Oversight Council is formed immediately to monitor systematic risk in the financial system. The Treasury, along with federal regulatory agencies and an independent member appointed by the President, are charged with identifying firms that threaten stability and subject them to tighter oversight by the Federal Reserve and with break up firms that pose an urgent threat—to be accomplished through an "orderly liquidation" process instead of bankruptcy or bailouts. So the same process used for banks will apply more broadly to non-banks.

The costs will be covered in the short term by a Treasury credit line, then recouped by sales of the liquidated firms assts. For the remaining shortfall, there will be certain claw-backs of creditor payments that exceed liquidation value, along with assessments on large financial companies in a complex assessment scheme that requires the "riskiest" to pay more.

The Stability Council will also make recommendations to the Federal Reserve for increasing strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with more regulation on those considered the riskiest.

The Council will have the ability to approve a Federal Reserve decision to break up large, complex companies, but only as a last resort. It will also have the ability to require non-bank financial companies that pose a risk to U.S. financial stability to submit to supervision by the Federal Reserve.

Leveling the playing field

The legislation initially included two requirements in order to offset the advantages that the too-big-to-fail banks have over smaller banks:

• A bank tax on the largest banks to encourage them to shrink, and to pay for the clean up of the large banks that fail. This provision was removed as a concession to get the bill passed.
• The second is to require banks to have more capital and liquidity to make a collapse less likely. Higher capital requirements are included in this bill with the amount left to the regulators to determine.

Rein in Wall Street

Study to identify needs

The SEC will conduct a study of the entire securities industry to identify needed reforms in the wake of the Madoff and Stanford Financial ponzi schemes.

Exchanges for Derivatives

Because of their leverage and lack of transparency, derivatives pose a threat to the financial system. Requiring most derivatives now traded dealer-to-dealer to be traded on public exchanges or passed through clearing houses will lessen the risk that one dealer's failure will bring others down. The SEC is charged with developing the necessary rules within one year.

Regulate Hedge funds

Requires hedge funds and private equity firms overseeing $150,000,000 or more in capital to register with the SEC, subjecting them to systemic risk regulation by the Financial Stability Oversight Council. At the same time, it shifts to state supervision those Registered Investment Advisors with assets under management under $100 million (from $30 million).

New Insurance Agency

Creates a Federal Insurance Office to monitor all aspects of the insurance industry, with an emphasis on identifying gaps in the existing regulation that could contribute to a systemic crisis. Currently, insurance is regulated by each state.

Credit Rating Agencies

Addresses the role that credit rating agencies played in the economic crisis and charges the regulators to create rules to reduce conflicts of interest and market reliance on credit rating agencies. Also imposes a liability standard on the agencies.

Whistleblower

The Commodities Futures Trading Commission will establish a whistleblower bounty program, with incentives to identify wrongdoing in the securities markets and to reward individuals whose tips lead to successful enforcement actions.

Volker Rule

The "Volker Rule," based on the proposal from former Federal Reserve Chairman Paul Volcker, restricts banks from making certain investments deemed to be speculative. Banks will have two years to wind down their proprietary trading activities. Insurance companies will retain limited trading privileges and banks will be able to invest three percent of their Tier 1 capital in hedge/private equity funds. Banks will be allowed to trade interest-rate, foreign exchange and high-quality credit swaps, while commodity, equity and non-investment-grade credit contracts must go into separate affiliates. This rule will affect fewer than 10% of all swaps, as foreign-exchange swaps comprise the majority of the market.

Insurance

As part of the Treasury, a new Federal Insurance Office will be created to gather information about the insurance industry, including access to affordable insurance products by minorities, low and moderate income earners and underserved communities. Additionally, the office will monitor systemic risk in the insurance industry.

Minorities and Women

A new Office of Minority and Women Inclusion will be formed at federal banking and securities regulatory agencies will address employment and contracting diversity matters, coordinate technical assistance to minority-owned and women-owned businesses, and seek diversity in the workforce.

Regulating the Regulators

The Federal Reserve will now be subject to audits by the GAO regarding emergency lending, discount window lending and open market transactions. Additionally, by Dec. 1, details of all emergency lending that took place during the financial crisis will be published on the Federal Reserve website.