From the August 01, 2010 issue of Futures Magazine • Subscribe!

Are U.S. markets ready for reform?

With the recent financial crisis and subsequent recession being compared to the Great Depression, it seems only fitting that financial reform efforts by Congress contain the most sweeping reforms to the financial sectors since those passed after the Great Depression.

In response to the numerous crises, the House of Representatives recently passed the Dodd-Frank Wall Street Reform and Consumer Protection Act to prevent future breakdowns and bailouts. The Senate is expected to follow suit. While the more than 2,000-page legislation is far reaching, some of the most important areas of reform include consumer protection, credit rating agencies and of course derivatives.

As the new legislation is intended to prevent another financial collapse like the one that just took place, the bill begins with provisions that may have prevented, or at least slowed, the housing crisis by creating a new federal regulatory body in the form of the Consumer Financial Protection Bureau. The intention for this new bureau is to be a stand alone, independent body with the sole purpose of protecting consumers from potentially dangerous financial products. As such, it has the authority to examine and enforce regulations on banks and credit unions with assets of over $10 billion, all mortgage related businesses, payday lenders and student lenders. Additionally, it also oversees large non-bank financial companies such as debt collectors and consumer reporting agencies.

By creating this new bureau to oversee consumer financial products, lawmakers hope to prevent consumers from being taken advantage of by predatory lending schemes and to ensure that banks are practicing responsible lending. Although the bureau will exist to oversee lending practices, one area that was given exemption was auto loans, which will be out of the purview of the bureau. Through this agency, lawmakers hope to prevent bad loans from being made in the first place.

Along with the establishment of the Consumer Financial Protection Bureau, the bill also institutes a number of reforms designed to change the way mortgages are issued. Chief among these reforms are requirements that lenders ensure a borrower’s ability to repay the loans they are issued, prohibitions from financial incentives that encouraged lenders to steer borrowers into more costly loans and penalties for lenders and mortgage brokers who do not comply with the new rules.

During the housing bubble, after banks had made the bad mortgage loans, they were then able to bundle a number of them together and sell them to investors.

A big reason some banks were able to package together these subprime mortgages and sell them off to investors at such profit was that those packages had received inflated ratings from credit rating agencies. Banks were able to shop around and choose the credit rating agency they wanted to rate their products, creating a conflict of interest that led to complex risky products that included subprime debt being given conservative investment grade ratings.

In response to this practice, the bill increases the Securities and Exchange Commission’s (SEC) oversight of credit rating agencies by creating an Office of Credit Ratings at the SEC with its own authority to examine and fine agencies. In addition to investigating any potential instances of conflict of interest between a credit rating agency employee and an entity the agency had rated in the previous 12 months, the SEC also is to create a new mechanism that will eliminate the shopping for ratings practice after conducting a study and submitting the report to Congress.

Derivatives shake-up

Most important for the futures industry are requirements that over-the-counter (OTC) trading be moved to exchanges and cleared. Since the beginning of the process this has been a major goal of the legislation and exactly how complete these requirements are and what entities and products are exempted has been a major battlefield in the legislative process.

The legislation would require a significant portion of OTC trading be conducted on electronic trading facilities and cleared through a central counterparty clearing house. It includes some of the “Volcker Rule” in concept, but is watered down.

“The lobbyists for Wall Street should all get bonuses for a job well done,” says David Matteson, partner with Drinker Biddle & Reath. “Historically investment banks have made significant profits in [OTC] markets and it makes sense that the banks wanted to protect that profit making, that is why they lobbied pretty strongly to keep as much of that OTC business as possible. That is the push/pull in this because the banks have made a lot of money making markets in these OTC instruments or issuing OTC instruments and they don’t want to give up those profits.”

But many would argue it is the pursuit of those profits that led investment banks to create and market risky products that in part led to the crisis in the first place.

“The whole reason we are looking at financial reform is because banks assumed too much risk and had to be bailed out,” Matteson says. “Banks want to continue to generate profits and take risk but we as a society are saying ‘wait a minute we don’t want to allow you to put the financial system at risk again where tax dollars are going to have to be used to bail you out if those risks overwhelm [the system].’”

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