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.
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].’”
One industry insider noted that the percentage of OTC trading could actually rise as a result of the end user exemption in the legislation. He says, “much of the risk of a future meltdown will persist as a result.”
The legislation also codifies the authority of the Commodity Futures Trading Commission (CFTC) to establish position limits, including aggregate position limits applied to both OTC positions and exchange traded futures. While most of the provisions in the bill won’t take affect for over a year after passage, the CFTC is to enact these limits 180 days after passage for exempt commodities and 270 days for agricultural commodities.
Jon Corzine, chairman and CEO of MF Global and a former legislator and head of Goldman Sachs, expressed general support for the bill (prior to it passing the House) but had issues with the Volcker rule.
“The idea of prohibiting proprietary trading in some of our larger institutions, to spin off derivatives books, is not a good idea,” he said. “Somebody is going to want to have their risk intermediated and it is going to go somewhere. If it is not in the banking system, it may go someplace where it is less easy to observe, more expensive to access and may even be offshore.”
Based on initial analysis of what parts of the Volcker rule are actually in the legislation, Corzine and others objecting to it don’t have much to worry about.
Originally the rule would have prevented any systemically important bank holding company from engaging in proprietary trading as well as investing its own capital in hedge funds or private equity funds. Instead of the outright ban originally proposed, the final version will allow banks to provide no more than 3% of a fund’s equity, and will be limited to investing up to 3% of the bank’s Tier 1 capital in hedge funds or private equity funds.
Further, an amendment proposed by Sen. Blanche Lincoln (D-Ark.) requiring banks to spin off a portion of their proprietary trading with their own capital was weakened. While the original amendment required banks to spin off all their proprietary trading or else lose FDIC insurance, the final version only requires banks to spin off the riskiest parts of their trading, primarily credit default swaps.
Although the bill was already formed at the time, CFTC Chairman Gary Gensler testified before the Financial Crisis Inquiry Commission on July 1 specifically about the role OTC derivatives played in the financial collapse.
“Another lesson from the financial crisis was that the entities that made markets in derivatives were ineffectively regulated or sometimes not regulated at all. The derivatives affiliates of AIG, Lehman Brothers and Bear Stearns had no effective regulation for capital, business conduct standards or recordkeeping. Without such comprehensive regulation, they were relying mostly on their own risk management practices and profit motives to determine how much capital they would have to keep and what other business decisions they would make,” Gensler says.
Consequently, the new financial bill aims to bring greater regulation to the OTC derivatives market by granting the CFTC and SEC greater authority to regulate irresponsible practices and excessive risk taking (see “Reading the fine print,” below). Further, the bill mandates central clearing and exchange trading for derivatives that can be cleared, although it will be left to regulators to determine which derivatives those include. Ideally, this will provide more transparency in pricing and more liquidity in the system.
New rules for money managers
Financial reform also increases regulation of hedge fund managers. From a hedge fund perspective, the agreement eliminates a provision in the Investment Advisers Act that exempts hedge fund managers who advise fewer than 15 clients and do not hold themselves out to the public as investment advisors.
According to Matteson, investment advisors managing more than $100 million will have to register with the SEC, however, the threshold of assets under management for any advisor that exclusively manages private funds relying on the 3c1 or 3c7 exemption (most hedge funds) will be $150 million. Those hedge fund managers managing less than $150 million would come under state regulators.
“A lot of midsize hedge fund managers are going to have to deal with state investment advisors’ registrations,” he says.
State securities laws vary and fund mangers will need to know the laws of each state, says Matteson. “Because any state can adopt their own rules, hedge fund managers are going to need to know about the laws of each state where their investors are located to know they are in compliance with those local laws.”
Long way off
Financial reform legislation, as of this writing, has not even been passed by the Senate or been signed by the president but most experts say how it will ultimately look has a lot to do with rule writing by the regulators after its passage.
Gary deWaal, general counsel at Newedge says, “Most of the impact of the bill won’t be felt until a year after enactment because that’s when the regulations are due.”
In terms of the battle over exemptions, much has been punted to the regulators. Jay Gould, head of the investment fund practice at Pillsbury Winthrop Shaw Pittman LLP, says, “This legislation, as written, is quite broad, which means that the really significant details will be worked out in the regulatory rule-making process.”
DeWaal agrees. “It is an open issue to be closed during regulatory meetings. I don’t know how much it really clarifies.”
Corzine, speaking at the Managed Funds Association forum in June, expressed support for the measure but warned that regulators could override the intent of Congress in the rule making process. Conversely, former FDIC Chairman Bill Isaac strongly opposes the measure on numerous grounds but in particular because of the way it handcuffs the FDIC and Federal Reserve’s ability to handle a crisis.
The difference of opinion may have a lot more to do with the backgrounds of each: Corzine was head of Goldman Sachs and a senator and governor while Isaac headed up a regulator. But both point to the fact that financial reform will have a lot to do with what happens on a regulatory level after the bill becomes law.
“Because certain portions of the bill are written so broadly and convey so much discretion upon the banking, securities and commodity regulators, the real strength of the legislation will be determined in the regulatory process,” adds Gould.
Daniel P. Collins and Christine Birkner contributed to this article.
Not all reform has come from Congress, as the CFTC and SEC have been jointly investigating the “flash crash” that took place on May 6 in which liquidity dried up to the point that some stocks were selling for only a penny. So far, the SEC has already put into place two new regulations to prevent another incident.
The first was to set up single stock circuit breakers on the S&P 500 on a trial basis until Dec. 10, 2010. With these in place, all trading in a stock that has dipped 10% in a five-minute period will be frozen for five minutes. According to a SEC press release at the time, “The pause, which would apply to stocks in the S&P 500 index, would give the markets the opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion.”
Additionally, plans were introduced to clarify the process for breaking clearly erroneous trades. Following the “flash crash,” a level of 60% was arbitrarily set so that any trade that took place 60% or farther from its reference point was busted. This new rule works to standardize the levels at which clearly erroneous trades would be busted.
As some stocks now have the single stock circuit breakers and others do not, there are two proposed sets of levels to be instituted on the same trial basis as the circuit breakers. For stocks that are subject to the circuit breakers, trades will be broken if they take place from 3-10% from the circuit breaker trigger price, depending on the price of the stock. For stocks that are not subject to the circuit breakers, trades will be broken if they take place from 10-30% from the reference point depending on the number of stocks involved in the dip.