Three Major Points of the U.S. Financial Reform Bill

Sources:
Restoring American Financial Stability Act of 2010
Wall St. J.: Senate Passes Sweeping Financial Overhaul
NY Times: 3 Auto Dealer Tactics the Overhaul Missed
Financial Times: A New Era: Key Points of the Senate Bill
CNN: Wall Street Reform: What’s in the Bill?
The Boston Globe: Agency has Teeth, Panelist Says

On Thursday July 15, 2010, the Senate voted 60 to 39 to approve the 2,300 page financial reform bill. The bill marks the most drastic revision of financial regulation since the Great Depression. So, how will the bill affect the financial sector? The bill changed many aspects of financial regulation­­­ ­ (far too many to discuss all of them here), but below are three major points of the bill.

Consumer Financial Protection Agency (CFPA)

The financial reform bill created the CFPA to do exactly what its name implies—protect consumers from abuses of the financial industry. Among these abuses are predatory subprime mortgage lending (a major catalyst of the financial crisis) and mis-selling of credit cards. However, the CFPA will not have power over automobile dealers writing car loans. The CFPA is responsible for writing the rules to protect consumers from abuses, but the bill does not require the CFPA to implement any specific laws.

The CFPA will be housed within the Federal Reserve and will be funded by fees paid by banks. It will operate completely independently from the Fed and have a protected funding stream that will shield the CFPA from congressional and corporate interference.

The rationale for creating the agency is that abuses by some financial institutions helped lead to the financial crisis. Of course, commentators have criticized the CFPA on numerous grounds.

One criticism of the CFPA is that automobile dealers and the loans that they arrange for consumers are not subject to CFPA oversight. Proponents of the automobile dealer exemption believe that “auto dealers are part of Main Street, not Wall Street” and that automobile loans played no part in the financial crisis. In response, those that challenge the exemption are quick to point out “that Wall Street firms bundle into bonds many of the loans that dealers help originate and conveniently forget that lots of dealers are actually owned by publicly traded companies.” Thus, according to the critics of the exemption, auto dealers are actually part of Wall Street.

Another criticism is that the strength of the CFPA is unknown. The bill merely created the CFPA, but does not require the CFPA to implement any specific laws. As a result, these critics believe that the CFPA will be weak if those who write the rules implement weak, loophole-laden laws.

Derivatives

The bill requires that derivatives that trade in over-the-counter (OTC) deals now be traded on exchanges or similar systems and routed through a clearinghouse. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to something else such as stocks, bonds, interest rates, or commodities. Customized swaps can still be traded OTC, but they would have to be reported to central repositories so regulators have a better idea of what is taking place in the market. Put simply, a swap is a simultaneous buying and selling of the same security—such as a bond—to hedge risk, speculate, or reduce funding costs. There will also be new capital, margin, reporting, record keeping, and business conduct rules for derivative dealers.

Before the bill was passed into law, the OTC derivatives market was largely unregulated, disclosure requirements were minimal, and it was made up of highly sophisticated parties (banks and hedge funds). An example of an OTC derivative is a credit default swap, which many believe was a cause of the global financial crisis (and here). A credit default swap is similar to an insurance contract that pays out if, for example, a party defaults on its home mortgage. Previously, counterparties in OTC derivative transaction executed their transactions directly with each other rather than through a clearinghouse. As a result, the counterparties had no assurance that the other would perform. By requiring trades to be executed through a clearinghouse, counterparty risk is minimized—if a counterparty cannot meet its obligations the clearinghouse will cover the loss of the defaulting party. The use of a clearinghouse will decrease counterparty risk and increase transparency.

The bill provides exemptions for non-financial companies using contracts to hedge risk. A company hedges risk to attempt to eliminate the volatility of an underlying asset. Speculation is different than hedging in that the main purpose of speculation is to profit from betting on the direction an asset will move. For example, an airline will buy options in oil to reduce the volatility (hedge) of the price of fuel. On the other hand, a speculator will buy a call option if it believes that the price of oil will increase solely to make a profit.

Volcker Rule

The Volcker rule prevents deposit-taking banks from buying and selling financial products for their “trading account”. The law then defines the trading account as an account meant to profit in the “near term” from “short term” movements in prices. Additionally, it prevents these banks from owning more than a small piece of hedge funds and private equity firms. The bill does provide an exception (government bond exemption) which allows banks to trade in Treasuries, government backed bonds, and municipal bonds.

The Volcker rule attempts to reduce moral hazard for the largest banks which came as a result of the government bank bailouts of 2008-2009. Moral hazard is the idea that when governments bail out financial institutions that have engaged in risky behavior—e.g., risky trades—that threatens the financial system, they send signals to other financial institutions that they too can engage in similarly risky behavior with the expectation that they will be bailed out if they get into trouble. Essentially, the Volcker rule bans banks from using their own funds, which were backed by taxpayer cash, to speculate in the financial markets. For example, in the fourth quarter of 2007, Morgan Stanley took a $7 billion dollar trading loss. Eventually Morgan Stanley took bailout money from the government. Furthermore, Citigroup had significant holdings of mortgage-backed securities and collateralized debt obligations of which it took significant losses. Following these losses, Citigroup received $45 billion in government money and guarantees. Thus, the financial reform bill introduced the Volcker rule to help reduce the number of risky bets that banks make on their own behalf.

The government bond exemption has come under fire. Critics of the government bond exemption believe that there is still a risk of loss in government bonds. Critics point to the European sovereign debt crisis and the poor financial state of some local U.S. governments as evidence that government bonds are in fact risky. Critics argue that using leverage, it is possible for banks to make large speculative bets in exempt bonds which could lead to major losses and therefore, more bailouts.

Proponents of the exception argue that, because banks hold many of these bonds on their balance sheets, disallowing trading in these bonds would cause banks significant hardship. They believe that government bonds are safer than corporate bonds, and therefore should not be treated the same as corporate bonds. Regardless of the risk in government bonds, deposit-taking banks may invest in government bonds for their own benefit.

Discussion:
1) Did the financial reform bill go too far or not far enough?
2) Will the CFPA be effective? What will it take for it to be effective? What is the most important issue that the CFPA needs to tackle?
3) Are government bonds safer than corporate bonds? Should they be exempt from the Volcker rule?