Financial Reform Bill, Part 6

Posted in Financial Markets, Politics and Policy at 10:24 pm

In this post I’ll address Section 6, entitled, “Protects Investors”.

From the summary:

Provides tough new rules for transparency and accountability for credit rating agencies to protect investors and businesses.

Here are the specifics:

Fiduciary Duty: Gives SEC the authority to impose a fiduciary duty on brokers who give investment advice – the advice must be in the best interest of their customers.

I thought I read that applying the “fiduciary duty” standards of Financial Advisers to Brokers was removed in the latest round. Perhaps that was misreporting in the media – it appears Congress is simply punting on this issue by giving the authority to do this to the SEC and letting them decide.

Encouraging Whistleblowers: Creates a program within the SEC to encourage people to report securities violations, creating rewards of up to 30% of funds recovered for information provided.

Well intentioned, but it’s not hard to see how this one could have negative unintended consequences.

SEC Management Reform: Mandates a comprehensive outside consultant study of the SEC, an annual assessment of the SEC’s internal supervisory controls and GAO review of SEC management.

A good proposal. We should do this with every government agency.

New Advocates for Investors: Creates the Investment Advisory Committee, a committee of investors to advise the SEC on its regulatory priorities and practices; the Office of Investor Advocate in the SEC, to identify areas where investors have significant problems dealing with the SEC and provide them assistance; and an ombudsman to handle investor complaints.

Odd. This is the core mission of the SEC. Establishing a committee within the SEC to advocate for its core mission seems to me to indicate management dysfunction within the organization.

SEC Funding: Provides more resources to the chronically underfunded agency to carry out its new duties.

That one is a no-brainer. The SEC is in dire need of additional funding, however, there ought to also be some performance targets associated with receiving it.


Reducing Risks Posed by Securities

Skin in the Game: Requires companies that sell products like mortgage-backed securities to retain at least 5% of the credit risk, unless the underlying loans meet standards that reduce riskiness. That way if the investment doesn’t pan out, the company that packaged and sold the investment would lose out right along with the people they sold it to.

This one sounds good in theory, but in reality, a major reason why banks found themselves in trouble was that they retained too much exposure to the securitized products, both directly on balance sheet and indirectly through SIVs and such, as opposed to too little exposure.

If anything, it was the mortgage brokers, rather than the banks, who should have been made to have more skin in the game to properly align incentives.

Better Disclosure: Requires issuers to disclose more information about the underlying assets and to analyze the quality of the underlying assets.

A good provision. It remains to be seen whether this will take the form of aggregate statistics – LTVs, FICO scores, DTIs, etc. at the portfolio level, or whether it will require loan level detail.


Better Oversight of Municipal Securities Industry

Registers Municipal Advisors: Requires registration of municipal advisors and subjects them rules written by the MSRB and enforced by the SEC.

Puts Investors First on the MSRB Board: Ensures that at all times, the MSRB must have a majority of independent members, to ensure that the public interest is better protected in the regulation of municipal securities.

Fiduciary Duty: Imposes a fiduciary duty on advisors to ensure that they adhere to the highest standard of care when advising municipal issuers.

All good ideas in theory. In practice, I can’t help but wonder how this would have altered behavior with regard to the Auction Rate Securities debacle. Again, devil is in the details.

Overall, I’m neutral on this section – some decent ideas, some potentially bad ideas (risk retention of securitization for banks), but mostly the same approach as the rest of the bill – establish committees to make recommendations along with vague expansions of authority.

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