Financial Reform Bill, Part 8

Posted in Financial Markets, Politics and Policy at 6:45 am

This post will be the last in the series. After looking through the original document, there appeared to be a number of provisions that floated outside of the section headings. I’ll address each of them here:


At federal banking and securities regulatory agencies, the bill establishes an Office of Minority and Women Inclusion that will, among other things, address employment and contracting diversity matters. The offices will coordinate technical assistance to minority-owned and women-owned businesses and seek diversity in the workforce of the regulators.

I’m not really sure why this is in here. I would have imagined this would apply to all federal agencies, but if not, it’s not something that should apply only to financial regulatory bodies.


Require Lenders Ensure a Borrower’s Ability to Repay: Establishes a simple federal standard for all home loans: institutions must ensure that borrowers can repay the loans they are sold.

Oh come on. We really need to elevate the level of public discourse a few nothches above kindergarten.

Prohibit Unfair Lending Practices: Prohibits the financial incentives for subprime loans that encourage lenders to steer borrowers into more costly loans, including the bonuses known as “yield spread premiums” that lenders pay to brokers to inflate the cost of loans. Prohibits pre-payment penalties that trapped so many borrowers into unaffordable loans.

Ok, but almost all of these problems could be avoided by simply shopping around.

Penalties for Irresponsible Lending: Lenders and mortgage brokers who don’t comply with new standards will be held accountable by consumers for as high as three-year’s interest payments and damages plus attorney’s fees (if any). Protects borrowers against foreclosure for violations of these standards.

Well, that certainly puts some teeth into the regulations.

Expands Consumer Protections for High-Cost Mortgages: Expands the protections available under federal rules on high-cost loans — lowering the interest rate and the points and fee triggers that define high cost loans.

I looked this one up, and a high cost mortgage is defined as one where:

  • The APR at consummation will exceed by more than 10 percentage points the yield on Treasury securities having comparable periods of maturity to the loan maturity; or, 
  • The total “points and fees” payable by the consumer at or before loan closing will exceed the greater of 8% of the loan amount or $400.

Meeting wither of these criteria triggers a raft of additional regulation, including additional disclosures as well as the prohibition of “balloon payments, negative amortization, advance payments, an increase in the interest rate after default, the rule of 78s in calculating prepayments, or a prepayment penalty except under certain conditions”.

The new legislation simply lowers the threshold for triggering this.

Additional Disclosures for Consumers on Mortgages: Lenders must disclose the maximum a consumer could pay on a variable rate mortgage, with a warning that payments will vary based on interest rate changes.

This is good. Too many home buyers jumped into ARMs without really understanding the risks. Of course, it didn’t help to have the Chairman of the Federal Reserve encouraging it as a rational way to save on interest.

Housing Counseling: Establishes an Office of Housing Counseling within HUD to boost homeownership and rental housing counseling.

Fine, so long as the counseling doesn’t always focus on helping prospective home buyers figure out ways to buy houses they canot affors. For some people, the advice simply has to be “keep renting for awhile, you’re not ready to buy a house, and you’ll be worse off if you do”.


Raising Standards and Regulating Hedge Funds

Fills Regulatory Gaps: Ends the “shadow” financial system by requiring hedge funds and private equity advisors to register with the SEC as investment advisers and provide information about their trades and portfolios necessary to assess systemic risk. This data will be shared with the systemic risk regulator and the SEC will report to Congress annually on how it uses this data to protect investors and market integrity.

Registration of Hedge Funds is a good idea. It does not, however, “end the shadow financial system”.

Greater State Supervision: Raises the assets threshold for federal regulation of investment advisers from $30 million to $100 million, a move expected to significantly increase the number of advisors under state supervision. States have proven to be strong regulators in this area and subjecting more entities to state supervision will allow the SEC to focus its resources on newly registered hedge funds.

I’m not sure I buy the argument that “states have proven to be strong regulators in this area” and so we should raise the threshold for federal regulation.

Might this cause some additional “regulator shopping” and encourage hedge funds with under $100 million in assets seek to relocate themselves in states with weak regulation? I don’t know, but it seems likely.


New Requirements and Oversight of Credit Rating Agencies

New Office, New Focus at SEC: Creates an Office of Credit Ratings at the SEC with expertise and its own compliance staff and the authority to fine agencies. The SEC is required to examine Nationally Recognized Statistical Ratings Organizations at least once a year and make key findings public.

Disclosure: Requires Nationally Recognized Statistical Ratings Organizations to disclose their methodologies, their use of third parties for due diligence efforts, and their ratings track record.

Independent Information: Requires agencies to consider information in their ratings that comes to their attention from a source other than the organizations being rated if they find it credible.

Conflicts of Interest: Prohibits compliance officers from working on ratings, methodologies, or sales; installs a new requirement for NRSROs to conduct a one-year look-back review when an NRSRO employee goes to work for an obligor or underwriter of a security or money market instrument subject to a rating by that NRSRO; and mandates that a report to the SEC when certain employees of the NRSRO go to work for an entity that the NRSRO has rated in the previous twelve months.

This is all fine and well, but it does not address the fundamental conflict inherent in having the security issuers pay for credit ratings on the securities they issue.

Liability: Investors can bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source. NRSROs will now be subject to “expert liability” with the nullification of Rule 436(g) which provides an exemption for credit ratings provided by NRSROs from being considered a part of the registration statement.

Right to Deregister: Gives the SEC the authority to deregister an agency for providing bad ratings over time.

These two provisions have the potential to do a lot of good. The threat of being sued for providing bad ratings, and having your firm deregistered for consistently doing it is a fantastic incentive. It remains to be seen how the courts will rule in these suits, and how willing the SEC will be to deregister repeat offenders, however.

Education: Requires ratings analysts to pass qualifying exams and have continuing education.

This is a good provision.

Eliminates Many Statutory and Regulatory Requirements to Use NRSRO Ratings: Reduces over-reliance on ratings and encourages investors to conduct their own analysis.

A big step in the right direction. We should eliminate all federally mandated use of credit rating agencies.

Independent Boards: Requires at least half the members of NRSRO boards to be independent, with no financial stake in credit ratings.

This one seems too obvious to even be mentioned. I’m surprised these sorts of conflicts are allowed today.

Ends Shopping for Ratings: The SEC shall create a new mechanism to prevent issuers of asset backed-securities from picking the agency they think will give the highest rating, after conducting a study and after submission of the report to Congress.

Easier said than done, unless you either eliminate buyer pays entirely or have the government simply assign ratings agencies to securities issuers.


Volcker Rule Implemented a strengthened version of the Volcker rule by not allowing a study of the issue to undermine the prohibition on proprietary trading and investing a banking entity’s own money in hedge funds, with a de minimis exception for funds where the investors require some “skin in the game” by the investment advisor up to 3% of tier 1 capital in the aggregate

Covered previously.

Can someone tell me what pressing social value there is in allowing banks to invest in hedge funds?

The investors should not have the power to require some “skin in the game” by the investment advisor. The entire idea is absurd.

I have long been in favor of an updated Glass-Steagall. In fact, I would go so far as to prevent both commercial banks and investment banks, under an updated Glass-Steagall, from having anything to do with hedge funds. By this, I mean ban hedge funds from taking loans from commercial banks or raising funds in the public capital markets. Ban them from engaging in repo transactions as well. If they want to gamble, let them, but restrict them to gambling solely with their owners’ equity.

Abolishes the Office of Thrift Supervision: Shuts down this dysfunctional regulator and transfers authorities mainly to the Office of the Comptroller of the Currency, but preserves the thrift charter.

Makes sense.

Remember this:


Stronger lending limits: Adds credit exposure from derivative transactions to banks’ lending limits. .

Ok, but how is this exposure to be calculated?

Improves supervision of holding company subsidiaries: Requires the Federal Reserve to examine non-bank subsidiaries that are engaged in activities that the subsidiary bank can do (e.g. mortgage lending) on the same schedule and in the same manner as bank exams, gives the primary federal bank regulator backup authority if that does not occur.

Makes sense.

Intermediate Holding Companies: Allows use of intermediate holding companies by commercial firms that control grandfathered unitary thrift holding companies to better regulate the financial activities, but not the commercial activities.

I need to research this one further. I don’t like the idea of commercial firms owning banks, and I especially don’t like the idea of holding company structures that obfuscate the relationship, which is what this sounds like.

Interest on business checking:Repeals the prohibition on banks paying interest on demand deposits.

Wait, what? I thought Regulation Q was done away with 20 years ago.

Charter Conversions: Removes a regulatory arbitrage opportunity by prohibiting a bank from converting its charter (unless both the old regulator and new regulator do not object) in order to get out from under an enforcement action.

Another obvious one that leaves anyone with a pulse boggled at how this could have been allowed previously.

Establishes New Offices of Minority and Women at the federal financial agencies

Covered previously.


Federal Insurance Office: Creates the first ever office in the Federal government focused on insurance. The Office, as established in the Treasury, will gather information about the insurance industry, including access to affordable insurance products by minorities, low- and moderate- income persons and underserved communities. The Office will also monitor the insurance industry for systemic risk purposes.

International Presence: The Office will serve as a uniform, national voice on insurance matters for the United States on the international stage.

Streamlines regulation of surplus lines insurance and reinsurance through state-based reforms.

A step in the right direction. It was always unsettling how a company with the size and reach of AIG could have been regulated by a sleepy old state insurance office, outside the oversight of the federal government.


Protects Small Businesses from Unreasonable Fees: Requires Federal Reserve to issue rules to ensure that fees charged to merchants by credit card companies for credit or debit card transactions are reasonable and proportional to the cost of processing those transactions.

Neutral on this one. I’m not sure the Federal Reserve is best equipped to deal with this. It seems to me it’s more a question of the use of monopoly power, in which case the FTC should have jurisdiction from an antitrust perspective.


Monitor Personal Financial Rating: Allows consumers free access to their credit score if their score negatively affects them in a financial transaction or a hiring decision. Gives consumers access to credit score disclosures as part of an adverse action and risk-based pricing notice.

A step in the right direction, albeit a small one.

As someone who has personally suffered harm from incorrect information on my credit report, and having had to exhaust an inordinate amount of time and effort to get it rectified, I’d prefer to see a provision allowing consumers to sue credit reporting agencies for failing to remove erroneous information in a timely manner.


For Investors

Public Disclosure: Requires public disclosure to the SEC payments made to the U.S. government relating to the commercial development of oil, natural gas, and minerals on federal land.

SEC Filing Disclosure: The SEC must require those engaged in the commercial development of oil, natural gas, or minerals to include information about payments they or their subsidiaries, partners or affiliates have made to a foreign government for such development in their annual reports and post this information online.

Congo Conflict Minerals:

Manufacturers Disclosure: Requires those who file with the SEC and use minerals originating in the Democratic Republic of Congo in manufacturing disclose measures taken to exercise due diligence on the source and chain of custody of the materials and the products manufactured.

Illicit Minerals Trade Strategy: Requires the State Department to submit a strategy to address the illicit minerals trade in the region and a map to address links between conflict minerals and armed groups and establish a baseline against which to judge effectiveness.

I’m not an oil/gas/minerals person, but more disclosure is generally a good thing.

Deposit Insurance Reforms: Permanent increase in deposit insurance for banks, thrifts and credit unions to $250,000, retroactive to January 1, 2008.

This makes sense, given how long its been since the $100k limit was established.

One could argue that premiums charged banks by the FDIC should be raised substantially, perhaps even by a factor of 2.5%, in exchange for the increased insuranc eprovided. If banks pass the costs on to the consumer through higher fees or lower interest rates, that’s a good thing. Insuring deposits is a valuable service, it exposes the government to some risk, and depositors rather than taxpayers ought to be paying for that.

Restricts US Funds for Foreign Governments: Requires the Administration to evaluate proposed loans by institutions such as the IMF or World Bank to a middle-income country if that country’s public debt exceeds its annual Gross Domestic Product, and oppose loans unlikely to be repaid.

Interesting. I’m not sure how the US, as a member of the IMF and World Bank, can unilaterally make this sort of decision without running afoul of the agreements we made when joining these organizations. It’s pretty obvious this provision was added as a response to the recent sovereign debt problems in parts of the EU.

Here are my thoughts on the overall legislation. Like any sweeping legislation it contains good provisions, mediocre provisions, and bad provisions. Taken as a whole, it’s unquestionably better than doing nothing. My two biggest concerns are:

1. The overall approach of the legislation is to establish new regulatory agencies, shuffle around existing agencies, and then assign broad, but vague responsibilities to the agencies in the new structure. There is also quite a bit of establishing committees to conduct studies and make recommendations that may or may not be addressed in the future. The legislation itself continuously shies away from actually implementing changes.

2. At least from what I have seen, the legislation does nothing to address the shadow banking system. During the crisis, the FDIC had to step in and provide deposit insurance to money market funds. That was a monumental decision with far-reaching implications. Where is the regulation of money market funds in this legislation? Where is the regulation of repos? Where is the regulation of the commercial paper market? Where is the regulation of hedge funds, beyond requiring the largest ones to register with the SEC? In other words, where is there at least an attempt to bring the shadow banking system out of the shadows, and prevent another run on it from occuring?

For the above two reasons, if I had to grade the financial reform legislation, I’d give it a C-.


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    07.18.10 at 8:10 am

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