For America’s financial institutions, 2008 should have signaled the end of the deregulatory era. Beginning in the 1980s, firms were allowed to operate with increasingly less oversight from federal regulators as many of the laws that governed how banks could merge, compete, account, and trade were either crippled or outright repealed. The prevailing logic was that financial markets had evolved to a level of sophistication that government intervention was a disruptive intrusion into an otherwise functioning system. It was believed that major financial panics like the Depression of the 1930s could be avoided completely, a view seemingly validated by the rapid economic prosperity witnessed between 1989 and 2007. But in 2008, a sudden decline in demand for, and the price of, residential homes sparked a rapid depreciation in the value of several classes of securitized mortgage derivatives, held and traded by every major financial institution in the country. Hundreds of trillions of dollars worth of derivative contracts went from liquid assets to toxic debt overnight, prompting a wholesale retreat from said “mortgage backed securities” and bank stocks and panicked investors scrambled to move their money from banks holding “toxic assets.” In a few short weeks, markets erased their gains of the previous seven years, as the rupturing housing bubble sent America into its deepest recession in over 80 years.
In the 1930s, the onset of the Depression prompted lawmakers in Congress to reevaluate the government’s role in regulating the financial industry due to the scope and severity of the crisis. It stood to reason that the 2008 crisis would bear similar fruit, with Congress restoring the old laws to their former selves and writing new ones to handle the more complex transactions banks had conducted amongst themselves. What the American people received in exchange for nearly 1.4 trillion dollars of their tax dollars is at best a dog and pony show.The severity of the 2008 financial crisis should have prompted Congressional lawmakers to turn back the deregulatory tide that established and enabled many of the recession’s primary factors. Instead, the policy response from Washington resulted in a piece of legislation that fails to truly address foundational weaknesses in the US financial system.
Taming the Toros and Protecting the Toreadores
By 2010, the American financial system had been pushed back from the precipice of collapse. Two successive bailouts, in 2008 and 2009, plus two rounds of “quantitative easing” from the Federal Reserve had managed to recapitalize ailing banks and non-bank financial companies to keep interbank lending afloat and credit markets out of the deep freeze. However, the misappropriation of bailout funds in 2008, along with the public outcry against continued financial assistance for firms on Wall Street demanded a response from the federal government. What came of it was a cumbersome piece of legislation called the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Dodd-Frank was enacted by Congress in response to the circumstances that caused the collapse of the housing bubble and its recession in 2008. Its primary purpose is to safeguard the American financial system against systemic risk, and attempts to achieve this aim by impacting a variety of financial institutions, transactions, securities, and financial actors. It’s also intended to streamline the process of regulation for federal regulators by setting guidelines for the regulation of several types of over-the-counter derivative contracts and either eliminating or merging regulatory agencies together. To understand its provisions, its easiest to divide them by the rules they create for financial markets, federal regulators, and enforcing consumer protection.
New Rules for the Financial Sector
- Title II – Sets guidelines to simplify how federal regulators resolve a finanicial institution entering bankruptcy (specifically those that hold FDIC or SIPC insured deposits) and whose assets are being liquidated. It also defines which regulatory authority will oversee the procedure between the Federal Reserve, SEC, and the Federal Insurance Office.
- Title III – Increases the FDIC deposit insurance threshold from $100,000 to $250,000 per depositor.
- Title IV – Establishes new rules requiring hedge fund advisers and managers to disclose more information to potential clients before they invest in the fund and increases the level of reporting necessary.
- Title VI – Makes legal the “Volcker Rule” intended to limit proprietary trading (where a bank’s deposits are used to trade on its own accounts to produce profit) and reduce how much risk financial institutions can have on their balance sheets. It also introduces rules on how banks can invest in hedge funds and other speculative investments.
- Title VII – Introduces guidelines for regulating over-the-counter derivative markets and specific classes of derivative instruments including credit default swaps and credit derivatives. Additionally, there is to be no federal financial assisatnace to any entity that trades with any class or type of swap.
- Title IX – Provides definitions for “asset backed securities” and further outlines what CMO, CDO, CBO, CDO-ABS, and CDO-CDO’s are. Defines new role for financial entities that securitize these products and how these entities can invest in, and sell the instruments they create. Mandates that securitizers have partial vested interest in the credit risk posed by the derivatives. This title also includes new rules for executive compensation requiring a shareholder vote to approve the compensation of an executive at least once every 3 years and another vote once every six years to increase the frequency of compensation approval votes. Allows for shareholders to disaprove any “golden parachute” compensation an executive might receive and shareholders must be made aware of any relationship between what an executive receives and the issuing firm. Companies are required to let shareholders know if any employee or member of the board of directors is allowed to purchase securities that are designed to hedge or mitigate risk found in assets that are included in a compensation package.
- Title XIII – Lowers the ceiling of funds available from the Troubled Asset Relief Program from $700 Billion to $475 Billion.
- Title XIV – Establishes a framework for determining the original holder of a given mortgage loan contract by creating a legal definition for a “residential mortgage originator”. Law requires mortgage originators to include something that uniqely identifies them on all loan documents and prevents mortgage originators from receiving compensation based on anything other than the amount of money borrowed for the mortgage. Mortgage originators have to verify a borrower’s ability to pay and a violation of this standard can be used by borrowers as a legal defense against forclosure. This title founds new undwerwritings standards for residential loans.
New Powers Granted to Federal Regulators
- Title I – Creates the Financial Stability Oversight Council and the Office of Financial Research as new arms of the Treasury Department tasked with: monitoring and investigating financial markets for “systemic risk,” drafting and promoting new standards for market discipline, and to respond to threats of systemic risk in order to protect the US financial system.
- Title III – Removes the Office of Thrift Supervision and relegates its powers to other federal regulatory bodies. Its powers to regulate bank holding companies move to the Federal Reserve, its powers to monitor state savings associations move to the FDIC and its authority over other thrifts move to the Office of the Comptroller of the Currency.
- Title V – Creates the Federal Insurance Office, charged with monitoring the insurance industry in the United States and abroad. It does not have authority over healthcare and crop insurance. The title also awards the FIO with authority to monitor and create rules for state-based nonadmitted insurance (insurance that can be sold by an insurance company and/or agent that does not have a license to do so in a given state) and reinsurance (insurance purchased by one insurance company from another insurance company).
- Title VII – Grants the CFTC and SEC the power to create and enforce rules governing over-the-counter derivatives and repeals an exemption for “security based” swaps from the Gramm-Leach-Bliley Act of 1999.
- Title VIII – Implores the Federal Reserve to create uniform risk management standards for financial institutions deemed “systemically important” by providing the Fed with a greater role in supervising the risk management techniques used by ‘systemically important’ firms.
- Title IX – Creates the Office of the Investor Advocate, an advisory committee for investors designed to offset the influence of special interests within agencies like the SEC who monitor and regulate the securities industry. The SEC is authorized to create “point of sale” disclosure policies that are given to investors who purchase investment products or services. The disclosures should detail the costs, risks, and any conflicts of interest. The SEC is allowed to establish standards of “fiduciary duty” (the ethically highest standard of care) for broker-dealers in regards to their client. The SEC can offer a reward and protections for whistleblowers who come forward about misdealings at their firms. Title IX also sets guidelines for the regulation of Credit Rating Agencies:requiring improved internal controls on their governing structure, creating the Office of Credit Ratings to oversee the regulatory process, and allows federal regulatory to temporary or permanently suspend a rating’s agencies registration if the entity is found in violation of federal statues. Lastly this Title gives regulators authority over certified public accounting firms.
- Title XI – This title requires new regulatory standards from the Federal Reserve System including: capital requirements, limits on leverage (the ratio of a financial institution’s debt and its valuable assets), liquidity requirements, risk management, credit exposure and portfolio diversity. The Federal Reserve must also draft plans for the orderly bankruptcy of a financial institution, and draft reports that detail one financial firm’s exposure to another
New Rules for Consumer Protection
- Title X – Creates the Bureau of Consumer Financial Protection in charge of regulating consumer financial products and services.
Granted the law does have its fair share of high points. It allows the SEC and CFTC the authority to create and enforce rules governing asset-backed securities, credit-default swaps, and other classes of over-the-counter derivatives, which played a significant role in the onset of the housing crisis. The law gives guidlines on which regulatory authorities have oversight authority given the situation, and provides a framework for the creation of rules for different institution and product types. It’s largely successful in improving transparency on transactions that occur between institutions and clients by enacting more stringent accounting and reporting standards, requiring increased disclosure before a transaction is entered into, and mandating that more complex derivatives be traded on public exchanges or clearinghouses. Additionally, Dodd-Frank does much to address the unscrupulous (and often predatory) actions of the mortgage lending and servicing industries, requiring new minimum acceptable standards for loans and loan applicants. But even with its broad scope, Dodd-Frank fails to address several factors that were key components of the housing meltdown: the rise of institutions “Too Big To Fail,” the ability of investors to short sell a stock into free fall, and the usage of Special Purpose Vehicles as shelters for illquid assets.
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