A Summary of the Restoring American Financial Stability Act and the Wall Street Transparency and Accountability Act of 2010.
By: Jordan Young
In part two of our three-part Financial Reform 101 series, we'll be summarizing the actual language of the Senate financial regulatory reform legislation. These two bills have been proposed by the Senate Committee on Banking, Housing, and Urban Affairs and the Committee on Agriculture, Nutrition, and Forestry, respectively.
For simplicity's sake, we'll refer to the Restoring American Financial Stability Act as the Dodd bill, after primary author Senator Chris Dodd, and the Wall Street Transparency and Accountability Act as the Lincoln bill, after Senator Blanche Lincoln. The Dodd bill is comprehensive, containing sections designed to address a variety of different areas needing reform, whereas the Lincoln bill contains only language pertaining to derivatives regulation. Because Ag (Senate Committee on Agriculture) has primary jurisdiction over derivatives, Dodd only wrote place-holder language in his bill's derivative section so we'll just focus on Lincoln's language during the corresponding section below. All other section will be summaries of the Dodd bill.
Consumer Financial Protection
The Dodd bill creates a new Consumer Financial Protection Bureau (CFPB) charged with protecting consumers from unfair, deceptive, and abusive financial products and practices. It also aims to provide Americans with clear, easy-to-understand information on loans, credit card contracts, mortgages, and other financial products.
The need for such a watchdog existed long before the recent crisis, but advocates argue the bureau could have drawn attention to the initial catalyst for the crisis, the selling of subprime mortgages, by both providing individuals with clearer information on what they're being sold and monitoring the system-wide trends that can lead to major destruction. One of the many problems with our current system of regulation is the conflicting interests of many regulators. There is no agency primarily charged with looking out for the consumer right now, in fact those responsibilities are currently handled by the Office of the Comptroller of the Currency, Office of Thrift Supervision, Federal Deposit Insurance Corporation, Federal Reserve, National Credit Union Administration, the Department of Housing and Urban Development, and Federal Trade Commission. With so many agencies sharing authority it is difficult to hold anyone accountable for a failure.
Additionally, when a new unfair or abusive product or service is discovered, it often takes months or years for Congress to act. The CFPB would be able to act quickly without the drawn-out and politically-charged legislative process of Congress.
The original proposal for consumer financial protection would have created a new stand-alone agency much like the Environmental Protection Agency. After some strong statements of opposition from Republicans and centrist Democrats, Dodd decided to shift the agency into a bureau of the Federal Reserve. The change created some backlash from the left, but I would argue that there are really a list of four specific qualifications for a worthwhile consumer financial protection effort. Whether housed in another entity or on its own, these qualification are the criteria we should use to judge the effectiveness of a proposal.
Elizabeth Warren, the Harvard economist who has become the chief advocate for consumer financial protection, has listed the following as the criteria for an effective regulator: 1) an independent director appointed by the President and confirmed by the Senate; 2) independent budget authority so it is not prone to the whims of the appropriation process; 3) independent rule-making authority; and 4) independent enforcement powers. A close reading of the Dodd bill shows that the proposed bureau largely meets these tests and Elizabeth Warren has cautiously praised the language.
However, one area of concern with the language as currently proposed is the veto power given to the Financial Stability Oversight Council, which could overrule the CFPB if two-thirds of its members find that the Bureau's actions increase systemic risk.
Here's a point-by-point summary of the Consumer Financial Protection Bureau:
- Headed by an independent director appointed by the President and confirmed by the Senate;
- Has a dedicated budget paid by the Federal Reserve Board;
- Has autonomous rule-writing authority for consumer protections;
- Has oversight authority over banks, credit unions, mortgage-related businesses, payday lenders, debt collectors, etc; and,
- Takes over and consolidates consumer protection responsibilities currently held by seven separate agencies.
The section also:
- Creates a new Office of Financial Literacy to educate consumers; and,
- Creates a national consumer complaint hotline.
Derivatives
The Lincoln bill creates a strong new system of derivatives regulations. In the current market, derivatives are often traded over-the-counter (OTC) with almost no regulation or transparency. In most cases the only individuals who know of the derivative's existence are the buyer and the seller. Many policy analysts agree that a two-pronged approach to the derivatives market is necessary.
First, to address systemic risk, clearinghouses are needed to provide an additional, uninvolved participant in the trade. A clearinghouse is an institution that acts as the opposite legal party for all derivative contracts, sort of like a middle man. This new middle man is structured to regulate, monitor, and guarantee the trades it facilitates, insuring that both participants post the necessary collateral for their trade and that both parties can pay in the event they lose the bet.
Second, to address the lack of transparency, exchanges are needed. It is said that sunshine is the ultimate disinfectant, and the exchange shines light on both an individual trade and the market as a whole by creating price transparency. Any interested party can see the price being offered. The high-resolution audit trail created gives managers and regulators something to monitor and investigate, allowing them to see problematic trends in the market.
The Lincoln bill creates well-regulated versions of both.
It also:
- Charges regulators with closing any and all loopholes they find in the system as they develop;
- Requires banks to spin off swaps desks if they are protected by federal deposit insurance or access the Federal Reserve discount window;
- Exempts commercial end users from mandatory clearing while prohibiting financial entities from opting out;
- Bans federal assistance, including federal deposit insurance and access to the Federal Reserve discount window, to swaps entities in connection with their trading in swaps or securities-based swaps; and,
- Allows the Commodity Futures Trading Commission, which overseas the futures markets, to impose position limits on swaps that perform or affect a significant price discovery function in the market.
Systemic Risk
The Dodd bill creates a new Financial Stability Oversight Council (FSOC). The FSOC is charged with identifying systemic risks posed by large, complex institutions as well as practices within those firms that pose risk to the firm. It will "make recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with significant requirements on companies that pose risks to the financial system."
This Resolution Authority is extremely necessary to detect systemic risks and deter companies from risky endeavors, but many analysts would prefer the bill set hard limits on leverage and capitol requirements.
The FSOC will be chaired by the Secretary of the Treasury with nine members representing the Consumer Financial Protection Bureau, Federal Reserve, Securities & Exchange Commission, Office of the Comptroller of the Currency, Commodity Futures Trading Commission, Federal Housing Finance Agency, Federal Deposit Insurance Corporation, and an independent member. The Council is designed to encourage communication and information-sharing among regulators who proved too internalized in the recent crisis.
The FSOC also:
- Has authority to require regulation of nonbank financial institutions by the Federal Reserve if its complexity or size threatens systemic stability;
- Has approval authority to require a large financial institutions to divest some of its holding if it poses a risk;
- Creates a new Office of Financial Research within Treasury to be staffed with economists, accountants, lawyers, former supervisors, and other specialists to support the council’s work by collecting financial data and conducting economic analysis; and,
- Submits annual reports to Congress on the collection and analysis of data to monitor emerging risks.
Too Big to Fail
The Dodd bill responds to the Too Big to Fail problem created by the repeal of Glass-Steagall through the following provisions:
- Charges the FSOC with possible implementation of the Volcker Rule, which requires regulators to implement regulations for banks, their affiliates and holding companies, to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit relationships with hedge funds and private equity funds;
- Requires large institutions to periodically submit Funeral Plans, which are plans for how to conduct a quick and orderly shutdown should the institution fail; the plans will also provide regulators with an understanding of the structure of the organization;
- Creates a new liquidation procedure to unwind significant financial institutions; and,
- Creates a $50 billion pool funded by the largest institutions to be used to liquidate the institutions if needed. This pool reduces the likelihood that taxpayers will have to provide a future bailout.
Other regulations from Glass-Steagall are also reinstituted including language to discourage the excessive growth and complexity of the system, regulation towards liquidity provisioning, and reforms of the credit ratings agencies to bring new transparency and competition.
Improved Regulation and General System Reforms
- Requires large hedge funds to register with the SEC and disclose financial data. No regulator currently has jurisdiction or authority over hedge funds.
- Institutes efforts to strengthen and improve the competence of the SEC, including annual assessments and independent funding so the SEC isn't subject to the Congressional appropriations process.
- Draws clear lines of responsibility among regulators by streamlining the responsibilities of the FDIC, OCC, and Federal Reserve.
- Requires companies that create securities to retain a portion of the risk to discourage the sale of garbage and to disclose information about the reference asset.
- Strengthens the Federal Reserve while providing new transparency, such as audits of emergency lending facilities.
- Disallows any entity supervised by the Federal Reserve Board from voting for directors of the Federal Reserve Bank, and their past or present officers, directors, and employees cannot serve as directors. Currently the member banks elect directors, who choose the Federal Reserve Board president.
- Requires the president of the New York Federal Reserve Bank be appointed by the President with the approval of the Senate rather than election by the member banks the NY Fed is charged with overseeing.
- Establishes an Office of Credit Rating Agencies at the SEC and requires it to examine the agencies rating methodology and track record, and publicly disclose the findings annually.
- Gives all corporations' shareholders the right to a non-binding vote on executive compensation.
Conclusion
The Dodd and Lincoln bills are strong in many areas and provide a reasonable and comprehensive system of regulations and reforms to prevent future crises and abusive practices. From a policy perspective, I'm generally pleased with the language, but as the process is ongoing and there are further opportunities for amendment, I would submit the following as a list of ways to improve the language further:
- Set hard limits on leverage ratios within the bill to act as a floor for the FSOC's decisions.
- Institute the Volcker Rule outright, rather than leaving the decision up to the FSOC.
- Provide the CFPB with rule-writing authority over auto-lenders.
We hope this summary has been helpful. Please join us for the final installment of this series on the political process for passing financial regulatory reform. As always, questions and discussion are welcomed in the comments section.
Inside the Meltdown That Woke Us Up to How Necessary Reform Is.
By: Jordan Young
In part one of our Financial Reform 101 series, we'll be looking at what actually happened on Wall Street and how this crisis was caused. I've made every effort to make this understandable, but realize that many people believe Wall Street insiders intentionally embrace complicated definitions and endless lingo foreign to outsiders precisely so normal Americans can't understand the system. I encourage you to ask questions in the comments section if any of the following confuses you.
I would also point out at the outset that this is not an exhaustive explanation and there were certainly other contributing factors to the crisis. I would argue, however, that the circumstances detailed below were the main causes and provide the general picture of the problem we need to fix.
I also apologize for the length of these posts. I hope they're worth the time I put into writing them.
Abusive Lending Practices
For nearly thirty years leading up to the crisis, Wall Street had been embracing riskier and more speculative practices to make more and more money in shorter and shorter periods of time. This mindset led some of our smartest financial insiders to become more and more entrepreneurial in their schemes, and, as we'll see below, to suspend their intellect in favor of more and more ridiculous get-rich schemes.
The heart of the crisis was really born from a wave of abusive lending practices. At the beginning of the 2000s, lenders began approving more and more loans to lower-income Americans. Seeking out the poor and minorities in huge numbers, they offered them mortgages on homes they couldn't afford. These lenders originally claimed altruism as their motivator, asserting they were simply helping more people achieve the American dream. No matter that these people were living entirely on credit and couldn't possibly afford the mortgage they were being offered after the initial teaser-rate wore off. From the lenders perspective, this simply meant they'd be able to keep people in debt in perpetuity, encouraging a cycle of refinancing: endlessly paying interest, and never fully paying off their mortgages. Even more troubling, if the lenders could make the original loan and then sell it to someone else, they didn't even need to care whether the loan was repaid. They could simply pass the risk off to someone else.
The next step on the road to crisis was to allow Wall Street to get in on the game. Lenders would proceed to sell these mortgages to institutions, which would bundle them together into bonds and sell them to Wall Street firms.
Gramm-Leach-Bliley and the Beginnings of the Speculation Craze
In 1932, Congress approved the Glass-Steagall Act as part of FDR's response to the Great Depression. Glass-Steagall had separated depository banks (which took your money and kept it for you) and investment banks (which used money to invest in different efforts in hopes of making money). The idea had been simple: it was too risky to allow a bank to use the money its depositors had entrusted to it to invest in risky schemes where that money might be lost. And since Congress had created the Federal Deposit Insurance Corporation (FDIC) in the same piece of legislation, which pledged to protect depositors money with funds from the U.S. Treasury, such a concept didn't seem like too much for which to ask.
After more than six decades though, Wall Street saw Glass-Steagall as an unnecessary and annoying stumbling block to making a lot more money. So, they successfully lobbied Congress to repeal much of it in 1999, in a piece of legislation known as the Gramm-Leach-Bliley Act. Wall Street exploded with action, creating new institutions like Citigroup to put their depository and investments arms under the same roof.
In the 80's and 90's, Wall Street had discovered they could basically speculate, or place bets, on just about anything. You simply needed a person or institution with money on both sides. One guy bets Microsoft stocks will increase by at least 30% within two years, and another bets they will not. At the end of the two years, whichever guy was right pays the other. In order to do this, Wall Street had a concept called a security.
A security is a negotiable financial instrument representing some value. For the purposes of this crisis, the type we care most about is equity securitization. Examples of these include common stocks and derivatives contracts, such as futures and options. A futures contract requires the purchaser to buy or sell some item at a fixed price at some future date. An option gives the purchaser the right to do so if they so choose. For example, if I think the value of something is going to increase from $20 (where it is now) to $50 in six months, I might buy a futures contract on this item that requires me to buy fifty more of this item in seven months at the price of $25. This would allow me to buy more of these items, which would then cost $50, at half the price. If I'm wrong, and the price stays at $20, then I'm forced to buy more at a price of $25 each.
These derivatives contracts will be the main focus of the rest of this piece, since they provided the vehicle for the crisis.
Derivatives Trading and Sub-Prime Speculation
The name derivative is taken from the concept that the value of the item is derived from some underlying or "reference" security or commodity. For example, you could have a derivative in the form of a futures contract on the new iPad. The value of my contract to me is dependent on the underlying commodity, in this case the iPad.
Most derivatives are traded with almost no regulation and in private transactions which keep them from being seen by others. These derivatives are classified as Over the Counter (OTC), meaning there are no parties involved but the buyer and the seller. This means the person or institution selling the derivative can charge whatever they like without the buyer knowing for how much some other seller might offer it to them.
So a major new market began for derivatives based on sub-prime mortgage bonds, which acted as securities.
Now, Wall Street relies heavily on confidence. A giant firm like Goldman Sachs depends on the fact that other firms and individuals are confident it's a strong and solid firm. Without this, people stop trusting Goldman Sachs with their money, which causes more people to lose confidence, and on and on.
Inherent in every attempt to make money on Wall Street is the concept of risk. There is always some risk that my speculation will not work out the way I want it to. So a firm like Goldman Sachs, theoretically, needs to make sure it isn't exposed to so much risk that it causes people to lose confidence. To determine the risk of a particular deal, Wall Street employs ratings agencies like Moody's and Standard & Poor's. For the sake of avoiding confusion, we'll operate on S&P's rating system. The best possible rating something can receive is AAA. A commodity, security, or firm rated as AAA is considered highly reliable and stable, in fact, holding a security rated AAA is considered so safe, a firm doesn't even have to declare it as risk. There's little to no risk here. The system goes down gradually from AAA to AA, A, and BBB. Anything below BBB is considered "junk." BBB is sort of medium class risk.
The vast majority of major firms hold a AAA rating, meaning you should be able to trust them and they desperately want to keep that rating. Every transaction a firm does is rated based on its quality and risk. If you're trading U.S. Treasury bonds, those are rated at AAA. If Goldman Sachs were to take on $50 billion in BBB-rated bonds, their exposure to risk would shoot up dramatically. They would stand a reasonable chance of losing hundreds of billions of dollars.
The problem in the system is that the ratings agencies aren't omniscient. They're basically just guessing at the risk related to something. So when they were shown these sub-prime mortgage bonds the firms had taken on, they judged them to only be as risky as the recent housing market might suggest they were. Housing prices had been going up for a while and there was no reason to assume they wouldn't continue to go up forever (yes, this sounds ridiculous, but it's what they thought). So these bonds got tacked with fairly random ratings, many at AAA.
Sub-Prime Mortgage Bonds
The problem with using mortgages as securities is that at least some individuals will default on their mortgages, no matter how secure the original loan seemed to be. People lose jobs, they have catastrophic medical problems, they have unforeseeable life circumstances interrupt their plans, and so, they default. And sub-prime mortgages ran an even higher likelihood of that happening, whether or not the firms knew that at the time. In order to make these mortgages more stable, they were packaged together as bonds containing hundreds, sometimes thousands of different mortgages.
These mortgages were then piled up in a bond, which is sort of similar in this case to a tower. Each floor of this tower, known as a tranche, represented an individual loan. The tranches at the top were those that repaid the fastest. These received AAA ratings, but because they were thought to be low risk, they also paid the lowest rate of interest. This was for people looking for small amounts of sure money. The lower the tranche, the less likely the loan would ever be repaid and the higher the risk, all the way down to BBB-rated loans which carried a very high level of interest. These were for those willing to take a chance at making more money.
Individuals or institutions wanting to purchase these securities would get to choose in which tranche they were interested. People would make money every time a person made their mortgage payment. By the second quarter of 2005, the mortgage bond market was huge, larger than the market for U.S. Treasury notes and bonds. Largely because the repeal of Glass-Steagall meant firms which held billions of dollars of average Americans money were also engaging in these speculative practices and because the shadowy nature of the market itself meant that almost no one was even aware which firms were exposed to risk, the sub-prime mortgage market had silently placed footholds in almost every corner of the financial sector. The entire economy was now dependent on its stability, which was in turn dependent on the continued rise of housing prices. If housing prices fell, large numbers of people who were already teetering on the edge of the cliff and living on credit would fall off. They would suddenly be under water on their mortgages, owing more than their home was worth. It was already a recipe for disaster.
Collateralized Debt Obligations
Incredibly, Wall Street wasn't done. At this point it was decided that more money could be made if it weren't for the seemingly more risky BBB-rated tranches of the bonds (eventually it would become clear that almost all sub-prime mortgages carried an extreme level of risk, regardless of the rating awarded them; AAA and BBB would both default in near equal numbers). Thus was born the Collateralized Debt Obligation (CDO).
A CDO basically allowed a firm to take bottom tranches of a bond, the most risky, and repackage them together with the bottom tranches of other bonds as CDOs. Now CDOs were made up entirely of BBB-rated mortgages, but when they were submitted to the ratings agencies with a new sheen they were declared AAA simply because they had been packaged together. The firms then proceeded to sell off these new "risk-less" instruments just as they had done for the bonds themselves.
Now, this didn't mean that the bonds were pulled from their original home at the bottom of the bond. The firms basically copied the loans and made a new security out of thin air for people to trade. This meant that one person owned the original tranche and carried its risk, while another had an exact duplicate of that risk.
Credit Default Swaps
Now, a small number of individuals by this time had predicted the forthcoming crisis and had sought a means to bet against the market. While most of Wall Street was betting the bonds would continue to increase in value, a few bet the entire thing would collapse. To do this, they used a complicated type of insurance called a Credit Default Swap (CDS). The buyer would essentially short an entire bond, by buying insurance against its failing. And as each tranche of the bond defaulted, they would slowly get paid. At first, few took this bet; in fact, it wasn't until 2007 that major firms started to use CDSs to limit their risk by hedging their own bonds.
Like the market for mortgage-backed securities trading, the CDS market was shockingly secretive and was marked by a total lack of regulation or oversight. This allowed firms like AIG, Lehman Brothers, and Bear Sterns to take on billions and billions of dollars in risk. They were not only exposed to the initial risk that individuals wouldn't be able to pay back their loans, but they would owe an additional amount of insurance to a completely unrelated third party as well. Eventually, the type of derivative known as a CDS became much more dominated by those purchasing insurance on the failure of the firms themselves. A company like Merrill Lynch would take one look at a AAA-rated firm like AIG and offer extremely cheap insurance to just about anyone foolish enough to bet on its failure. Through this practice, the risk was spread even wider. The incredible interconnectedness of these firms would prove to be a major problem.
All Hell Breaks Loose
Eventually, all good things must come to an end, and so it was with the sub-prime mortgage craze. As we know, eventually the housing market stopped going up as waves of individuals defaulted on their loans. As more and more people defaulted, they brought the market down, causing further individuals to default, created a death-spiral that sent the entire market plummeting.
As this happened, firms scrambled to figure out exactly how much risk they had taken on. Remember that many of the derivatives and assets had been rated as AAA, which meant the firms didn't even have to declare them as risk on their balance sheets. As it became clear that these firms were exposed to massive amounts of risk, confidence fell dramatically. Major firms weren't just on the hook for the money they owed, they now found people scrambling to pull their money out and sell their stocks, causing a similar death-spiral in confidence. This run on the firms led to the possibility of company failures throughout the system. And as this happened, firms realized they had exposed themselves to each others risk as well by selling Credit Default Swaps insuring each others stability.
The rest, as they say, is history. Major firms now exposed to massive amounts of risk were on the brink of failure and economist were nearly unanimous in their belief that a domino effect was inevitable. A total system collapse of the entire financial market was inevitable unless someone stepped in to guarantee the firms. The lack of a wall between depository and investment banks meant that such risk also now threatened the money regular Americans had entrusted to the banks. If the banks were allowed to fail, one after another, the financial sector would collapse and the federal government, through the FDIC which insured individuals deposits, would be on the hook to pay out.
So drastic measures were adopted. The Federal Reserve injected nearly a trillion dollars in capital into the system. Congress approved an emergency bailout through a program known as the Troubled Asset Relief Program (TARP) which loaned billions of dollars to stabilize the firms. Treasury adopted the Term Asset-Backed Security Loan Facility (TALF) to purchase the bad assets from the firms and take the risk off their books. All of this was done to prevent a financial armageddon caused by the actions of a few wealthy individuals trying to become more wealthy. Through actions that can only be described as risky, greedy, stupid, and staggeringly ridiculous, these individual brought the entire global economy to its knees. More than a year and a half later, we are still recovering, and although the economy has improved significantly too many Americans are still out of work. At the same time, Wall Street seems to have learned nothing from the crisis.
Conclusion
In the coming weeks, Congress will attempt to put into place a system of basic regulations to prevent such a crisis from happening again. In our next Financial Reform 101 piece we'll explore the actual reforms being discussed and how they address each individual piece of the crisis detailed above, from a consumer financial protection system to look out for consumers and prevent abusive loan practices to new public trading systems and oversight for derivatives trading to a simple and safe plan for breaking up banks that would otherwise pose a risk to the entire system.
There is certainly room for debate about how best to fix the egregious problems detailed above, but it's my hope that this piece gives everyone a clear picture of the problem itself and that that understanding better equips us to have the necessary discussion about a way forward.
Mitch McConnell's Attack on Financial Reform, and Why We Shouldn't Outlaw Future Bailouts.
By: Jordan Young
Senate Minority Leader Mitch McConnell has been attacking the Dodd financial regulatory reform (FinReg) bill in the last few days, claiming it "guarantees endless taxpayer bailouts." Several Republican senators have already showed some willingness to break with McConnell on this issue, with Senator Judd Gregg (R-NH) calling the comments "a bit over the top," and Senator Bob Corker (R-TN) calling on senators to "act like grown-ups."
There's obviously a large levels of rhetoric here somewhat divorced from the facts. The bill certainly doesn't codify future bailouts and puts into place a series of requirements that large financial institutions have funeral plans and that they put capitol in place to bail themselves out if need be.
That said, I'm starting to think McConnell is trying to make an argument for which many people on the left and the right might express support. While the legislation doesn't codify future bailouts, it also doesn't ban them. Many are so understandably upset that taxpayers had to bailout the banks that they want to make sure it never happens again. That's certainly a goal we can all get behind, but it's important to make sure we are treating the cause and not the symptom here. The bailout was and is unpopular, but the risky behavior of banks should be more so.
I continue to believe, and I think most economist would back me up, that as upsetting as the bailout was, it was incredibly necessary and saved our economy from a total melt down. If we get distracted by our anger at the bailout, we may miss the opportunity we have here to address the real problem. If that happens, we could find ourselves in another crisis, but this time without the ability to save ourselves.
Banning future bailouts is not the answer. Addressing the reason the last one was necessary is.
