"The most sweeping regulatory overhaul since the Great Depression!"
"It's just a fig leaf!"
Depending upon who you listened to, the financial reform bill that passed yesterday was lionized by some as the most awesome thing since condoms, or derided by others as totally insufficient to protect us from the indiscretions of happy-go-lucky banks.
So which is it? What key measures in the 2,322-page text actually matter, and will they stop the next financial Armageddon?
Here's what you need to know:
Insanely high leverage, often built upon short-term loans and risky assets, was a major part of why the financial crisis was so devastating. When Lehman Brothers borrowed $30 for every $1 of assets it held, it took only slightly more than a 3% decline in the value of its assets, or for its lenders to lose confidence, for the company to go broke. That huge leverage also meant that the devastation wrought by Lehman's collapse was that much greater.
A measure by Representative Jackie Speier forces the Federal Reserve to limit leverage to 15-to-1 or smaller for banks the Fed deems a "grave threat" to the economy. A separate rule by Senator Susan Collins also creates leverage limits and requires that banks hold good quality capital. These two critical provisions set ceilings for leverage that bank-friendly regulators would have a harder time nullifying.
A mostly unnoticed provision, Section 610, limits how much short-term funding and derivatives exposure a financial institution can have with a single bank. This has the potential to really limit interconnectedness, bank size, and the Ponzi scheme-like explosion of debt we saw in mortgage assets. Jane D'Arista, an expert on financial reform, told me she thought this measure might even rein in the Wall Street oligopoly.
Banks Gone Wild!
Derivatives contracts were an area that lobbyists and many in Washington didn't want touched -- better, they thought, to leave this complicated stuff to our infallible regulators, or allow it to remain riddled with loopholes, so as not to upset bank profits. Various experts and lobbyists have told me there's no doubt that regulation of these critical components made it into the final bill because of popular support, like the 7,000 Fools who signed the derivatives petition.
Instead of writing enormous derivatives contracts with billions in potential losses that they will have no hope of ever paying back in case they make an oopsie (cough -- AIG (NYSE: AIG ) -- cough, cough) and then getting bailed out by taxpayers, major derivatives participants (but not end-users like airlines) will have to post collateral to central clearinghouses. If enforced, this could make the system safer by substantially reducing the deadly interconnectedness of banks and hedge funds, and it will help to ensure that financial institutions keep their derivatives risk more in line with their ability to pay.
The Volcker Rule, promoted by former Fed chairman Paul Volcker and Senators Jeff Merkley and Carl Levin, is a "Glass-Steagall-lite" regulation that tries to separate simple, federally backed banking from the more dangerous and testosterone-laced areas of Wall Street. It requires federally insured banks to give up much of their proprietary trading, as well as many of their investments in hedge funds and private equity. This will help to prevent banks like Citigroup (NYSE: C ) , JPMorgan (NYSE: JPM ) , and Bank of America (NYSE: BAC ) from going wild with mortgage-backed securities, hedge funds, and other risky investments.
It will also force Goldman Sachs (NYSE: GS ) and Morgan Stanley (NYSE: MS ) to choose between keeping their taxpayer guarantees or their risky bets. The Volcker Rule is a crucial reform, though it might be a little tricky for regulators to implement, compounded by loopholes inserted at the last minute for State Street (NYSE: STT ) and Fidelity, in exchange for Sen. Scott Brown's vote -- these loopholes could weaken and delay its implementation considerably.
Should 300,000 people die from eating poisoned spinach, you'd want to have a word with the Food and Drug Administration. When 300,000 mortgages blow up in a month, you blame ... wait, we don't even have a watchdog to police crazy financial products like liars loans and Alt-A mortgages for which failure was almost guaranteed! Until now, that is. Instead of leaving the watchdogging to a bunch of indifferent, compromised regulators, a new consumer protection bureau will have the power to require that contracts be legible even to all the non-lawyers out there, and to ban products that are, for lack of a better term, Ponzi-like scams.
Ratings agencies further contributed to the crisis by assigning AAA-ratings to terrible products, in effect laundering the aforementioned scams. Thanks to Sen. George LeMieux, the bill repeals the federal charters that protect ratings agencies from competition. If implemented, an amendment by Sen. Al Franken will assign raters to structured finance deals so that banks can't shop around for the highest rating.
A big selling point of the bill is that it will end the problem of "too-big-to-fail." This is not entirely true. It will ban bailouts, sure, but if the measures I just told you about don't prevent huge banks from failing, the bill won't do much to cure the cause of bailouts: the existence of too-big-to-fail banks.
Should such a bank fail, there's a good chance we'll have yet another financial crisis, or Congress will have to pass a new law to authorize bailouts … "just this one last time!"
Senators Sherrod Brown and Ted Kaufman had proposed an elegant solution to too-big-to-fail : just limit the size of banks to "reasonably huge" rather than "black hole," but it was shot down by these 61 Senators.
However, a separate measure by Representative Paul Kanjorski somehow made it in the bill, albeit in a weaker form. If the Federal Reserve and two-thirds of a special council of regulators believes a bank to be a "grave threat" to financial stability, the Fed can tell the bank to stop its dangerous activities or break it up into smaller parts. Who knows if regulators will ever fulfill this responsibility? Historically, they've severely underestimated the risks posed by too-big-to-fail banks -- but now, at least, that responsibility is written into the law, and it only takes one occurrence for the Fed and regulators to jump in and break up too-big-to-fail banks.
Will it all work?
These reforms will almost certainly help to make the financial system safer. But will they be enough to stop the next financial Armageddon?
I've closely followed each of these cobbled-together compromises as they've developed over the past year and would say the bill began as a "D+" but moved to a "B-" as passed, primarily as a result of public efforts that vastly improved it. As you can see, these provisions could actually work. The bill includes important measures that may be enough to prevent another crisis if properly implemented.
But there are also sufficient loopholes and regulatory discretion that if lazy or Wall Street-friendly regulators and laissez-faire ideologues once again dominate the regulatory agencies in the future, they could have enough leeway to go the Greenspan route and look the other way as Wall Street "self-polices."
Given the stakes -- preventing the next financial Armageddon, millions out of work, and trillions in bailouts and lost tax revenue -- weighed against the risk of upsetting profits at six or so companies, I'd have opted for the safer route: fewer loopholes, tougher minimum regulatory requirements, and a more explicitly de-concentrated and simplified financial system.
Time will tell if this bill and future attempts to rein in the risks Wall Street takes with our economy and taxpayers will be enough. The fight between Americans and banks -- with Washington caught somewhere in between -- is far from over.
But what do you think? Will these measures prevent the next financial Armageddon? Let us know in the comments box below.
And if you have any questions about the financial reform bill, feel free to ask away -- I'll be happy to answer them for you.