Will This Stop the Next Financial Armageddon?

"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:

Leverage
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.

Terrible products
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.

Too-Big-to-Fail
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.

Fool editor Ilan Moscovitz doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (19)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 16, 2010, at 4:28 PM, Tygered wrote:

    Thank you so much for at least pointing out both the good and the bad of this bill. Up to now, all I've heard is how terrible it was. Your article shows us that politics is indeed "the art of the possible." Even though I had hoped that more would be possible, at least this bill is a start. Thank you for a well-written article.

  • Report this Comment On July 16, 2010, at 4:42 PM, TMFDiogenes wrote:

    I had hoped more would be possible too. It was really only recently, when I stepped back and saw how far the bill had come as a result of popular efforts, that it really hit me: most of the important reforms that we thought would have no chance at all, though weakened to varying degrees, were actually in the bill.

    Thanks, really appreciate it, Tygered,

    Ilan

  • Report this Comment On July 16, 2010, at 5:27 PM, Husk wrote:

    With human nature and banks too big to fail, we are doomed to repeat history. The question is how soon.

  • Report this Comment On July 16, 2010, at 5:42 PM, WyattJunker wrote:

    Soros talked about a much simpler Dutch system where the bank's management had an inextricable risk/reward with the success or failure of the bank. Their own personal fortunes were tied to the upside and downside risk associated with the bank's balance sheet which lead to more historically traditional lending.

    This could have been done without a 2,300 page bill and without adding to the bank's reserve requirements. It is structural and not gimmicky, unlike this new finreg bill, which really if we're being honest was more about bread and circus for the ignorant voters, which the politicians knowingly took advantage of.

    Now, they have more control over the banks and we will have less access to capital as they freeze up.

    There goes those jobs.

  • Report this Comment On July 16, 2010, at 5:43 PM, epnpg wrote:

    No ! Corrucption , money , and thirst for power will always defeat reform as long as we do not have term limits.

  • Report this Comment On July 16, 2010, at 7:27 PM, TMFDiogenes wrote:

    Hey Wyatt,

    I agree -- the bill should have done much more on the issue of incentives and moral hazard. I don't think that these guys believe they're deceiving voters, though. From my interactions, I'd say that they really believe they are striking a good balance between protecting our economy and letting the financial system do what it does. Part of this is that there have been basically no attempts to regulate Wall Street for 30 years; everything was deregulatory, so anything that harms Wall Street considerably seems to them to be tough by comparison.

    So I think the main architects of the bill quite sincerely believe that they're doing the right thing. And they are... just not quite enough of it to guarantee that it will work under negligent regulators like the ones we had in years past.

    I've heard a little about the Dutch system but am not too familiar with it. Do you have a link to one of his articles on it?

    Thanks!

    Ilan

  • Report this Comment On July 17, 2010, at 2:34 AM, SetMyPeopleFree wrote:

    Of couse you would defer our fate to Soros, as this montrosity of beauracratic power and control is right up his alley. Glass-Stegal was 17 pages or so ansd worked for MANY DECADES. This political takeover of banks and NON BANKING COMPANIES AT THE WHIM OF THE BEARACRATS OF THE COMMIE REGIME IS 2300 PAGES OF CRAP DESIGNED TO GIVE ALL POWER TO MORONS, YES MORONS, WHO HAVE NEVER HAD A JOB , A COMPANY , OR A LOVE OF CAPITALISM. ARE YOU ON THE OBAMMIE-COMMIE TAKE FROM SOROS? MUST BE, SINCE NO MENTION OF FANNIE, FREDDIE OR THE TWO CRIMINALS OVERSEEING THEIR CORRUPTION AND DEVASTATION AND USING POLITICAL MEANS TO STOP ANY ATTEMPST AT REFORM-- YOUR COMRADES IN ARMS, DIRTY DODD AND BALONEY FRANKS. GO PEDDLE YOUR GARBAGE AT NBC OR NY COMMIE TIMES; WE WILL FIND A WAY TO UNDO THIS COMMIE/STATISTS/FASCIST STRANGLEHOLD ON OUR ECONOMIC FREEDOMS AND BRING THIS NATION BACK TO IT'S PROPER PLACE AS THE LEADER AND LAST GREAT HOPE OF THE WORLD. Are you oblivious to what has happened in your Euro paradise of socialism/statism with self-serving politicians controlling everything? Soros has really helped the British economy in the past, has he not? Just how are we stopping Armeggedon by institutionalizing the community activist/redistribution scam at the expense of all financial institutions and everyone with money in any bank, savings and loan or 401(k) plan? OBVIOUSLY, YOU ARE NOT AN ECONOMIC DUNCE LIKE 90% OF THE ADMINISTRATION, SO YOU ARE OBVIOUSLY A FRONT MAN FOR RADICAL LEFTISTS TAKEOVER OF THE ENTIRE ECONOMY TO SATISFY SOME CHILDISH IDEA OF UTOPIA/FAIRNESS BROUGHT ON BY PERCEIVED PRIVILIGED GUILT. GET OVER IT PREPPIE BOY, TOO MANY OF US HAVE WORKED TOO HARD AND LONG FOR OUR LITTLE SLICE OF THE PIE WE NEED TO KEEP TO ENSURE OUR CHILDREN CAN LIVE LIKE OBAMA, YOU, AND ALL THE REST WHO HAVE NEVER WORRIED ABOUT ACTUAL SURVIVAL IN YOUR MISERABLE , PAMPERED, WORTHLESS LIVES. MAY GOD BLESS YOU AND OPEN YOUR HEART TO THE MESSAGE OF THE FOUNDERS AND THE EVIDENCE OF HOW THE MOST GOOD FOR THE MOST PEOPLE HAS RESULTED FROM A LARGELY FREE AND OPEN ECONOMY.

  • Report this Comment On July 17, 2010, at 3:07 AM, TMFDiogenes wrote:

    Me:

    "I'd have opted for the safer route: fewer loopholes, tougher minimum regulatory requirements, and a more explicitly de-concentrated and simplified financial system."

    "I've heard a little about the Dutch system but am not too familiar with it. Do you have a link to one of his articles on it?"

    SetMyPeopleFree:

    "Of couse you would defer our fate to Soros, as this montrosity of beauracratic power and control is right up his alley. Glass-Stegal was 17 pages or so ansd worked for MANY DECADES....[TONZ OF ALLCAPPPPPS!!]"

    Ummm... given that I've endorsed Glass-Steagal [sic] in this article and in many, many past articles but haven't read the thing you're attacking, why the crazy train? Or maybe it's directed at the other guy?

  • Report this Comment On July 17, 2010, at 10:16 AM, ISeeThemNow wrote:

    @TMPDiogenes:

    SetMyPeopleFree's comment was not directed at you, it was in reply to WyattJunkers reference to Soros.

    SetMyPeopleFree has a very important message that people should take seriously - look beyond the capslock and grammar and he is spot on.

    I agree with WyattJunkers post also, except that we need to be careful who we look up to for solutions - Soros says the right things on certain issues, but the way he pushes at implementing them is clearly in line with an agenda that is not good for the people.

    I apologize in advance for the long post.

    In all the smoke and mirrors, we need to keep an eye on the target. The govt. needs to drastically reduce in size (and reduce the fiscal burdon on the people and small businesses along with it), it needs to stop the incessant legislation, it needs to stop getting involved in business. The govt has no assets, it has no money and it creates nothing - it can only take from the people either directly through taxation or in a more serpentine fashion via inflation of the money supply (money printing). So it needs to stop subsidizing select businesses at the expense of others. This is what allows certain corporations (mostly those around the central banks) to grow excessively and become "too big to fail". With a set of basic anti-monopoly laws - which has existed for a long time - the free market takes care of malinvestments and distortions through the bankrupty process (ie: failure). The people are then free to do business with eachother, those that get excessively greedy pay for their mistakes by failing, without punishing others who showed discipline, talent, hardwork etc. But the way things are going now with the incessant legislation, licensing of everything and associated fiscal burden, the people become increasingly enslaved to para-govt corporations. This is how freedom is taken away from the people slowly without them realizing.

  • Report this Comment On July 17, 2010, at 1:18 PM, TMFDiogenes wrote:

    ISeeThem,

    Interesting and well-written post, but I don't think it's accurate in the case of banking:

    "So it needs to stop subsidizing select businesses at the expense of others. This is what allows certain corporations (mostly those around the central banks) to grow excessively and become "too big to fail". With a set of basic anti-monopoly laws - which has existed for a long time - the free market takes care of malinvestments and distortions through the bankrupty process (ie: failure)."

    It's just not the case that subsidies and regulation are what led to tbtf. Which regulations are you thinking of? The massive concentration and oligopolization in banking, as well as the growth in industry wages, occurred in lockstep with the deregulation of interstate banking laws. The last 30 years have been one victory after another for proponents of deregulating Wall Street. The explosion in the size has been going on at least since 1995. The '90s, which saw the final repeal of Glass Steagall, can hardly be characterized as a time of stifling regulation for Wall Street.

    Anti-monopoly laws aren't up to the task because you can be tbtf without being a monopoly: see C, BAC, JPM, GS, MS, WFC, wtc.

    And bankruptcy doesn't work for tbtf banks; the bankruptcy judge in Lehman Brothers case said LEH "can never be deemed precedent for future cases. It's hard for me to imagine a similar emergency."

    The last several decades -- from Democrat to Republican administrations -- is a history of deregulating Wall Street so it can do whatever it wants, which resulted in tbtf. And bankruptcy just doesn't work for tbtf -- that's why they're tbtf. So if you're worried about tbtf and bailouts, the only solution is to make banks permanently smaller and less interconnected, and/or to stop them from doing crazy things.

    http://www.fool.com/investing/general/2010/04/28/nows-your-c...

    http://rortybomb.wordpress.com/2010/05/04/13-bankers-financi...

  • Report this Comment On July 17, 2010, at 1:24 PM, ChrisBern wrote:

    Thanks for the overview article. My main take-away, unfortunately, is that the underlying outcome of 2008 (bailouts of large, interconnected, failing financial institutions) is not adequately addressed by this bill. I'd assign a 99.9% probability that if one of our huge 5 or so banks were to fail in the future, and it looked systemic, we'd bail them out again. That's unfortunate because everyone knows this, and so more than ever the moral hazard of knowing there's a government backstop is present. In the long-run, therefore, expect more risky behavior and bailouts.

  • Report this Comment On July 18, 2010, at 3:50 PM, mountain8 wrote:

    It's amazing. I don't read anything in Caps. Caps just tell me you are much too radical to be of any use.

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