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Financial Reform Bill Clears House, But Hurdles Remain

Confounding the skeptics, the Conference Committee on financial regulatory reform kept to its schedule and wrapped up consideration of landmark financial regulatory reform legislation in the early hours of the morning Friday, June 25, appearing to set the stage for final passage before the July 4 recess.

With consumer and investor protections largely intact, CFA Legislative Director Travis Plunkett said the bill promises “the biggest transformation of financial regulation in this country since the Great Depression. The conferees are to be commended for provisions that will improve the marketplace for consumers and investors and thereby improve the stability of our economy.” He praised Senate Banking Committee Chairman Christopher Dodd and House Financial Services Committee Chairman Barney Frank (honored the previous evening at CFA’s Annual Awards Dinner) for “their exceptional efforts to move meaningful financial reform legislation through the conference committee.”

Several developments over the subsequent weekend, however, complicated the task of moving the bill through the Senate. The death of Sen. Robert Byrd (D-WV) and the threatened defection of some or all of the Republicans who had supported the bill when it first came to the floor left supporters without the 60 votes needed to end a Republican filibuster.

The Republican supporters of the bill – including Sen. Scott Brown (R-MA), Sen. Charles Grassley (R-IA), Sen. Olympia Snowe (R-ME), and Sen. Susan Collins (R-ME) – had all received concessions during Conference Committee negotiations to ensure their continued support. However, they objected to a $19 billion assessment on large financial institutions and hedge funds to cover the costs of the legislation and prevent those costs from being added to the deficit. Sen. Brown, the first to voice that objection, said it was an unacceptable “tax.”

Meanwhile, Sen. Russ Feingold (D-WI) announced his continued opposition to the bill – including his intention to oppose allowing the bill to advance to a final vote – on the grounds that it did too little to end “too big to fail” institutions and to make other structural changes needed to prevent a recurrence. And Sen. Maria Cantwell (D-WA), who won important concessions in conference to strengthen the derivatives title, said she was still reviewing the legislation to determine whether to support it.

With their hand strengthened, Republican supporters were able to force new negotiations last Tuesday to find an alternative payment mechanism. Those negotiations produced an agreement that combines funding from the early termination of the TARP program with an increase in the minimum level of reserves at the FDIC. The Conference Committee reconvened late Tuesday afternoon, and the change was approved on a party line vote by both House and Senate conferees.

The House then moved quickly to pass the legislation on a 237-192 vote last Wednesday. Exact timing of the Senate vote remained up in the air but it was not expected until after senators return from recess the week of July 12th.

“The banks, the Wall Street firms, and the Chamber of Commerce threw everything they had into defeating or fatally weakening this bill,” said CFA Director of Investor Protection Barbara Roper. “They hired hundreds of lobbyists and spent millions of dollars. That bought them some successes, and the fight won’t truly be over until the bill has passed the Senate and been signed into law. Despite some disappointments, however, it is consumers and investors and taxpayers who have come out on top in the conference report.”

Plunkett added a cautionary note, however. “For the legislation to achieve its goals, regulators – including the CFPB, FTC, CFTC, SEC, and bank regulators – will all need to provide the kind of vigorous oversight of the financial services industry that was lacking in the years leading up to the crisis, and some Members of Congress will need to restrain their tendency to ride to the rescue of powerful industry players when regulators attempt to rein in abusive practices,” he said. “In short, they will need to learn the true lesson of the crisis, that tough regulation cannot be sacrificed in the name of global competitiveness or financial innovation if the safety of the system is to be protected.”

The remainder of this issue describes the conference agreement on key consumer and investor protection issues worked on by CFA staff.

 

Strong, New Consumer Financial Protection Bureau Created

One of the most hotly contested issues in the regulatory reform debate centered on creation of a strong, new agency to protect the interests of financial consumers. Although the agency was reconfigured as a bureau within the Federal Reserve Board, it retained many of the key characteristics viewed as essential to its effectiveness.

“A crucial component of the legislation is the creation of a new Consumer Financial Protection Bureau (CFPB) that will have as its sole mission the best interests of consumers,” said Susan Weinstock, CFA’s Financial Reform Campaign Director. “It’s high time that consumers have a cop on the beat to rein in abusive and deceptive financial products and services. The bill sets up an autonomous consumer bureau with independent funding, which are key elements for an effective regulator.”

CFA has been urging Congress to enact a consumer financial regulator for a number of years. Key elements of an effective regulator included in the conference report include:

• Its structure as an autonomous bureau housed within the Federal Reserve;
• Independent funding, including increases so that inflation will not erode the bureau’s budget over time;
• Adoption of a single director model, allowing the bureau to act quickly if problems arise;
• State authority to go beyond CFPB rules so that a local problem can be stopped before it turns into a national disaster. Unfortunately, the bill does allow the Office of Comptroller of the Currency to block state consumer protections without ensuring that there is a similar federal protection in place.

Another positive element was delegation to the CFPB of enforcement authority over payday lenders of all sizes. “The payday loan industry hired an army of lobbyists and worked hard to be excluded from the CFPB’s jurisdiction, but ultimately failed,” said CFA Financial Services Director Jean Ann Fox. “The CFPB will be able to enforce its rules to curb unfair, deceptive, and abusive credit practices industry-wide, although an amendment to spring the payday loan debt trap offered by Sen. Kay Hagan (D-NC) was blocked by congressional supporters of the payday loan industry.”

On the other hand, a broad special interest “carve out” from consumer bureau authority was provided to auto dealers who sell or broker loans. As a result, the CFPB will cover banks and credit unions when they make auto loans, but the Federal Reserve will continue to have that jurisdiction over auto dealer-lenders under the current bill, without any mandate to coordinate their efforts to ensure a level playing field for all auto loans. The anti-consumer carve-out for auto dealers was somewhat ameliorated by the Conference Committee decision to grant the Federal Trade Commission the authority to operate under less restrictive rules than would otherwise apply when writing rules to protect consumers from unfair and deceptive acts and practices by auto dealer-lenders.

In another loss for consumers, the bill approved by the Conference Committee also retains a provision passed by the Senate that would allow abusive small lenders to receive a “sneak peek” at rules under consideration by the consumer bureau. “Despite these limits, Congress has established a strong, independent regulator that will have the authority to attack virtually all of the abusive practices that confront consumers in the financial services marketplace today,” Plunkett said.

 

Compromise Reached on Top Investor Protection Priority

After months of wrangling, the Conference Committee delivered on the issue identified as the top priority for Main Street investors – requiring brokers to act in their customers’ best interests when they give investment advice. The conference report combines a six-month study with full and unimpeded authority for the SEC to impose the same fiduciary duty on brokers to act in the best interests of their customers that all other investment advisers now face.

“This is a good compromise and a major win for investors,” said CFA Director of Investor Protection Barbara Roper. “Now it will be up to the Securities and Exchange Commission (SEC) to deliver on this promise,” she added, “but with strong statements from SEC Chairman Schapiro, Commissioner Walter, and Commissioner Aguilar in favor of a fiduciary duty for brokers we are confident that progress on this long-delayed reform is finally on its way.”

The Investor Protection title also includes additional measures to create a powerful new advocate for investors within the SEC, to eliminate or limit the use of pre-dispute binding arbitration clauses in brokerage and investment adviser contracts, to improve disclosures that investors receive when they purchase investment products or hire investment professionals, to reform broker-dealer compensation practices, and to strengthen the SEC’s enforcement tools.

Unfortunately, the conference report also includes two provisions that seriously erode investor protections. One weakens post-Enron protections against accounting fraud at a majority of public companies – those with under $75 million in market capitalization – and the other prevents the SEC from regulating equity-indexed annuities, among the most abusively sold products on the market today.

“While it is dispiriting to see members of the Conference Committee vote to weaken investor protections and undermine SEC authority in the very bill that is supposed to restore investor confidence and market integrity,” Roper said, “the overall effect of the title is to strengthen investor protections. As a result, the investors who are suffering the devastating impact of a financial crisis they did nothing to cause will get important new protections to ensure that they are fairly treated in the marketplace.”

 

Bill Reforms Abusive Mortgage Practices

Unsound and abusive mortgage lending is generally agreed to be the root cause of the current financial crisis. In response, and in addition to creating a new CFPB to oversee all credit practices, the conference report contains a clutch of important mortgage lending reforms. These include the following:

• It establishes a federal standard for all home loans that requires institutions to ensure that borrowers can repay the loans they are sold.
• It prohibits the financial incentives for subprime loans – so-called yield spread premiums – 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.
• It establishes penalties for irresponsible lending. Lenders and mortgage brokers who don’t comply with new standards will be held accountable by consumers for as much as three-years of interest payments and damages plus attorney’s fees (if any). And it protects borrowers against foreclosure resulting from violations of these standards.
• It 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.
• It requires additional disclosures for consumers on mortgages. Lenders will be required to disclose the maximum a consumer could pay on a variable rate mortgage, with a warning that payments will vary based on interest rate changes.
• And, it establishes an Office of Housing Counseling within HUD to boost homeownership and rental housing counseling.

The bill also includes provisions designed to rein in reckless mortgage lending by Wall Street securitizers by requiring companies that sell products such as mortgage-backed securities to retain at least five percent of the credit risk, unless the underlying loans meet standards that reduce riskiness. That way if the investment doesn’t pan out, the company that packaged and sold the investment would lose out right along with the people they sold it to. And it requires issuers to disclose more information about the underlying assets and to analyze the quality of the underlying assets.

Finally, the bill includes provisions to help address the problems created in communities and among homeowners by the mortgage crisis by:

• providing an additional $1 billion in funding to states and localities, on top of $6 billion already committed, to combat the ugly impact on neighborhoods of the foreclosure crisis — such as falling property values and increased crime – by rehabilitating, redeveloping, and reusing abandoned and foreclosed properties;
• providing $1 billion for bridge loans to qualified unemployed homeowners with reasonable prospects for reemployment to help cover mortgage payments until they are reemployed.; and
• authorizing a HUD-administered program for making grants to provide foreclosure legal assistance to low- and moderate-income homeowners and tenants related to home ownership preservation, home foreclosure prevention, and tenancy associated with home foreclosure.

“The bill goes a long way to restoring a sensible balance in mortgage lending between consumers and lenders and protecting borrowers from predatory practices,” noted Barry Zigas, Director of Housing Policy. “Only the flim-flammers, bamboozlers and con artists who profited by misleading borrowers should have problems with what Congress has done.”

 

Credit Rating Agencies Will Face New Oversight and Accountability

A key reason lenders were willing to write mortgage loans that they knew borrowers could not repay was their ability to sell those loans to be repacked into mortgage-backed securities that earned top, investment grade ratings from the credit rating agencies. The conference report includes a broad package of reforms, including provisions to:

• strengthen regulatory oversight of ratings agencies, creating a new office within the SEC and providing that office with additional regulatory authority;
• increase rating agency accountability by making them legally liable when they are grossly negligent;
• improve rating transparency, so that investors are better able to assess the reliability of the ratings;
• improve corporate governance at ratings agency, including by giving users of credit ratings a role in oversight of key rating functions;
• reduce the conflicts of interest inherent in the rating agency business model, by requiring first an SEC study and then action to create a more objective procedure for making ratings assignments; and
• eliminate all references in federal laws and regulations to credit ratings. While CFA shares the goal of reducing reliance on ratings, the approach taken in the legislation does too little to study how ratings are used and to determine whether alternatives are available that provide a more reliable measure of creditworthiness.

“The willingness of credit rating agencies to slap investment grade ratings on products whose risks they did not understand and could not measure enabled the sale of toxic securities that spread risk throughout the financial system,” stated Roper. “We are hopeful that these reforms will simultaneously improve the reliability of ratings while reducing the financial system’s vulnerability to ratings failures.”

 

Sweeping Regulation Imposed on OTC Derivatives Markets

The massive unregulated over-the-counter derivatives markets contributed to the crisis by enabling risky conduct by financial institutions that thought their risks were hedged, by creating a domino chain of connections between financial institutions that spread that risk through the system, and, because of the total lack of transparency in the market, by causing fear that froze the credit markets when the dominos began to fall.

“Bringing tough, comprehensive regulation to the derivatives markets is one of the most important components of financial reform to restore safety and stability to the financial system,” Roper said. “Like all the other titles, the derivatives title has its imperfections, but it delivers on the major priorities of requiring the large majority of clearable swaps to go through central clearing facilities and to trade on an open exchange and by imposing new regulatory oversight on swaps dealers and major swaps participants.”

Among other things:

• The bill provides only a limited exemption from the clearing requirement, primarily for commercial firms hedging commercial risk. Once it is passed, large banks, insurance companies, hedge funds and other financial institutions will be required to submit standardized swaps to clearinghouses and post margin to back their bets.
• The bill requires swaps that can be traded on exchanges to do so, and it requires real-time public reporting of all cleared contracts. This provides regulators with the information they need to police the market and market participants with the benefits of price competition.
• The bill imposes comprehensive regulation – including capital and margin requirements, business conduct standards, and reporting requirements – on swaps dealers and major swaps participants. No longer will a future AIG be permitted to take on massive risks without the knowledge of regulators and without adequate capital to back those bests.
• The bill closes a loophole that allowed U.S.-based counterparties to trade contracts on U.S.-delivered commodities from terminals in the United States via an exchange registered in London, all to evade U.S. regulation. If the bill is adopted, the CFTC will have the authority it needs to require these foreign boards of trade to register in the United States and comply with minimum standards comparable to those here, including reporting standards.

On the other hand, the conference report significantly weakened provisions included in the Senate bill to push swaps dealing out of insured depository institutions and to impose a fiduciary duty on swaps dealers in their dealings with government entities, pension funds, retirement plans and endowments. Even in these areas, however, progress was made.

“With billions of dollars at stake on the outcome, the major dealer banks put everything they had into weakening this section of the legislation. From the beginning, they fought to expand the exemption from central clearing, defeat the exchange trading requirement, and prevent efforts to move swaps dealing into separately capitalized affiliates. Fortunately, on most fronts, their efforts came up short,” Roper said. “If this legislation passes, meaningful regulation will at long last be imposed on this massive and potentially destabilizing market.”