Last week’s Congressional votes have opened the door for both houses of Congress to finally take up the bill developed by the Senate Committee on Banking, Housing, and Urban Affairs. The next two weeks will be spent, the New York Times‘ Carl Hulse observed, with both parties competing to amend the bill.
As our own Diane Vacca observed last fall, the late-2008 crash alerted all of us to the fact that the dissolution of the post-Great Depression controls on banking had some very serious downsides. Among them, perhaps, was the discrediting of the very ratings agencies investors have traditionally depended on (such as Moody’s and Standard & Poor’s), something DeutscheBank’s Karen Weaver foreshadowed in an interview with us six months before the Big Bust. So who can we depend on to keep our money safe, short of putting it all in gold bars under the bed?
To one extent or another, all the legislators working on the Wall Street reform bill are trying to answer that question.
But what’s in the bill that was filed, and what has been voted on so far? Like the problem it’s trying to address, it’s long and complex. Below is a sampling of how the bill tries to address some of the more obvious fault lines–the systemic problems identified by the Financial Crisis Inquiry Commission–drawn from the committee’s own summaries.
Stopping the casino: “Wall Street should have a socially important purpose, and not resemble a casino, where people are more concerned with valuing an option than valuing a business,” investment guru Warren Buffett said recently. The Senate bill incorporates the ‘Volcker Rule,’ suggested by former Fed chairman Paul Volcker, 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. Nonbank financial institutions, such as hedge funds and private equity investment firms, would be supervised by the Fed and could also be subjected to restrictions on proprietary trading.
Reining in derivatives: Perhaps the knottiest of the issues the Senate is wrestling with is that of all the new financial instruments, fabricated from mathematical sleight-of-hand and other people’s money.
According to a report from the Congressional Research Service, for a while these instruments seemed like the best game in town: “Since 2000, growth in derivatives markets has been explosive (although the financial crisis has caused some retrenchment since 2008). Between 2000 and the end of 2008, the volume of derivatives contracts traded on exchanges, such as futures exchanges, and the notional value of total contracts traded in the over-the-counter (OTC) market3 grew by 475 and 522 percent respectively. By contrast, during nearly unprecedented credit and housing booms, the respective value of corporate bonds and home mortgages outstanding grew by 95 and 115 percent over the same period.” Then came the crash; a few weeks ago we posted footage of former regulator Brooksley Born exposing the damage. Arkansas senator Blanche Lincoln (right) has given the issue particular heat, and authored the derivatives section of this bill.
Of course, many sensible investors already spurned derivatives when they had the choice. Take, for example, Warren Buffet’s Berkshire Hathaway holding company: hedge fund manager Alan Schram, reporting on a shareholders meeting of the company, noted that Berkshire holds “250 derivative contracts, down from some 23,000 contracts ten years ago, with a notional value of 1 percent of that of some other large institutions.” But many of America’s pension funds and 401(k)s were not quite so farsighted.
Derivatives “have some utility but have to be conducted safely, under responsible rules,” Buffett told shareholders. So what sort of “responsible rules” does the Senate bill currently propose? For starters, it would “require issuers to disclose more information about the underlying assets and to analyze the quality of the underlying assets” of derivatives and, perhaps more importantly, require that companies that sell products like mortgage-backed securities to retain at least five percent of the credit risk, “unless the underlying loans meet standards that reduce riskiness.” It would also change the rules and the composition of the Municipal Securities Rulemaking Board, to stop outside “investment managers” from placing bets with taxpayer funds and corporate pension contributions.
More systemically, it brings “an estimated 90 percent of the market for derivatives, which are essentially bets on the future price of something, onto a regulated trading exchange—similar to a stock exchange, where price and volume data are publicly available to potential investors,” Brooksley Born’s former aide Michael Greenburger told ProPublica’s Marian Wang. “It leaves certain exceptions for foreign exchange deals and commercial use (such as an airline company’s use of derivatives to hedge against prices of fuel skyrocketing).” Let’s watch as senators parry over those exceptions, and see whether what they agree on is enough.
Leverage requirements. The word “leverage” may make you think of a grizzled Timothy Hutton on a Fox TV show. But for banks and shadow bankers, it means how much in the way of assets has to stand behind your investment, whether in cash, real estate, or farm implements. “If you’re a bank, the upside of leverage is that it gives you a lot of money that you can use, well, to make more money,” writes Washington Post wonk Ezra Klein. “It’s the difference between investing $1 in the stock market and $40. The downside is that it makes your firm fragile.”
If your leverage is at 2:1 — that is to say, you’ve borrowed one dollar to add to the dollar you already had — you could lose a full dollar and still be able to pay your creditor back. If you’re at 10:1, anything beyond a 10 percent decline in your assets means that if your creditors want repayment, you can’t pay them back (as you’ve lost more than your original dollar). At 20:1, a 5 percent decline will put you underwater. At 40:1, a mere 2.5 percent decline can finish you off. The more leverage you have, the less bad luck you can survive.
Therefore, the Senate bill would create a Financial Oversight Regulatory Commission, which would “impos[e] tough new capital and leverage requirements that make it undesirable to get too big” and therefore “too big to fail.” C-SPAN addicts, here are your marching orders: keep track of how this aspect of the bill changes in upcoming weeks.
Preventing future runs on the “shadow banking” system: What happened in September 2008, when all credit froze, did not include hordes of depositors rushing to pull their money out of Chase or Bank of America branches. Those institutions are covered, and regulated, by the Federal Deposit Insurance Corporation (FDIC). What did happen was an immediate blowout in the complex, interwoven, and immensely profitable network of financial institutions operating outside federal supervision, which magnified the collapse of one sector (subprime mortgages) until it nearly broke the economy.
Chief among these, perhaps, are hedge funds and reinsurance companies (think AIG). The Dodd bill establishes an Office of National Insurance to better monitor the latter, and would require a hedge fund with significant assets to register with the SEC like any other broker. Hedge funds, according to the bill summary, would have to “provide information about their trades and portfolios necessary to assess systemic risk. This data will be shared with the systemic risk regulator and the SEC will report to Congress annually on how it uses this data to protect investors and market integrity.
As even the most casual observer of last week’s Senate hearings on Goldman Sachs might have noticed, it’s a long and complicated way back to the stability investors once expected. “It took twenty-five years of misguided economic theorizing and legislation, along with insufficient regulation, to create an outlaw financial sector,” wrote economist John Cassidy for The New Yorker. “Rehabilitating it will be a mighty, multiyear endeavor.”
Coming soon: our report on the controversial bailout-or-no-bailout provisions, the current state of the Consumer Financial Protection Agency, and how the Senate plans to deal with those suddenly rascally ratings agencies.