An Overview of Financial Reform

The Dodd-Frank Wall Street Reform and Consumer Protection Act.

“All told, these reforms represent the strongest consumer financial protections in history,” Obama said.

“And these protections will be enforced by a new consumer watchdog with just one job: looking out for people – not big banks, not lenders, not investment houses.”

Skimming the local newspaper stands is generally a downer for me, but this week was particularly depressing. It seems like every day a new article emerges to remind us just how bleak the American economic landscape is.

A study released this month by the Employee Benefit Research Institute appeared in papers across the country, announcing that almost half of American’s aged 36 to 62 will not have enough money set aside for retirement, leaving them working… well, until they die.

The unemployment rate, unsurprisingly, continues to hover above 10%, and on top of that, lending across country remains minimal.

And so, with the recession dragging on into its second year, readers may be surprised to discover that Americans by and large don’t care about the financial reforms recently passed in congress – nearly 45% have no opinion, according to a recent poll released by Rasmussen.

As economist Richard Wolff notes, American workers are looking at the new wave of Democratic party reforms and thinking to themselves, “been there, done that.”

As we’ll see in this two-part story, the new reforms will likely do very little to stop either immediate or long-term failures in our banking and financial systems.

Below is given a brief rundown of the two and a half thousand page bill known as the The Dodd-Frank Wall Street Reform and Consumer Protection Act.

Derivatives trading:

Derivatives are, very simply, financial contracts between two parties based on the price of a certain product. If, for example, a farmer were to sign a contract with a super market, agreeing to sell x amount of apples for y amount of money at a specific date in the future, this agreement would be considered a “derivative.”

Derivatives come in many shapes and sizes however, and can be incredibly complex. Derivatives can be based on shares in a company, currency rates, or the prices of goods.

In other words, possible derivatives contracts are nearly endless, and so are the potential gains and losses associated with them.

The vast majority of derivatives deals are being made by an incredibly small handful of firms. As of 2009, according to the U.S. Department of Treasury, five major banks controlled 97% of the U.S.’s total derivatives markets, valued in trillions of dollars.

But because these large firms are also highly influential in other financial markets, their failures with derivatives can severely impact the rest of the global economy, as we saw in the 2008 financial crisis.

Several specific types of derivatives have recently received wide-spread attention for their role in the financial crisis – particularly Asset-Backed Securities (ABS’) and Collateralized Debt Obligations (CDO’s).

Both ABS’ and CDO’s helped inflate the prices of housing and credit by allowing banks and financial institutions easier ways of funding risky investments.

In order to obtain more money for mortgage loans, for example, banks would stick many mortgages together into a single package and sell them to large financial institutions.

Packaging mortgages into a single portfolio decreased the risk normally associated with buying a single mortgage, because even if one of the mortgages failed, there would still be many more generating an income.

In exchange for buying these portfolios, large financial groups would receive all of the income made from the mortgage payments, and the banks who sold the portfolios would then have new money in which to make more loans to home buyers.

This had two effects. First, it allowed banks to make loans to people it knew could not normally pay them back – these risky loans were made “safe” by lumping them together with other loans.

Secondly, as more homes were sold, it raised the price of houses across the country to absurd heights.

In the new financial regulation, legislators have ordered the creation of derivatives exchanges, or “swap execution facilities,” where derivatives would be traded openly in much the same way stocks are. In this way, derivatives trading would be more transparent for regulators.

But the bill exempts any financial institutions from having to participate in these exchanges if a derivative is used to “hedge” or reduce an investment’s risk. Lenders cannot, however, loan to risky home buyers anymore – at least not without proof of income.

“Too Big To Fail”:

If you’ve tuned into the news at all over the past two years, you’ve probably heard a lot of talking heads tossing around the term “too big to fail.”

The term and the philosophy behind it (that some institutions are simply too important for the government not to bail out), have been the source of heated debate since the economic catastrophe of 2008.

To prevent another collapse, legislators have empowered regulators to close down banks whose failures may threaten the economy. But the bill’s potential impact ends there.

The new legislation does nothing to limit the growth or influence of mega-banks over the economy. Their holdings, size, and power remain fundamentally unchanged, much to the pleasure of Goldmann Sachs, who successfully lobbied to defeat a proposed growth limit for banks.

Missing from the regulation is also any guarantee that we won’t have to publicly fund another bailout.

Regulators are still allowed to protect the creditors of large banks – meaning that taxpayers may still have to pick up the check for failing financial giants in the future.

Consumer Protection:

Predatory car loans:

Perhaps as interesting as what wound up being put into the bill is what wound up being taken out.

In the original legislation, politicians had considered including car loans amongst other consumer products to be more closely regulated. Stories of rampant and blatant fraud amongst loaning institutions spurred senators to address the issue.

In many cases, poorer car buyers would be led on by salesman, allowed to drive their new cars off the lot, and then be called back days later threatened with arrest for auto theft if they did not come back and pay more money.

New regulations on auto loans were carved out of the legislation, however, under the pressure of the auto industry’s lobby.

Debit card issuers, however, may not make out so well.

Bank Fees:

The new financial regulation will put a “soft cap” on fees banks are allowed to charge retailers for debit card transactions.

Before this new soft cap, banks were allowed to charge whatever fees they liked – normally in the range of 1 to 2 percent of purchase prices.

With the new regulation, the Federal Reserve will now be empowered to set limits on processing fees. The limits, however, are vague.

According to the legislation, the limits should be both “reasonable” and “proportional to the processing costs incurred.” Of course, one may wonder what “reasonable” means to an institution where “Wall Street gets what it wants,” as economist Willem H. Buiter once remarked.

Advocates of the new cap argue that the measure should help both retailers and consumers, by lowering the cost of debit transactions for businesses. Although the new caps will almost certainly help businesses, there is no evidence that retailers will pass their savings onto customer.

Mortgage loans:

Perhaps the best intentioned of the new consumer reforms are the added regulations on home loans.

New regulation will require potential home buyers to prove their ability to pay back their loans. This will stop the practice of NINA loans (short for “no income, no asset”) to poor homebuyers who racked up a sizeable number of foreclosures over the past few years.

To enforce some of these new regulations, a new agency, the Consumer Financial Protection Bureau, has been created.

The Bureau, while still awaiting a director, will be given a $450 million annual budget and several hundred employees with which it can begin enforcing new financial policies.

The Bureau will further be empowered to regulate other industries, such as pay-day loan institutions. The hope is that the notorious interest rates payday offices charge (sometimes as high as 30%) may be curbed.



For the original article, and more like it, feel free to visit The Trial by Fire.

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