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This past week President Barack Obama signed into law sweeping changes meant to provide the framework believed required to regulate the financial services industry and prevent the potential for a systemic collapse of the economy, a collapse that we came precariously close to during the Autumn of 2008. In addition to the regulatory authority, several bodies have been created that will oversee the application of the law.
Recalling the causes for the near collapse, during the early 2000’s, after the repeal of the Glass-Steagall Act, a bill signed into law during the Great Depression and meant to provide regulation and oversight to the financial industry, banks and other financial organizations began to securitize mortgages in an effort to collect fees, maximize profits and make home loans available to more Americans. Unfortunately, this process of securitization led to lax underwriting procedures for mortgages by regulated entities such as FannieMae, and FreddiMac and banks as well as unregulated entities including Bear Stearns, Lehman Brothers and AIG. A bubble and subsequent collapse occurred in the housing market. The rest is history.
Enter financial reform.
For consumers, the federal government has established the Consumer Financial Protection Bureau within the Federal Reserve that will oversee banks and credit unions with more than $10 billion in assets as well as all mortgage related businesses. Furthermore, the law also permanently lifts Federal Deposit Insurance (FDIC) to $250,000 and establishes minimum underwriting standards for mortgages. Regarding mortgages, the law now requires verification of income, job status and credit history.
The law also attempts to address the issue of “too big to fail,” one which led the U.S. Treasury to bail-out AIG and Citigroup, but let Bear Stearns and Lehman Brothers go by providing authority to the Treasury, FDIC and the Federal Reserve to seize, regulate and perhaps even liquidate struggling companies, regardless of whether or not they can be defined as a bank in the strictest terms or not, if their collapse would pose a systemic risk to the U.S. Economy. In order to provide adequate oversight, the government would assess charges on firms with more than $50 billion in assets.
The assumption of excess risk, a contributor to the meltdown, is also intended to be regulated by the law through a limit on proprietary trading by financial firms. In addition, the law also raises capital requirements.
The securitization of mortgages noted above as well as the usage of derivatives, intended to maximize profits from the potential increase in market value of the underlying real estate also contributed to the deep recession when real estate prices tumbled. Furthermore, given the fact that much of this risk was taken by unregulated firms, the Government was slow to respond. The Financial Reform Bill, officially known as the Wall Street and Consumer Protection Act, begins to regulate the over-the-counter derivatives market by requiring transactions to be completed over an exchange, thereby increasing transparency.
Finally, the law also establishes a Financial Services Oversight Council, chaired by the Secretary of the U.S. Treasury, and charged with identifying potential issues or companies that pose systemic risk to the global economy.
THE BOTTOM LINE – No legislation is ever perfect. However, we believe that this is certainly a step in the right direction as it will hopefully provide early warning signs, thereby preventing a similar near-death economic collapse like the one we experienced during the latter stages of 2008 and early 2009 and from which we continue to recover.