The Senate’s action last week to discourage high-risk behavior and regulatory failures has been hailed as the most sweeping reform of the banking and financial system since the 1930s, yet the landmark legislation leaves huge gaps in addressing the causes of the 2008 financial crisis, according to analysts and experts.
Most notably, the Senate-passed bill doesn't address the future of Fannie Mae and Freddie Mac, the mortgage giants at the center of the credit market collapse, which hold $5.5 trillion of residential housing loans, about three-quarters of the market. Nor does the massive, 1,500-page bill establish comprehensive regulation of insurance companies, such as American International Group. Instead, the bill would create an insurance office at the Treasury Department merely to collect data from state insurance regulators.
"This bill is a very good first step to bringing some of the opaque portions of the market under regulation [but] there's a number of key questions that haven't been addressed," said David Min, associate director for Financial Markets Policy at the Center for American Progress, noting that past regulatory overhauls took effect in several stages. "In the 1930s, the regulations that we all take for granted today didn't happen in one fell swoop."
The Senate approved the measure late Thursday, by a vote of 59 to 39, after nearly three weeks of often rancorous debate. Four Republicans voted in favor of it—Olympia J. Snowe and Susan Collins, both of Maine, Charles Grassley of Iowa and Scott Brown of Massachusetts—while Democrats Maria Cantwell of Washington State and Russell Feingold of Wisconsin opposed it as too lenient on Wall Street.
Now a handful of Democratic lawmakers and leaders must resolve differences between the Senate measure and a House-passed bill so a final version can be approved by Congress and sent to President Obama for his signature by July 4. Experts note that there are a number of differences that could trip up the negotiators—most notably, oversight of financial derivatives. Even after a final bill is agreed to, there will likely be months and years of work by regulators to iron out and interpret scores of requirements negotiated by lawmakers under tight legislative deadlines.
"This is the mother of all reform bills that is likely to be birthing children for so many years,” said Dan Crowley, a partner at the K&L Gates law firm, who represents financial services firms. “Every financial services body in the city is going to be promulgating regulation and conducting studies and reporting back to Congress . . . It's the beginning of what is likely to take years."
In pressing for passage of the legislation, Obama and Democratic lawmakers sought to reassure Americans that never again will the global economy be threatened by hidden use of arcane financial “swaps” and other derivatives, ineffective regulators, mortgage fraud and excessive risk-taking by firms deemed too big to fail. The crisis arose when a weakening housing market and credit crunch exposed sub-prime mortgage abuses and the extreme use of leverage by firms such as Lehman Brothers and AIG, which had committed transactions worth many times the entire value of the company. The government stepped in with a $700 billion bailout to stop a domino effect of failures from toppling world markets.
TheSenate-passed bill create a new consumer-protection watchdog at the Federal Reserve to prevent abuse in financial products including mortgage, auto and credit card loans, and would empower the government to liquidate failing financial firms and establish a council of federal overseers to police the financial system for risks to the global economy. Also, the legislation would establish oversight of the now largely unregulated derivatives market, while imposing new restrictions on rating agencies and giving shareholders a say in corporate affairs.
"We put an early warning system in place for systemically important firms," said Sen. Mark Warner, a Virginia Democrat. "There's pretty much agreement, 18 months after the bailout, you've got to end too big to fail."
But the sweeping legislation leaves major financial regulatory questions unanswered – especially what to do about Fannie Mae and Freddie Mac. The government took over both institutions during the crisis, pumping in $145 billion since then to keep them solvent. A provision in the Senate bill, not seen in the House version, calls for the Treasury to study the issue and propose a solution by the end of 2011.
Rating agencies would be subject to a new office in the Securities and Exchange Commission under the Senate version of the bill, but it's unclear exactly how practices would change from the conflict-ridden system that awarded AAA ratings to mortgage-based securities that turned out to be worthless. The Senate even approved two apparently conflicting amendments: One would eliminate any legislative reference to national rating organizations and the other would establish a lottery-like system aimed at making ratings conflict-free.
The Senate legislation, crafted by Banking Committee Chairman Christopher J. Dodd, D-Conn., is generally tougher on Wall Street, calling for rules against proprietary trading by banks, requiring banks to spin off their swaps desks and allowing fewer exemptions from regulatory oversight. On the other hand, the House proposed a stand-alone consumer protection agency, instead of housing it within the Fed, and would tax banks to create a $150 billion fund to pay for future bailouts, while the Senate scrapped that approach. The final version is likely to drop the fund.
"In this final stretch we hope lawmakers will resist Wall Street’s efforts to water down the bills' strong provisions," said Michael Calhoun, president of the Center for Responsible Lending, an advocacy group. "First among these is the creation of a strong consumer financial protection agency with power to establish common-sense lending rules."
Conferees are likely to end up closer to the Senate version, analysts said, as the landscape has shifted since the House passed its legislation in December. A federal lawsuit charging Goldman Sachs with fraud and a one-day stock market drop of 1,000 have raised new questions about the soundness of financial markets and their regulation—and stepped up pressure for government action.
"It's more likely that the House-passed bill will be viewed as the starting point and proposals that are perceived as being stronger will be adopted in the conference," Crowley said. "The trend is strongly in favor of stricter regulation and more protection and all that entails."
Another controversial issue on the table is the ability of U.S. banks to deal in over-the-counter derivatives. As of Dec. 31, the four largest U.S. banks controlled derivatives with a face value of $202 trillion, nearly half the global market volume. Under a measure written by Senate Agriculture Committee Chairman Blanche Lincoln, an Arkansas Democrat facing a runoff election next month, banks would be banned from directly dealing in derivatives, which reaped $22.6 billion of revenue for the industry in 2009. One key unsettled question is which type of derivatives or derivatives users would be exempt from new margin, collateral and exchange trading requirements in the legislation.
But even after the bill becomes law, regulators will have to propose and implement provisions called for in the measure, leaving room for strict or lenient interpretations of the legislative intent. Heavy margin, capital and collateral requirements could be untenably costly for financial firms; but too-light rules might fail to prevent a return to risky behavior. The legislation calls for about two dozen separate regulatory studies, which could lead to future rules—or simply a report that will gather dust on a shelf.
"This bill will produce a lot of unintended consequences that will be with us for years," predicted Andrew Lewin, principal at the Podesta Group, a lobby group representing financial services firms. "We're only just beginning to understand how a lot of these changes would impact the real world."
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