Facts on Financial Reform

It was the fall of 2008 when the economy first shuddered and started its nervous breakdown. Nearly two years later, Congress finally approved passage of major financial reform legislation. Time will tell how if the new laws keep markets safe and sane. Below is a summary of some major provisions; President Obama is expected to sign it into law next week.

Consumer Financial Protection Bureau. Consumer advocates have been pushing for an agency to look out for the interests of everyday Americans. The bureau will be responsible for writing new rules on financial consumer products (mostly loans and credit cards) and enforcing existing bank and credit union regulations. It will also monitor payday lenders and check-cashing businesses. It will also operate a toll-free consumer complaint hotline for individuals to report problems with financial institutions. The agency, which is part of the Federal Reserve, will be led by a director appointed by the President and confirmed by the Senate. Critics point out that the auto-loan industry is exempt from the bureau's oversight and that the agency will only monitor banks with $10 billion or more in assets.

New mortgage rules. Ever inflated your income on a loan application? Good, neither have we. But apparently some people did. That's why lenders are now required to verify applicants' credit history, income, and employment status. There are also restrictions on how many loans the banks can sell to investors. The new rule is supposed to make banks bear more risk, so that they limit lending to people at a high risk of default.

Size matters. The bill creates the "Financial Stability Oversight Council," which is supposed to monitor the U.S. economy for underlying systemic risks. It will make recommendations to the Federal Reserve for how to keep our economy from crashing by keeping tabs on firms that are deeply interconnected within the financial system.

Liquidation authority. The Federal Deposit Insurance Corporation will have a mechanism to unwind "failing systemically significant financial companies." Taxpayers will bear no cost for liquidating large, interconnected financial companies, according to the bill summary.

An audit for the Fed. Owners of the "Audit the Fed" shirts might like this one. The Government Accountability Office (GAO) will perform a one-time review of Federal Reserve emergency lending. The details should be on the Federal Reserve website by December 1, 2010. The GAO will have the authority to conduct more audits in the future, but there is no requirement.

Credit card rules. Ever wonder why some merchants don't allow you to use credit cards on small purchases? Credit card companies charge merchants so-called "interchange fees" for transactions. The bill directs the Federal Reserve to issue rules that ensure that the "fees charged to merchants by credit card companies for credit or debit card transactions are reasonable and proportional to the cost of processing those transactions."

The Volcker Rule. Named after the former chairman of the Federal Reserve, the new rule prohibits banks from engaging in proprietary trading, i.e. trading the bank's money to turn a profit. Advocates for this rule say these kinds of trades tend to put banks into a conflict of interest with their customers. The rules also would limit banks' relationships with hedge funds and private equity funds.

Derivatives. Don't worry folks, no calculus here. A derivative is simply an investment whose value depends on an underlying asset. Here's an example of a good derivative: Southwest Airlines has to buy jet fuel over the coming year to run its planes. If oil prices skyrocket, Southwest loses money. So the airline enters into an agreement that will pay if oil prices increase, lowering its potential for losses. But not all derivatives are so benign, and many blame their misuse for contributing to the financial panic of 2008. The new law gives the U.S. Commodity Futures Trading Commission along with the Securities and Exchange Commission authority to regulate over-the-counter derivatives. Banks would also be prohibited from trading certain forms of derivatives, and most of the trading must occur on transparent exchanges.

Hedge funds. Generally speaking, hedge funds are investment vehicles for selected groups of elite investors. The name comes from hedge funds' tendency to be very careful about managing, or hedging, risk. This means they often buy derivatives or other unusual types of investments. Under the new regulations, large hedge funds would have to register with the Securities and Exchange Commission and report their activities.

Credit rating agencies. The credit ratings agencies are the people who said, before the financial crisis hit, that securities built from subprime mortgages could be great investments. Wrong, wrong, wrong. The bill seeks to address the conflict of interest that arises when banks and financial institutions pay a credit rating agency to evaluate their securities. It calls for a study on the issue, and says that regulators will issue new rules in the future.

"Say on pay." Shareholders of publicly traded companies get to vote on executive pay, though the vote is nonbinding. Translation: The company can choose to disregard the shareholders' vote. (Yes, this doesn't seem like much of a say to us. But experts tell us it's actually progress in the longstanding fight to give shareholders more of a voice in corporate governance.)

Concerns and criticisms

Any major legislation has its critics, and financial reform is no exception. Here are some of the concerns that have been expressed about the legislation that was approved.

Fannie and Freddie. Fannie Mae and Freddie Mac are government-created companies that back many mortgages. They were supposedly private companies but were often thought of as public. When the financial crisis exploded, the Federal Housing Finance Agency placed them in conservatorship because they were out of money. The federal government now is likely on the hook for huge losses sustained by Fannie and Freddie when the housing bubble popped. The current bill doesn't address Fannie and Freddie's losses in any significant way. Experts we spoke with say losses could be anywhere from $200 billion to $400 billion, and the government will have to make good on that eventually.

"Too big to fail is too big to exist." Some economists argued that the idea of resolution authority for large firms is misguided. The large financial firms that pose "systemic" risk cannot be shut down without harming the broader economy, they said, and the big players should be broken up. Others argued against limiting size. The "no need for break-ups" crowd won out in the end.

"To be determined" regulations. Congress decided not to get bogged down in the details in many parts of the legislation. Instead the law instructs regulators to study and develop rules for many areas in the financial world. This means we'll have to wait and see how the law is actually put into practice, and regulators will have a lot of discretion.

Credit access. There is concern among some lawmakers that the law unnecessarily burdens financial institutions with regulations and may restrict consumer access to credit. Critics point out that banks may increase fees or just cut down on lending, either of which would hamper economic recovery.