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After the devastation wrought by the subprime crisis and the failure of Lehman Brothers, the Congress is finally getting close to passing essential legislation to fix our broken financial system. Below some key components of the Senate’s (Senator Chris Dodd’s) financial reform legislation which will have its first and possibly most important vote as early as late Monday, April 26, 2010.

I think the bill is a step in the right direction to end too big to fail. The fifty-nine Democrats need one Republican senator to allow debate. Irresponsible, and incorrect, rhetoric by the Republican leadership has turned a bill that does not really have much if any partisan leanings into a political football. Yet, the polling indicates that the American public wants a bill.

Therefore, the smart money currently believes at least one and probably more of the independent minded Senators will break ranks to support some version of a financial regulatory reform bill with the Democratic majority in the Senate.

My overall mark for the proposed legislation is a passing grade of C. I think that if some of the better amendments and changes make it into the financial regulatory reform bill it can still get an A grade. I have broken up my marks by category:

1. Resolution Authority:

This is probably the most essential piece of the bill. The Federal Deposit Insurance Corporation (FDIC) should have the authority act as a receiver for failed bank holding companies and other large financial institutions such as the bailed out insurer American International Group (AIG). The Lehman Brothers disaster showed that that Chapter 11 is not a viable bankruptcy regime for a large complex financial institution.

The devastation that followed the failure of Chapter 11 and a lack of alternative bankruptcy regime has crystallized the concept of too big to fail in the minds of the markets and policy makers. Bondholders and shareholders in large financial institutions should fear failure. I think the resolution fund, which is paid for by the large banks and is similar to deposit insurance premiums, is a good idea, but it should not be a deal breaker. (The resolution fund was a “Republican idea” which was not proposed by the White House.)

Current Grade: B+

My grade will fall to B- without any resolution fund, and it rises to an A- with a larger resolution fund.

2. Derivatives Regulation:

Senator Blanche Lincoln’s (D-AR) bill, which was passed by of the Agriculture Committee, would force standardized derivatives (except possibly foreign exchange derivatives) onto clearinghouses and exchanges. Further, it would allow the Commodities Futures Trading Commission (CFTC) to regulate swaps, much to the chagrin of big Wall Street banks. Higher standardized collateral requirements for credit default swaps could have prevented the AIG bailout entirely. Unlike the Dodd financial reform bill, which did not get a Republican vote when it passed the Senate Banking Committee, this part of the legislation got one Republican vote in committee.

Current Grade: C+

This part of the legislation could get an A- mark. To get the higher grade, the Federal Reserve should be allowed to lend to banks that are derivatives dealers. The Dodd Bill does not have this ill conceived proviso. It would be very dangerous to deny Federal Reserve lending to banks and brokers in a crisis. That ban will almost surely feed financial instability.

3. Ratings Agency Reform:

The reform bill makes it easier to sue ratings agencies. Since over 90 percent of the AAA ratings of some vintages of residential mortgage backed Collateralized Debt Obligations (CDOs) have been downgraded, the ratings agencies are obviously in a terrible need of reform. If Congress can help restore some scrap of trust in ratings agencies, it will be easier to restart securitizations.

While exposure to legal liabilities may make the ratings agencies more careful, the real problem is excessive competition between ratings agencies. If we paid English teachers by the number of essays that they graded and let students choose the teachers that graded their essays, the most successful English teacher would give A grades for Romeo and Juliet essays that asserted that Romeo and Juliet lived happily ever after. (If your Shakespeare is a little rusty, Romeo and Juliet both committed suicide.) Yet, the ratings agencies make their money by being paid by the banks that they give easy grades to. Ratings shopping needs to be stopped.

One way to lessen competition between ratings agencies would be to require that investment banks would have to get (1/3) of their deals rated Moody’s, (1/3) of their deals by Fitch, and (1/3) deals rated by S&P.

Current Grade: F+

The grade rises to D- if they adopt the “Gross Negligence” standard for suing the ratings agencies in the House Bill. I’m not aware of any good amendments that would improve the ratings agencies reforms substantially.

4. Extra Credit

a. Bank Tax:

The big financial institutions with over $50 billion in assets have to pay 15 basis points fee on their non-deposit liabilities, according to a White House proposal. This payment reimburses taxpayers for bearing the systemic risk that these large institutions impose on the financial system. This is likely to be tacked onto the legislation because it has the administration’s support.

Extra Credit Points: +5%

b. Break up the Big Banks:

Senator Sherrod Brown’s (D-OH) and Ted Kaufman’s (D-DE) Amendment basically follows the advice of James Kwak and Simon Johnson in 13 Bankers and puts strict size and leverage limits on the big banks. Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), Morgan Stanley (MS), JPMorgan Chase (JPM), and Wells Fargo (WFC) would have three years to spin themselves off into smaller banks. This is a good idea, but lacks the backing of the White House. Nevertheless, it may have a chance to make it into the bill, and the President is unlikely to veto this. A more likely scenario is that the final bill will adopt language which allows regulators to break up banks that pose systemic risks.

Extra Credit Points: +20% for strict size caps or +5% for just allowing regulators to decide if banks should be broken up.

Disclosure: I only own broad-based index funds. I do not own individual securities in the companies mentioned.

Source: Grading the Financial Regulatory Reform Bill