Financial Reform Bill: The Devil Is in the Details

Jun.28.10 | About: Financial Select (XLF)

I know I should have the definitive word on the financial reform bill by now, but I guess I don’t. “Reform” legislation always goes too far, almost by definition; so, I take that to be a given. Given that punishing the banks, especially Wall Street Banks, was a main goal of the exercise, some of the last minute compromises made it less worse than it might have been. This was confirmed Friday morning when investors bid up most major bank stocks two to three percent. This doesn’t mean the legislation will be good for banks; it just means that investors believe that what came out in the end was not as bad as the expectations already embedded in the market prices of bank shares.

The devil is always in the details, of course, and I haven’t seen the details yet. The summaries I have seen aren’t very comprehensive. However, the sheer size of the bill—around 2000 pages, I hear—gives me pause. I can’t help believing that some raising of capital standards and limits on leverage (the ratio of debt to equity) would have been sufficient. They wouldn’t have gotten at the proximate cause of the financial meltdown—the making and securitization of subprime mortgage loans—but they are what weakened many financial institutions and caused the fallout to be much worse than it should have been.

Some derivatives hastened the spread of the panic as well as made the impact worse, but as we saw in the early hours of Thursday morning it’s hard to legislate around something like derivatives, which legislators and most of the rest of us don’t understand. It’s hard not to throw out the babies with the bath water. However, as I read various accounts of the crisis behind the scenes, I must admit that I didn’t get the logic of allowing people without an insurable interest make large bets on whether institutions would fail and bonds would default. If you have some exposure to hedge, credit default swaps are fine, but, if you don’t have some risk to mitigate, I think maybe all bets should be off. Massive bets against a firm with credit default swaps along with short sales, especially naked short sales, can logically become a self-fulfilling activity, which may or may not have done Bear Stearns in. At least they didn’t help.

So, higher capital standards, some limits on leverage and prohibition of derivatives with no apparent social benefit may have done 90 percent of the good that needed doing with many fewer unintended consequences that are bound to come out of a 2000 page document that no single person has read yet.

On the proximate cause of the crisis, the securitization of bad mortgages, the bill did have a minor provision requiring the lender to keep some skin in the game—five percent. Five percent isn’t much, but even that was given a way around. If your mortgage is plain vanilla with a sensible down payment, perhaps the 5 percent rule will be waived. Of course, sensible mortgages would have avoided all this in the first place.

Disclosure: No positions