The Triumph of Crony Capitalism: Part 3

 |  Includes: IYF, RYF, UYG, XLF
by: Econophile

<< Click here to read Part 1, Part 2

Until I began to examine the Dodd-Frank financial overhaul bill I had no idea that it would so significantly change the direction of the United States. It's scope is so vast and pervasive that it is difficult to grasp its totality. I wrote this article to try to explain this and why I believe it is so important for us to understand it. Because of its complexity it was not possible to do this briefly, so I wrote this major "white paper" and divided it into four parts to make it easier to digest. Please stick with me for the next few days; your eyes will be opened.

Part 3

We continue to look at the Act's provisions.

Regulation of Derivatives and ABS

Recall that one of the major themes behind the Act is that the “murky” world of “exotic” instruments such as credit default swaps and asset backed securities (ABS) added unacceptable risk to the financial system. The goal of the Act is to provide “transparency” and “accountability” for those engaged in such instruments.

The SEC and Commodity Futures Trading Commission (CFTC) will regulate derivative markets. The CFTC is involved because they regulate the futures and options markets which are included within definition of “derivatives.”

The new rules:

  • Require securitizers of ABS to maintain 5% of the credit risk in assets transferred, sold, or conveyed through the issuance of ABS ... The new rules must allocate the risk retention obligation between securitizers and originators. The retained risk may not be hedged. [The “skin in the game” rule.]
  • Banks must spin off "riskier" swaps dealing activities but can still conduct such activities through separately capitalized affiliates.
  • All standardized swaps must be cleared and exchange-traded.
  • End users [i.e., those who use derivatives for actual commercial hedging purposes] are exempt from the clearing requirement ...
  • The banking regulators, the SEC and the CFTC, will set margin and capital requirements for uncleared swaps.
  • Security-based swap dealers and major security-based swap participants will be required to comply with SEC-prescribed business conduct standards. … [They] will have a duty to communicate with counterparties in a fair and balanced manner based on principles of fair dealing and good faith and other standards and requirements prescribed by the SEC. [If you read The Big Short, you might say that this is the “Goldman Sachs Rule.”]
  • It imposes new liability on securitizers for the underlying mortgages originated by third parties.

The Wall Street Journal ran an article exploring the world of farmers and futures contracts. Farmers rely on forward contracts to hedge their risks. What was interesting is the conclusion of the article: “There is no real understanding if the Act will exempt, say farmers who use futures as a hedge, or make it more difficult for them to hedge.”

Office of Credit Ratings

To regulate credit rating agencies, a new Office of Credit Ratings is established. The most significant outcome of the Act is that investors are allowed to sue the rating agencies. They are now treated like other “experts” such as lawyers and accountants and are subject to the same liabilities.

There are basically only three credit rating agencies, Standard & Poor’s, Moody’s Investor Service, and Fitch Ratings. They are referred to as Nationally Recognized Statistical Rating Organizations (NRSROs) under the Act. These private companies are sanctioned by the SEC and the Treasury to give credit ratings. A kind of monopoly if you will. Basically you can’t sell a security to the public without a rating from one of these companies.

When the rating agencies figured out what the legislation was doing to them, they promptly notified their clients that they couldn’t use their ratings in ABS securities registrations. That apparently put a halt to the ABS market and caused Ford to pull a pending offering. This caused the SEC to postpone the rules for six months until they figure out what to do.

This rule is actually a good thing in my opinion within the current regulatory structure. The failures of the rating agencies were part of the problem with the mortgage backed securities market. It is apparent that it wasn’t just that they didn’t understand the risk involved, rather they ignored it. If a lawyer gave an opinion that caused investors to lose money because of the lawyer’s negligence, the lawyer gets sued. Why not the rating agencies?

Office of Investor Advocate

A new Office of Investor Advocate is set up within SEC; plus there is an Investor Advisory Committee.

There are a number of provisions promoting “corporate democracy” such as allowing shareholders to nominated directors, to vote a non-binding resolution on executive pay and retirement packages, and establishes new rules governing corporate compensation committees. One of the aims of the legislation was to discourage corporations from paying “excessive” compensation to their executives, in the belief that it encouraged short-term thinking while sacrificing long-term stability.

The most significant rule is that the SEC is granted discretionary rule making authority to establish new standards of conduct for broker-dealers and investment advisers when providing personalized investment advice to retail customers. The concept is that the broker must act in the ”best interest of the customer without regard to the financial or other interest of the broker-dealer or investment adviser providing the advice.” This gets close to making broker-dealers act in a fiduciary capacity to its retail customers.

Bureau of Consumer Financial Protection

A new agency, the Bureau of Consumer Financial Protection, has the task of regulating consumer financial products such as, checking accounts, private student loans and mortgages. The agency will have the authority to "deal with unfair, abusive and deceptive practices.”

The new bureau will set standards for credit cards. Certain penalties are eliminated, reducing bank profits, which will raise costs for consumers in other areas. This has nothing to do with the bust, but rather is an exercise of power by the Democratic majority to impose politically popular “consumer friendly” rules that limit penalties that upset credit card users and borrowers.

New mortgage lending rules are established: prepayment penalties are limited, banks must lend on the basis of the borrower’s ability to repay, borrowers must submit more data showing they have the ability to pay, loan brokers and loan officers can’t be compensated for steering customers to a particular type of loan or rate, and new appraisal regulations establish rules on appraiser compensation.

A new Office of Housing Counseling is established within HUD. This new agency is described as follows:

The [Office] establishes rules necessary for counseling procedures, contributing to the distribution of home buying information booklets, carrying out functions regarding abusive lending practices relating to residential mortgages, providing for operation of the advisory committee, collaborating with community-based organizations with expertise in the field of housing counseling and providing for the building capacity to provide housing counseling services in areas that lack sufficient services

The creation of this agency is not encouraging. It is yet another wasteful bureaucracy within a vast federal structure.

The Act increases the requirement to qualify as an "accredited investor," the kind of investor one must have to avoid SEC registration for private placements. Accredited investors must now have a $1 million net worth excluding the value of their primary residence, whereas the old rule was simply a $1 million net worth.

Federal Insurance Office

This is new. Generally insurance companies are regulated by the states. The reason many insurance companies incorporate separate entities in each state is to avoid federal regulation. But, while most regulation is still relegated to the states, a new Federal Insurance Office can step in and take over a company if it threatens “financial stability”:

The Act creates the Federal Insurance Office (FIO), the primary task of which will be to monitor insurance issues of national importance and give reports to the Secretary of the Treasury and Congress on such issues. The FIO also will advise the Secretary on major domestic and international insurance issues. …

The Act gives the FIO the authority to supervise … an insurance company, if material financial distress at the company or the activities of the company could pose a threat to the financial stability of the United States. An insurance company subject to the FIO’s supervision will be required to meet certain “prudential standards” concerning its operation. The prudential standards will be more stringent than those applicable to other nonbank financial companies that do not present similar risks to the nation’s financial stability.

The Act provides for the orderly liquidation of companies under the FIO’s supervision if it is determined that they should be put into receivership. The prudential standards concerning the operations of insurers under supervision will be in addition to, or instead of, state insurance regulations. The prudential standards may limit the ability of subject insurance companies to operate with the same level of freedom they now enjoy under the state-based regulatory regime. Overall, the states’ ability to regulate insurance companies under the FIO’s supervision may be more limited as a result of the Act.

Remember AIG? Nothing, it appears, is beyond the reach of federal control. Like other powers granted by the Act, the new FIO can basically regulate any insurance company it finds to be a threat to financial stability.

Regulation of Investment Advisors

Formerly mildly regulated private investment advisors are now required to file a statement with the SEC describing their activities. The law applies only to those advisers with $150 million under management. Private family offices are exempt.

Hedge Fund Regulation

Large hedge funds and fund advisers ($150 million plus) must “register” with the SEC. Many large funds already register so this will only affect the smaller funds.

Extraterritoriality of the Act

This is one of the aspects of the Act that seems to be passed over by commentators, but the Act grants the regulators the power to extend control over economic activity normally beyond the jurisdiction of the federal government. Gibson Dunn explains the new extraterritorial provisions of the Act as follows:

Securities markets are increasingly global with multinational companies listing securities for trading in the United States and with trading in U.S. securities occurring in overseas markets. At the end of its most recent term, however, the Supreme Court ruled that Section 10(b) of the Securities Exchange Act prohibited fraud only in connection with the purchase or sale of securities listed for trading on a domestic, United States exchange and did not extend to securities listed abroad but traded in the United States through American Depositary Receipts. Morrison v. National Australia Bank, N.A. ___ U.S. ___, No. 08-1191 (June 24, 2010).

Congress added provisions to the Act which restored the authority of the SEC and of the Department of Justice. In particular, the Act amended Section 22 of the Securities Act, Section 27 of the Securities Exchange Act, and Section 214 of the Investment Advisers Act to confer U.S. court jurisdiction over violations of the three anti-fraud provisions involving (i) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors, or (ii) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.

I am sure this new authority will be tested in the courts, and perhaps the Morrison case may give us hope these vague powers will be deemed unconstitutional, but the intent of the Act is to allow no foreign refuge.

The federal government’s extraterritoriality push is part of a larger move toward supranational regulation of financial companies. Since the 2008 crash, countries have been meeting under the auspices of the Bank of International Settlements to discuss international financial stability. One of the outcomes of these efforts will be the new Basel III requirements regarding bank capital and liquidity structures. For example, the minimum Tier 1 leverage ratio for banks worldwide will be 3%.

Is Your Gold Conflict Free?

The Act condemns ‘conflict’ minerals from the Democratic Republic of the Congo, and as such the SEC will draft rules to assure a conflict free chain of custody to prove they are not from sources deemed exploitative such as local warlords. The minerals include gold which is produced by artisanal miners in certain areas. The SEC will produce a map of Congo to aid buyers.

Disclosure: No positions