It was also almost 10 years ago that the major stock indexes started a bear market due the great financial crisis of 2008-2009. Some of the legacies of that time still impact us today. One of the legacies of the financial crisis is the Dodd-Frank Wall Street Reform and Consumer Protection Act. The goal of this law was to ensure that the conditions that lead to the financial crisis never happened again.
Figure 1: Monthly chart of the S&P 500 during the financial crisis of 2008-2009. The index lost nearly 60% of its values before it bottomed in 2009.
But while everyone was watching James Comey's testimony last week, Congressional Republicans passed The Financial CHOICE Act. This bill rolls back several of the regulations found in Frank-Dodd. This bill is almost 600 pages long, and there's a lot to unpack. Let's take a closer look at some of the provisions in this bill and see how they affect you.
Figure 2: Financial CHOICE Act logo. Image provided by the The Financial CHOICE Act website.
The Bureau of Consumer Financial Protection
Republicans have long wanted to reign in the Bureau of Consumer Financial Protection, and this new bill does just that. The Financial CHOICE Act weakens the powers this federal department. It also changes the reporting structure of the bureau, so that its director reports to the president. Now the president can fire the director of the Bureau at will.
The bill also attempts to encourage small banks to issue more mortgages. In a nutshell, The Financial CHOICE Act cuts regulations in an attempt to decrease the costs of granting mortgages to higher risk buyers. Lawmakers hope this will allow small banks to increase their lending.
The Repeal of the Volcker Rule
There are several provisions in this new bill that will directly impact the markets. For starters, it repeals the Volcker Rule. This regulation currently limits proprietary trading and speculation by banks. Proponents of the rule say that rampant bank speculation in subprime loans and exotic derivatives was a major cause of the financial crisis. Former United States Federal Reserve Chairman Paul Volcker also argued that banks were essential to health of the US financial system. As such, they shouldn't engage in speculative and risky investments. But critics claim that it's too complicated to differentiate between market making and speculation. They argue that this regulation is too cumbersome and complicated to implement. The repeal of the Volcker Rule will allow banks to invest in higher-risk financial products once again.
The Repeal of Orderly Liquidation Authority
The great financial crisis of 2008-2009 saw many new types financial firms in deep trouble. For instance, insurance company AIG nearly went bankrupt because it issued insurance policies on risky subprime mortgages that went bust. There were laws in place for dealing with failing banks, but not for insurance companies or non-bank financial companies. Title II of Dodd-Frank established the regulations, called Orderly Liquidation Authority (OLA), needed to handle the liquidation of these other financial institutions. But critics claim that Title II encourages bank bailouts and the notion of "too big to fail." So the Financial CHOICE Act eliminates OLA altogether.
The Repeal of the Fiduciary Rule
Additionally, the Financial Choice Act has language that repeals the fiduciary rule. This Obama-era regulation requires financial advisors to act in the best interests of their clients. The rule was born out of the concern that there were substantial conflicts of interest in the retirement planning industry. The rule has been on life support for a while now though, since President Trump has instructed Labor Department delay its implementation. But this bill may put the final nail in the coffin.
Fewer and Less Rigorous Bank Stress Tests
Dodd-Frank also required banks above a certain size to undergo financial stress tests. Banks were required to conduct these tests annually to determine their ability to deal with a new financial crisis. But The Financial CHOICE Act reduces the frequency of these tests to biannually. The stress testing would be limited to large banks and the bill will repeal some of the more qualitative aspects of those tests.
Changes to Corporate Governance
The Financial CHOICE Act also makes some startling changes to corporate governance and shareholder rights. First off, it changes the eligibility requirements for placing a proposal on a company's annual meeting ballot. Currently, a shareholder must own $2000 in company stock for one year to qualify. But the new bill changes that requirement to 1% ownership of company shares for three years.
The bill also does away with the requirement for companies to report the ratio of CEO pay to median employee pay. The regulation requiring the disclosure of employee and director's hedging of company stock is gone. And companies will no longer have to explain their chairman and CEO structures.
The Impact of The Financial CHOICE Act on Investors.
This bill aims to reduce regulations, and it does just that. It also reduces the deficit by $24.1 billion over the next decade. But there are several provisions in this bill that should trouble investors.
Thanks to the repeal of the Volcker rule, for example, the bill allows banks to make riskier investments in regulated and potentially even unregulated derivatives. That could lead to dramatic losses for banks if these financial instruments suddenly go south. The same kind of risky investment behavior helped to fuel the financial crisis 10 years ago. And with fewer and less rigorous stress tests, we won't even know if the banks are in danger of failing.
This bill also tries to do away with government bailouts of financial institutions by repealing OLA. But this will actually have the opposite effect! Without OLA, the Federal Reserve won't have the legal mechanisms it needs to deal with failing financial institutions. They won't have any choice but to bail out failing companies to prevent a widespread economic collapse.
The bill may have a negative effect on shareholder rights as well. It increases ownership requirements for shareholders to raise issues with the companies they own. This, in turn, makes it harder for shareholders to hold the companies they own accountable. It's no wonder that so many institutional investors and pension funds have come out against this bill.
Overall, this bill allows banks and other financial institutions to re-engage in some of the same behaviors that led to the financial crisis of 2008-2009. Sure the bill helps out the banks by repealing regulations. But it also increases the risk of a longer and deeper market downtrend when the next bear market comes. And it will come, in spite of what the president claims. Our economy is cyclical, and at some point the markets will cycle down to pattern out their gains.
The next step is for the Senate to pass their version of the Financial CHOICE Act. The Republicans hold a slimmer majority in the Senate, however, so the Senate bill likely won't have all the provisions of the House bill. For example, several experts expect the Senate to leave the Volcker rule and Bureau of Consumer Financial Protection alone. But other parts of the House bill may survive, such as the elimination of OLA. For now, we can only wait and see how things pan out in Congress.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.