Stockbrokers, credit raters, Fannie among study targets ordered by financial reform bill

Introduction

When faced with some of the toughest issues in writing the financial regulation reform bill, Senate and House negotiators resorted to a classic Washington approach: They ordered up studies.

Most of the reports required by the financial reform bill are a grab bag of issues that reflect concerns of an individual lawmaker, or are designed to deflect any immediate action. But not all of the 42 studies and reports listed in the massive bill’s table of contents are destined to gather dust. Several are intended to form the basis for regulations such as eliminating conflicts of interest at credit rating agencies, and spelling out options for housing finance giants Fannie Mae and Freddie Mac.

For instance, lawmakers sought to fast track a Securities and Exchange Commission analysis of whether ordinary investors understand the different standards of care that apply to investment advisers, who must place clients’ financial interests ahead of their own, and stockbrokers, who are not held to that standard. The bill specifically orders the SEC to “seek and consider public input, comments and data” to help prepare its six-month report, which will give stockbrokers a chance to weigh in. The bill language states that the SEC has the authority to require brokers to place their customers’ fiduciary interests first, an issue that an agency advisory committee has already been looking at.

“I don’t think this is a study that will just be put on the shelf, even though the industry hasn’t given up its fight to limit the scope of placing a fiduciary duty on brokers,” said Barbara Roper, director of investor protection at the Consumer Federation of America. “The key is who will (SEC Chairman) Mary Schapiro ask to lead this study.”

Another one that will be watched closely by reform advocates is an SEC analysis of how to reduce conflicts of interest when a big bank hires a credit rating agency to rate a new securities offering. The SEC gets two years to look at ways to create an impartial mechanism that would assign a credit rating agency to rate new asset-backed securities — an approach put forward by Democratic Sen. Al Franken of Minnesota. The SEC is also explicitly empowered to carry out a plan after it completes its report.

“This is a federal study that will actually result in concrete action,” said Caleb Gibson, federal affairs manager at Demos, a non-partisan think tank. “The language says that the SEC ‘shall’ adopt a new mechanism to assign ratings after studying the issue … and that one word makes all the difference.”

One of the most daunting studies ordered up by the bill gives Treasury Secretary Timothy Geithner six months to recommend the best way to get home finance giants Fannie Mae and Freddie Mac off the government dole. The two government-sponsored enterprises (GSE) have received more than $145 billion from taxpayers since they were effectively nationalized in September 2008, and the cost keeps rising. Among the options: privatization, liquidation, breaking them into smaller companies or shifting their functions into a federal agency. Geithner faces a Jan. 31 deadline to send his report to House Financial Services Committee Chairman Barney Frank, a Democrat who drew much criticism from Republicans for not including the GSEs in the financial reform bill.

David Berenbaum, chief program officer of the National Community Reinvestment Coalition, says the Fannie and Freddie report will be avidly read by lobbyists for consumer groups and Wall Street. “The administration has GSE reform on its list of priorities for early 2011,” Berenbaum said. “While it’s a little bit of an open question as for timing, I do believe that policymakers will be focusing in on this issue.”

“Studies in Washington are infamous for doing nothing and punting the ball,” said Lauren Weiner, spokeswoman for Americans for Financial Reform , a coalition of national and state groups. The coalition successfully lobbied to get new restrictions on banks’ risk-taking included in the final bill, rather than put on hold while a study was completed. “The original Senate bill for financial reform would have ordered a study before the Volcker rule could be adopted, and we were glad to see that taken out in the final version of the legislation,” Weiner said. The Volcker rule, named for former Fed Chairman Paul Volcker, limits how much of big banks’ own money can be invested in hedge funds and private equity.

The reform bill has been passed by the House and is expected to win approval from the Senate next week before going to President Barack Obama to sign into law. Some of the other studies required by the bill include:

• SEC Revolving Door — The Government Accountability Office will analyze how many SEC enforcement lawyers leave for high-paying jobs defending companies before the agency, a practice that Republican Sen. Charles Grassley of Iowa recently criticized. The one-year study will also recommend if “greater post-employment restrictions” should be placed on departing SEC employees.

• Carbon Markets — Led by the Commodity Futures Trading Commission chairman, an interagency group will take six months to recommend how to regulate and bring transparency to existing and future carbon markets, including trading in the spot market. Some fear that without the proper regulations and oversight, a carbon market could become a new financial bubble.

• Peer Lending — The GAO gets one year to examine if person-to-person lending platforms should remain under the SEC’s jurisdiction or be shifted to the new Consumer Financial Protection Bureau. The market for peer lending is dominated by Prosper and Lending Club, two Internet auction sites where consumers post loan requests for several thousand dollars, which triggers bidding from individuals and institutional investors to supply the loans. The GAO study must also consider how to safeguard consumer privacy and data, prevent money laundering, and whether to set minimum credit standards.

• Chinese Drywall — The Housing and Urban Development Department must examine whether drywall imported from China during 2004-07 contributed to mortgage foreclosures and if owners of homes with defective drywall can obtain property insurance. The report is due in four months.

• Government Watchdogs — The independence, effectiveness and expertise of both presidentially-appointed inspectors general and those appointed by agency heads will be assessed by the GAO. The one-year study was added to the bill after some lawmakers unsuccessfully sought to convert inspectors general at the SEC, Fed and CFTC into presidential appointees that must be confirmed by the Senate instead of being hired by their respective agencies.

• Brokered Bank Deposits -—The Federal Deposit Insurance Corp. will study if changing the definitions of brokered and core deposits would hurt the agency’s deposit insurance fund, stimulate local economies, or affect competition between big banks and community banks. The report’s recommendations are due in one year. The FDIC says banks classified as “undercapitalized” may not accept any brokered deposits while “adequately capitalized” banks must first obtain a waiver from the agency. Brokered deposits are sometimes known as “hot money” because they flow to banks willing to pay the highest rate of return and quickly move elsewhere when a higher rate is available.

• Self-Regulation by Hedge Funds — The GAO will get one year to look at whether a self-regulatory organization should be created to oversee hedge funds, much like FINRA regulates member securities firms and their trading in stocks, corporate bonds, and securities futures and options. “Industry lobbyists managed to pare down legislation that would have required self-regulation in the earlier drafts of financial reform legislation. But they weren’t able to kill it altogether,” lawyer Stephen Nelson wrotein a commentary published by Traders magazine. A self-regulatory group would free up SEC resources to focus on higher priorities, he said. “All other things being equal, this adds up to more intense regulation, which adversely affects industry profits.”

• Short-Selling — The SEC will revisit the issue of short selling, this time to weigh the benefits and costs of requiring real-time short sellers to make public their positions in listed securities. In addition to that year-long study, the agency must consider a voluntary pilot program in which public companies would agree to have all trades of their shares marked as “short,” “market maker short,” “buy,” “buy to cover,” or “long.” Short-selling, in which an investor bets that a stock price will drop, was blamed for contributing to a steep slide in bank stock prices at the height of the financial crisis.

• Private Education Loans — The Education Department, with help from the Federal Trade Commission and the U.S. Attorney General’s office, will study the rapid growth of the private education loan market and the repayment record of student borrowers. The two-year study will also examine private educational lenders, their underwriting criteria such as default rates, and their compliance with fair lending laws. Democratic Sen. Richard Durbin of Illinois has expressed concern about what he calls “slick marketing” and steep tuition costs at for-profit colleges that leave students deeply in debt.

• Credit Availability — The GAO will analyze the effect on lenders’ capital reserves of credit risk retention provisions for non-qualified mortgages, and if the new requirements reduce the risks to credit markets from the repackaging of securitized loans on the secondary market. The requirement orders loan securitizers to “keep some skin in the game” by retaining at least 5 percent of the credit risk. The subprime mortgage meltdown at the root of the financial crisis in 2008 is blamed in part on the risky mortgages that were packaged and sold as securities, leaving sellers of securities off the hook if anything went wrong with those risky mortgages.