Financial Reform Moves Forward, With Many Loopholes

As Congress inches toward restructuring U.S. financial regulation, lawmakers in the House and Senate have characterized their respective bills as sweeping and historic.

But proposals focused on consumer protection, privately-negotiated derivatives and credit rating agencies still allow broad exemptions for key players in the financial system. The Huffington Post Investigative Fund reviewed both reform packages and assembled a chart [1]that compares the bills—and their loopholes.

BACKGROUND » [2]
A quick guide to financial reform legislation.
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On Thursday, amid wrangling within the Democratic Party and intense lobbying by the financial industry, the full House began debating the “Wall Street Reform and Consumer Protection Act of 2009 [3],” a package of bills largely authored by Financial Services Committee Chairman Barney Frank (D-Mass.) Lawmakers are considering three dozen amendments—some that could substantially alter the bill--and the package likely will be voted on by the House on Friday. Few if any Republicans are expected to support the reforms.

The Senate Banking Committee, led by Sen. Christopher Dodd (D-Conn.), has crafted a single broad bill [4] for systemic reform. Dodd, however, has yet to corral bipartisan support and the bill likely will be reconfigured before the committee takes it up early next year.

"I didn't get everything I wanted, but this is the most significant increase in regulation of the financial industry since the New Deal."
— Rep. Barney Frank (D-Mass.)

Central to both chambers’ efforts is the creation of a new agency that the Obama administration has characterized as a must: a Consumer Financial Protection Agency.

The agency would consolidate oversight authority now divided among a range of federal regulators. It would have the power to write new regulations of financial products such as mortgages and credit cards. But some key sources of consumer loans--auto dealers, smaller banks, student lenders--would be exempt from enhanced oversight in the House bill. Late Wednesday, pro-business Democrats also forced compromise language into an amendment that prevents states from enforcing thougher standards for national banks.

Meanwhile, reforms aimed at the shadowy derivatives markets and credit rating companies—widely blamed as contributors to the financial tailspin—also contain loopholes.

Over-the-counter derivatives are among the most complex of financial products that Congress is trying to tame. These insurance contracts, which grew in popularity in the past decade, were unregulated at the time of the crisis and still remain a murky product.
Frank and Dodd are proposing regulations that will raise capital and margin requirements to prevent derivatives traders from committing more than they can cover. The bills also seek to track derivatives trading by increasingly moving it onto regulated clearinghouses and exchanges.

Both bills, however, allow a third option for trading--a “swap execution facility,” an alternative derivatives marketplace that could avoid robust regulation. The bills also offer wide exemptions for companies that use derivatives as a hedge against risk. Derivatives traded on foreign exchanges, as well as those based on foreign currency, will be exempt, a provision that some believe will encourage the customization of derivatives to fit the loophole. 

The bills also will allow credit raters to escape an overhaul. Investors lost billions of dollars in the fall of 2008 when bundles of bonds given high marks by the credit rating agencies swiftly lost value and ultimately defaulted. The ratings turned out to be wildly inaccurate and there are few avenues--save legal action—to hold credit raters accountable. So far, the raters are undefeated in court against investors.

The House does little to promote legal accountability. The bill clarifies that, to be held liable, a credit rater must have “knowingly or recklessly” issued a false rating.

The Senate bill goes further. It would allow investors to sue if the raters "knowingly or recklessly" failed to “investigate” a bond before rating it. The bill also would allow the SEC to “deregister” a rating company for issuing inaccurate ratings over time.  

Both bills would make the rating process more transparent by requiring the rating companies to publish their methodologies.
But that requirement, critics say, is not enough to prevent further rating failures.

“You’re asking the firms that need to be regulated to define their own processes for regulation, and then report on if they are not followed,” James Heintz, associate director of the Massachusetts-based Political Economy Research Institute.

Leven and Zilberman are Investigative Fund interns. Ben Protess and Christine Spolar contributed to this report.

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