Financial Reform

The Dodd-Frank Wall Street Reform and Consumer Protection Act.

“All told, these reforms represent the strongest consumer financial protections in history,” Obama said.

“And these protections will be enforced by a new consumer watchdog with just one job: looking out for people – not big banks, not lenders, not investment houses.”

Skimming the local newspaper stands is generally a downer for me, but this week was particularly depressing. It seems like every day a new article emerges to remind us just how bleak the American economic landscape is.

A study released this month by the Employee Benefit Research Institute appeared in papers across the country, announcing that almost half of American’s aged 36 to 62 will not have enough money set aside for retirement, leaving them working… well, until they die.

The unemployment rate, unsurprisingly, continues to hover above 10%, and on top of that, lending across country remains minimal.

And so, with the recession dragging on into its second year, readers may be surprised to discover that Americans by and large don’t care about the financial reforms recently passed in congress – nearly 45% have no opinion, according to a recent poll released by Rasmussen.

As economist Richard Wolff notes, American workers are looking at the new wave of Democratic party reforms and thinking to themselves, “been there, done that.”

As we’ll see in this two-part story, the new reforms will likely do very little to stop either immediate or long-term failures in our banking and financial systems.

Below is given a brief rundown of the two and a half thousand page bill known as the The Dodd-Frank Wall Street Reform and Consumer Protection Act.

Derivatives trading:

Derivatives are, very simply, financial contracts between two parties based on the price of a certain product. If, for example, a farmer were to sign a contract with a super market, agreeing to sell x amount of apples for y amount of money at a specific date in the future, this agreement would be considered a “derivative.”

Derivatives come in many shapes and sizes however, and can be incredibly complex. Derivatives can be based on shares in a company, currency rates, or the prices of goods.

In other words, possible derivatives contracts are nearly endless, and so are the potential gains and losses associated with them.

The vast majority of derivatives deals are being made by an incredibly small handful of firms. As of 2009, according to the U.S. Department of Treasury, five major banks controlled 97% of the U.S.’s total derivatives markets, valued in trillions of dollars.

But because these large firms are also highly influential in other financial markets, their failures with derivatives can severely impact the rest of the global economy, as we saw in the 2008 financial crisis.

Several specific types of derivatives have recently received wide-spread attention for their role in the financial crisis – particularly Asset-Backed Securities (ABS’) and Collateralized Debt Obligations (CDO’s).

Both ABS’ and CDO’s helped inflate the prices of housing and credit by allowing banks and financial institutions easier ways of funding risky investments.

In order to obtain more money for mortgage loans, for example, banks would stick many mortgages together into a single package and sell them to large financial institutions.

Packaging mortgages into a single portfolio decreased the risk normally associated with buying a single mortgage, because even if one of the mortgages failed, there would still be many more generating an income.

In exchange for buying these portfolios, large financial groups would receive all of the income made from the mortgage payments, and the banks who sold the portfolios would then have new money in which to make more loans to home buyers.

This had two effects. First, it allowed banks to make loans to people it knew could not normally pay them back – these risky loans were made “safe” by lumping them together with other loans.

Secondly, as more homes were sold, it raised the price of houses across the country to absurd heights.

In the new financial regulation, legislators have ordered the creation of derivatives exchanges, or “swap execution facilities,” where derivatives would be traded openly in much the same way stocks are. In this way, derivatives trading would be more transparent for regulators.

But the bill exempts any financial institutions from having to participate in these exchanges if a derivative is used to “hedge” or reduce an investment’s risk. Lenders cannot, however, loan to risky home buyers anymore – at least not without proof of income.

On the next page, we will cover sections of the bill dealing with both “too big to fail” and consumer protections.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s