Fixing the Financial System –
Efforts at Reform in 2010
AGA Winter Seminar
January 2011
2010 Highlights
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Squam Lake Report
“Flash Crash” Investigation of 5/6/10
The Valukas Report on Lehman Bros.
SEC action on “Window Dressing”
Basel III banking reforms
Settlement: Securities & Exchange
Commission vs State of New Jersey
2010 Highlights p. 2
• Status of Freddie/Fannie
• Several FASB issues
• NYSE Commission Report on Corporate
Governance
• Financial Crisis Inquiry Commission
report now due January 2011
• Dodd/Frank Financial Reform Bill
Background Economic Trends
• Increasing concentration of bank capital –
3 large banks
• Union of banking and investment capital in
same firms since repeal of Glass-Steagall
• Unsustainable federal spending
• Recovery underway but weak job growth
• Heightened income stratification
• So-called “Shadow Banking System”
Background: Shadow Banking
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Generally don’t accept traditional deposits
So not subject to regulatory oversight
Unregulated activity by regulated entities
Examples: money market funds, hedge
funds, finance companies, GSEs, SPEs
• Examples: many derivatives, credit default
swaps, repurchase agreements
• Vulnerability; lack of transparency
Squam Lake Report
• Subtitled, “Fixing the Financial System”
• Bipartisan panel/advisors to both parties
• Based on recommendations of 15
economists that includes:
• 8 of 9 past presidents of American Finance
Association
• And includes Robert Shiller, author of
Irrational Exuberance
Squam Lake Recommendations
• Central bank should be the systemic
regulator
• Address critical information gaps
• Improve regulation/disclosure of retirement
savings
• Strengthen bank capital requirements
• Encourage clearinghouse/ exchange for
credit default swaps
Squam Lake Report p. 3
• More flexibility in recapitalizing troubled
financial institutions
• “ A Living Will” for large financial
institutions; i.e. “planned demise”
• The final chapter: “Replaying the world
financial crisis, how our recommendations
might have helped.”
Flash Crash: a “Major Anomaly”
• May 6, 2010 2:45 PM sudden plunge
• DJIA fell 600 points in 5 minutes, regained
most of loss in next 10 minutes
• Unsettling impact highlights role of trading
• No full explanation until SEC/CFTC
(Commodities Futures Trading
Commission) report issued 10/1/10
• Culprit: a mutual fund sell algorithm
“Flash Crash” p. 2
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Waddell & Reed Asset Strategy Portfolio:
A “Go Anywhere” mutual fund
Sell order for S & P 500 futures with
75,000 contracts totaling $4 billion
Whole incident highlights high frequency
trading/market risk
• SEC still evaluating “circuit breakers”
Valukus Report on Lehman
• Anton Valukus report to bankruptcy court
on March 12, 2010
• Found “materially misleading” accounting
activities designed to remove assets from
the balance sheet
• Steps approved by Ernst & Young
• Executive level whistle blower fired
• Firm realized it was overleveraged and:
Valukus Report: “Repo 105”
• Just before end of quarter, exchanges
assets for cash in “repo” market - $49 bill.
• Values the assets at 105% of cash
received to treat it as a sale transaction
• Reports lower leverage in quarterly filing
• Reverses the exchange several days later,
essentially hiding assets to make firm
appear stronger
Bank “Window Dressing”
• Spring 2010: Wall Street Journal
investigation into bank quarterly reporting
• July 2010 BOA admitted temporally
shedding debt to meet internal goals
• Not illegal but deceptive; much smaller in
scope than Lehman Brothers Repo 105
activity
“Window Dressing” p. 2
• Called a “dollar roll” trade:
• Traded mortgage backed securities for
cash and agreed to repurchase shortly w/
similar securities –
• September 2010 SEC Commissioners
unanimously propose reinstatement of
1994 rule on additional disclosure of
trading to address this
Basel III
“The objective of the Basel Committee’s
reform package is to improve the banking
sector’s ability to absorb shock arising
from financial and economic stress,
whatever the source, thus reducing the
risk of spillover from the financial sector to
the real economy.”
– BCBS press release 12/19/09
Basel III
• Basel Committee on Bank Supervision
• Report issued to G-20 Nations meeting in
South Korea November 2010
- Tighter capital requirements: 4.5% of
common equity by 2015, further 2.5%
by 2019
- Leverage ratios; counter-cyclical buffers
Status of Fannie Mae and Freddie
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Federal National Mortgage Association
Federal Home Loan Mortgage Association
GSE: Government Sponsored Entity
9/7/08: Conservatorship by Federal
Housing Finance Agency (FHFA).
• Purchases loans, securitizes them, sells
them in the secondary market with the
assumption of federal guarantees
Fannie/Freddie p. 2
• As of December 2010 – FHFA estimates
total cost $320 billion.
• Challenge of shrinking or winding down:
Avoiding further damage to the housing
market
• Congressional committees to take up in
early 2011
SEC vs New Jersey
• August 2010 – first securities fraud case
against a state
• Charged N.J. mislead bond investors as to
health of 2 large pension funds 2001 – 07.
• Failed to properly fund the accounts
• N.J. settled w/ SEC
• SEC warning to government entities
FASB Issues
• New Chair appointed – Leslie Seidman
• Mark to Market Accounting
• Off Balance Sheet Reporting – FASB 140
replaced with FASB 167
NYSE Commission on Corporate
Governance
• White Paper on 10 core governance
principles.
• 1st principles is: “Fundamental objective
should be to build long-term sustainable
growth in shareholder value.”
• 2nd principle mentions risk management
and internal control
• Available on Protiviti web site
Financial Crisis Inquiry
Commission
• FCIC established by law in 2009 to
investigate and issue a report, now due in
January 2011
• Bipartisan; former Treasurer of CA Phil
Angeledes is the Chair; former Rep. Bill
Thomas Co-Chair
• Hearings on C-Span and White Papers on
Commission web site
• December 15, 2010 minority document
Dodd-Frank Wall Street Reform
and Consumer Protection Act
• Enacted into law July 21, 2010
• Most comprehensive financial reform
legislation since the 1930’s
• Intensive period of rule-making now
underway
• Estimated 243 rules; 67 one-time
studies/reports; 22 new periodic reports
Dodd Frank Overview Today
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Federal organizational changes
Systemic risk management – FSOC
Office of Financial Research
Orderly liquidation regime
Bank capitalization & securitization issues
Proprietary trading reforms
Derivative reforms
Dodd Frank Overview p. 2
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Hedge Fund developments
Credit rating agency reforms
Insurance industry developments
Bureau of Consumer Financial Protection
Mortgage reforms
SEC whistleblower rules
Municipal securities actions
Other miscellaneous developments
Oversight Changes
• OTS eliminated, duties to OCC/ FDIC
• Identification and monitoring of
systemically risky firms and a living will for
some firms
• More oversight of derivative markets
• Broad consumer product oversight
• Some oversight of hedge funds
Financial Stability Oversight
Council - Structure
• Chaired by Secretary of Treasury
• Voting Members: Heads of Treasury, Fed
Reserve, SEC, FDIC, CFTC, FHFA, OCC,
NCUA, Bureau of Consumer Financial
Protection, insurance representative
• Nonvoting Members: Directors of Office of
Financial Research and Federal Insurance
Office, State Insurance, Banking,
Securities Commissioners
Financial Stability Oversight
Council - Tasks
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Identify risks to US financial system
Identify systemically important companies
Make recommendations to Fed Reserve
Requires risk committees, stress testing,
and orderly liquidation plans
• Inclusion of off-balance sheet reporting
• “Hotel California” provision
Office of Financial Research
• To support Financial Stability Oversight
Council
• Housed in Treasury but largely
independent authority to gather
information backed by subpoena power
• Director appointed by President but w/
advice and consent of Congress
• Mandated reports
Orderly Liquidation
• Resolution regime (like w/ FDIC) would
make future bailouts unnecessary
• Under certain conditions would replace
bankruptcy code
• Guidelines re: oversight, procedures,
hierarchy for claims
• Orderly Liquidation Authority Panel
Orderly Liquidation p. 2
• Orderly Liquidation Fund
• “Taxpayers shall bear no losses from
liquidating any financial company under
this title and any losses shall be the
responsibility of the financial sector
recovered through assessment.”
Bank Capital & Securitization
• Collins Amendment drafted by FDIC
• Generally more stringent leverage and risk
based capital requirements
• Reflects changes proposed in Basel III
agreements
• Federal Reserve to establish new
standards
Securitization
• Process of turning mortgages, loans into
marketable securities
• Generally requires firms to retain some of
the risk
• Separate risk retention for different asset
classes
• Specifies federal rule making
The “Volcker Rule”
• Generally limits extent of proprietary
trading
• Amends Bank Holding Company Act of
1956: aim is to reduce speculative
investment of large firms
• Certain permitted activities and
exemptions
• 2 year transition
Derivatives
• “Financial contract whose value is linked
to an underlying price or variable”
• CFTC regulates commodity futures &
options on futures; SEC regulates options
on securities; swaps on OTC (exempt)
• OTC controlled by small banking group
• Market at 700 trillion in 2008
Derivatives p. 2
• Regulates most derivative transactions
• More derivatives traded and cleared
through regulated exchanges
• Divides jurisdiction between SEC/CFTC
• Required studies and rule-making process
has begun; area where rule-making will
lead to more clarity
Hedge Funds
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Outside federal securities law
Not a big role in current financial crisis
High leverage, trading strategies
Maybe 1/5 of trading on NYSE; very
significant market presence
• Risk seen in 1998 Long Term Capital
Management bailout and the Madoff
scandal
Hedge Funds p. 2
• Registration for advisors w/ funds over
$150 million • Recordkeeping/reporting requirements
• Small advisors regulated by States (or
SEC if state does not do that)
• Requires several major studies of
investors, short selling, and of feeder
funds.
Credit Rating Agencies
• Fitch, Moody’s, Standard & Poor’s
• SEC provides credit rating agencies with a
NRSRO designation: Nationally
Recognized Statistical Rating Organization
• Important as many state and federal laws
and regulations reference this designation
Credit Rating Agencies p. 2
• Amends Credit Rating Agency Reform Act
passed in 2006
• New Office of Credit Ratings reports to
SEC Chair
• Firewall rules between rating and
marketing activities
• Rules on independent directors,
compliance officer, internal control
Insurance Industry
• Insurance regulation generally left to
states based on 1945 law
• Federal Insurance Office located in
Treasury Department; limited activity
• No direct substantive regulatory authority
• Locates insurance expertise in Treasury
• Collects information and recommendations
for Financial Stability Oversight Council
Bureau of Consumer Financial
Protection
• Fragmented system around consumer
lending and financial products
• Housed in Federal Reserve but has
independent authority
• Director appointed by President but advice
and consent of Congress
• Regulates broad array of consumer
financial products but some exemptions
including car dealers
Bureau of Consumer Financial
Protection p. 2
• Oversight over: deposit taking, mortgages,
credit cards, loan servicing, check
guaranteeing, collection of consumer
reporting data, debt collection, real estate
settlement, money transmitting, financial
data processing
• Exceptions includes accountants
Mortgage Reform
• National underwriting standards for
residential loans
• Reasonable ability of borrower to repay
• Limits on some abusive practices, i.e.
balloon payment, prepayment penalty,
• Guidance on mortgage servicing and
escrow
• Restricts payment to mortgage originators
Other Activities
• Creates SEC “Office of Investor Advocate”
and ombudsman
• Guidance on fiduciary duty of broker
/dealers with customers
• Rules regarding accountability and
executive compensation
• Debit card interchange fees
• Permanent increase deposit insurance
Other Protections/Activities
• SEC study on financial intermediaries i.e.
“feeder funds.”
• Independent verification of client assets in
custody of various investment advisors
• SEC study on short selling
• SEC to be partially self funded
• New class of SEC registrant: municipal
advisor
SEC Whistleblower Bounty
• SEC proposed rules now available
• Original information on fraud could net
30% of monetary sanctions over $1m.
• Fear this will undermine company internal
control, fraud and ethics programs in place
since 2002 Sarbanes Oxley Law making it
more difficult for a firm to police itself
Municipal Securities
• Establishes SEC registration of “municipal
advisors” and defines their fiduciary duty
• Expands Municipal Securities Rulemaking
Board (MSRB) authority
• Reconstitutes MSRB with a majority of
independent board members
• Studies on role of GASB
Dodd-Frank: Conclusions
• Assumes new products/new issues; ability
for flexible response
• Most controversy around derivatives,
“Volcker Rule ” and Consumer Financial
Protection Board
• Funding issues have already arisen
• Many observers: the rule-making process
will lead to more clarity
• A “long and winding road.”
Books & Other Resources
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In Fed We Trust – David Weisel
The Squam Lake Report
The Big Short – Michael Lewis
Too Big To Fail – Andrew Ross Sorkin
A Colossal Failure of Common Sense –
Lawrence McDonald
• Article: “What Good Is Wall Street,” New Yorker
magazine 11/24/10 – John Cassidy
• Irrational Exuberance – Robert Shiller
Other Resources p. 2
• Financial Crisis Inquiry Commission
• Cambridge Winter Center for Financial
Institutions
• Congressional Research Service
• Law firm summaries on Dodd-Frank
(Davis Polk; Cadwalader; Skadden Arps)