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The Dodd-Frank Wall Street Reform and Consumer Protection Act: The Triumph of Crony Capitalism, Part 3


A continued look at the Act's provisions.


Editor's Note: This is Part 3 of a multi-part series. Read Part 1 here, Part 2 here, and Part 4 here.

Part 3

We continue to look at the Act's provisions.

Regulation of Derivatives and ABS

Recall that one of the major themes behind the Act is that the "murky" world of "exotic" instruments such as credit default swaps and asset backed securities (ABS) added unacceptable risk to the financial system. The goal of the Act is to provide "transparency" and "accountability" for those engaged in such instruments.

The SEC and Commodity Futures Trading Commission (CFTC) will regulate derivative markets. The CFTC is involved because they regulate the futures and options markets which are included within definition of "derivatives."

The new rules:

  • Require securitizers of ABS to maintain 5% of the credit risk in assets transferred, sold, or conveyed through the issuance of ABS ... The new rules must allocate the risk retention obligation between securitizers and originators. The retained risk may not be hedged. [The "skin in the game" rule.]

  • Banks must spin off "riskier" swaps dealing activities but can still conduct such activities through separately capitalized affiliates.

  • All standardized swaps must be cleared and exchange-traded.

  • End users [i.e., those who use derivatives for actual commercial hedging purposes] are exempt from the clearing requirement ...

  • The banking regulators, the SEC and the CFTC, will set margin and capital requirements for uncleared swaps.

  • Security-based swap dealers and major security-based swap participants will be required to comply with SEC-prescribed business conduct standards. … [They] will have a duty to communicate with counterparties in a fair and balanced manner based on principles of fair dealing and good faith and other standards and requirements prescribed by the SEC. [If you read The Big Short, you might say that this is the "Goldman Sachs Rule."]

  • It imposes new liability on securitizers for the underlying mortgages originated by third parties.

The Wall Street Journal ran an article exploring the world of farmers and futures contracts. Farmers rely on forward contracts to hedge their risks. What was interesting is the conclusion of the article: "There is no real understanding if the Act will exempt, say farmers who use futures as a hedge, or make it more difficult for them to hedge."

Office of Credit Ratings

To regulate credit rating agencies, a new Office of Credit Ratings is established. The most significant outcome of the Act is that investors are allowed to sue the rating agencies. They're now treated like other "experts" such as lawyers and accountants and are subject to the same liabilities.

There are basically only three credit rating agencies, Standard & Poor's, Moody's Investor Service, and Fitch Ratings. They're referred to as Nationally Recognized Statistical Rating Organizations (NRSROs) under the Act. These private companies are sanctioned by the SEC and the Treasury to give credit ratings. A kind of monopoly if you will. Basically you can't sell a security to the public without a rating from one of these companies.

When the rating agencies figured out what the legislation was doing to them, they promptly notified their clients that they couldn't use their ratings in ABS securities registrations. That apparently put a halt to the ABS market and caused Ford (F) to pull a pending offering. This caused the SEC to postpone the rules for six months until they figure out what to do.

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