What's this big finance-regulation overhaul really do?

WASHINGTON — With final Senate passage Thursday of the broadest overhaul of financial regulation since the Great Depression, the hard work really starts. Regulators must fill in the blanks in the legislation, and a new agency to protect consumers must be erected from scratch.

The landmark legislation will bring lots of changes. Here are some answers to questions about them, and how it will address some root causes of the deep financial crisis.

Q: What does the legislation do for ordinary folk like me?

A: The most significant change is the creation of a Bureau of Consumer Financial Protection, which will be independent but housed in the Federal Reserve, the nation's central bank. This new bureaucracy will have a single mission: consumer protection for credit products such as mortgages and credit cards. That responsibility had rested with multiple bank regulators, none of whom treated it as a priority.

Q: What does that mean for homebuyers?

A: The law includes a number of provisions that restrict predatory lending. The question is how aggressively the new bureau oversees mortgage lending. For example, will it set ironclad limits on so-called "liar loans," in which there was no income verification for mortgages? Will it ban adjustable-rate mortgages with low teaser rates that allowed borrowers to get into homes they couldn't afford? The bureau also is expected to force lenders to use clear language about borrowing costs.

Another important change is tough regulation for mortgage brokers. Many borrowers erroneously assumed that these brokers had their best interests at heart, when in fact there was no fiduciary duty to borrowers. Rather, lenders rewarded many brokers for getting borrowers into ill-suited mortgages.

The new law "ends steering payments that put mortgage brokers' interests out of sync with buyers' interests," said Sen. Jeff Merkley, D-Ore. He also authored some of tough restrictions on what banks can invest in if they're also investing money on behalf of clients.

The new bureau is expected to be most aggressive on mortgages, after the Fed failed to use the power it's had since 1994 to rein in reckless mortgage lending.

"We can't have that happen again. We've got to be very, very tough and consistent on this point," said Sen. Jack Reed, D-R.I.

To the ire of consumer advocates, however, the new agency will have only limited powers over auto lending.

Q: Would this legislation have prevented the financial crisis?

A: That's hard to say for sure, but it certainly would have given regulators the power to break up large failing financial firms, and there would have been transparency about who owes what to whom. The absence of such factors amplified the crisis of September and October 2008.

Q: How does this legislation fix what went wrong?

A: Various federal regulators will sit together on a "systemic risk" council that will police threats to the entire financial system. They'll also get so-called "resolution authority" that allows them to deconstruct a failing large financial firm in orderly fashion.

During the crisis, bankruptcy was the only option. That would have pitted creditors against shareholders and created panic. The Bush administration orchestrated the fire sale of investment bank Bear Stearns in March 2008, preventing panic. It tried to do the same with Lehman Brothers in September 2008, but when that failed, Lehman went bankrupt.

The ensuing panic nearly caused the collapse of global finance. That was prevented only by a massive government bailout program that was deeply unpopular with voters, and by the Federal Reserve's direct intervention in financial markets.

Those dark days occurred in an environment of little transparency about complex financial instruments called "derivatives." Investors, regulators and even CEOs of major financial firms were in the dark about some of these instruments. Absent clear information, everyone ran scared.

Q: I hear about transparency all the time. Why does it matter?

A: The lack of information about complex bets made on the probability of bond defaults was one reason the Federal Reserve stepped in and took majority ownership in insurance giant American International Group. Trillions of dollars' worth of private two-way bets were occurring outside regulators' view, and AIG was the biggest player. Today taxpayers could still be on the hook for about $162.5 billion, partly due to AIG's involvement in credit-default swaps.

Under the new law, however, deposit-taking institutions will be forbidden from significant involvement in the market for these swaps, which are bets on the chance of a bond default. Most derivatives transactions will have to occur on an exchange or central clearinghouse. There'll be real-time information about any given trade and, more broadly, about the swaps market, data that didn't exist when the meltdown hit in 2008.

Greed or malfeasance won't disappear from Wall Street, but regulators and investors will have more information than ever before to combat it.

Q: The legislation doesn't fix Fannie Mae and Freddie Mac. Weren't they a cause of the crisis?

A: Yes. The two mortgage finance giants, now in government conservatorship, certainly were contributing factors to the financial crisis. The Obama administration and congressional Democrats opted to leave Fannie and Freddie out of the bill, ostensibly to address them in separate legislation once the housing market recovers.

Fannie and Freddie buy mortgages originated by banks, then bundle them for sale to investors as bonds. From 2000 to 2006, Wall Street banks jumped aggressively into this business and out-competed Fannie and Freddie. In 2007, these Wall Street bonds backed by pools of U.S. mortgages began blowing up, and on came the financial meltdown.

Right now, Fannie and Freddie are the only mortgage-bond game in town. The private sector's secondary market, where Wall Street banks passed on their mortgages, is frozen. When this market revives, banks and other mortgage originators will have to keep a portion of what they generate on their own balance sheets to ensure they have capital at risk. This wasn't required during the run-up to the crisis.

Q: Will the bill prevent financial crises?

A: Probably not. The legislation mostly fights the previous crisis, not the next one, and Wall Street always finds innovative new ways to make markets spin. Regulators are empowered with new authority to police for risk. Banks will be required to have more cash on hand to cover losses. This will limit their risk-taking capabilities, and the authorities can order big financial firms to get smaller or face government intervention.

Financial markets are highly complex and ever innovating. A hard lesson of the financial crisis is that markets are profoundly interconnected, and in unexpected ways.

When Lehman Brothers filed for bankruptcy in September 2008, an unpleasant surprise followed days later.

Investors fled money market funds that pay 2 percent or 3 percent interest. To pay that interest, the funds take deposits or contributions and invest them in short-term debt issued by corporations called commercial paper. This sort of activity was always viewed as risk free.

However, Lehman was an issuer of commercial paper, and when it went bankrupt, panic ensued in places no one expected. Big manufacturers such as General Electric suddenly couldn't find buyers for their short-term debt, and investors frowned on putting savings at risk for the small returns offered in the money market funds that days earlier had been considered as safe as cash.

That's all to say that linkages are often hard to see. The best the legislation can hope to achieve is to provide regulators with an ample tool box, and it appears to do that. It will be up to the regulators to use the tools wisely.


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