The Wall Street Reform and Consumer Protection Act
Carlos M. Pelaez
The US House of Representatives passed by a vote of 223-202 on December 11, 2009, the H.R. 4173 Wall Street Reform and Consumer Protection Act (Wall Street Act). This writing analyzes the Wall Street Act by means of two main approaches to the causes, duration and depth of the credit/dollar crisis and global recession, which lead to different evaluations of banking and financial regulation.
First, the proposals emanating from government follow Official Prudential and Systemic Regulation (OPSR) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 30-4, Regulation of Banks and Finance, 217-24, International Financial Architecture, 101-60, Government Intervention in Globalization, 31-7, Globalization and the State, Vol. I, 30-43, Globalization and the State, Vol. II, 102-8). The assumed goal of OPSR is protecting depositors, investors, output and employment from failures in banking and financial markets. Financial crises are considered as the most important market failure, which is processed through “systemic risk.” The credit crisis allegedly originated in excessive risk taking by banks that were motivated in generating short-term profits to appropriate “irresponsible” compensation in bonuses and stock options. The failure of Lehman Bros in September 2008 affected the ability of other financial companies such as American International Group (AIG) and Citigroup to finance themselves in the market. Systemic effects consisted of paralysis of credit in multiple segments of financial markets, causing illiquidity of large companies and the collapse of their stock prices that prevented the raising of new capital. The government was forced into bailing out failing companies by equity infusions through the Troubled Assets Relief Program (TARP), which eventually restored confidence in financial markets.
Second, the alternative Finance View (FV) claims that the credit/dollar crisis and global recession were caused by government policies (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). The reduction of the interest rates on interbank loans or fed funds to 1 percent in 2003-4 with the announced determination to keep them at that level indefinitely distorted decisions on risk and returns of households, banks, companies and government. The interest-rate subsidy caused overproduction of housing and rising real estate prices fueled by the gigantic housing subsidy of the US of $221 billion per year, the purchase or guarantee of $1.6 trillion of non prime mortgages by Fannie and Freddie and the reduction of mortgage rates by elimination of the 30-year Treasury bond. The result of low interest rates and the housing subsidy was excessive construction of houses, laxity in borrowing and lending because house prices were expected to increase forever as central banks kept low interest rates, excessive risk exposures and leverage, low liquidity and unsound credit. Mortgage decisions based on permanently low interest rates turned sour when the Fed increased interest rates from 1 percent to 5.25 percent in 2004-2006, disrupting securitization and derivatives markets. The alarmist proposal of TARP in the second half of September 2009 as if it were required in avoiding another Great Depression because of “toxic assets” in all banks, instead of the failure of Lehman Bros, caused a crisis of confidence that stopped financing in many segments. Markets recovered on their own without withdrawal of toxic assets as first proposed by TARP and in the new administration by the Financial Stability Plan (FSP). Policy prolonged and deepened the credit/dollar crisis and global recession. The regulation passed by the Wall Street Reform and Consumer Protection Act is analyzed below by means of these two approaches.

(1)Cram down. The high moment of the US House of Representatives was the rejection by 241-188 votes of the “cram down,” allowing bankruptcy judges to reduce principal and interest rates on mortgages, extending repayment periods. Securitization of mortgages dates at least to the charter of Freddie Mac in 1970 to guarantee securities backed by mortgages and worked well until the zero interest rate and housing subsidy caused the credit crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-52, Regulation of Banks and Finance, 58-60, 79-80). Securitization allows a critical function of finance by bundling many small loans in large securities purchased by investors such as mutual and pension funds where individuals deposit their savings and build their retirements. Generalized default of mortgage-backed securities by bankruptcy judges as proposed in the cram down process would fracture the source of finance required for reconstruction of housing finance, economic growth and creation of employment. Investors and savers would not invest again in mortgage-backed securities and there could be a repetition of the credit crunch. The objective of the cram down of scaring ultimate holders of claims to modify mortgages failed but it scared investors financing new mortgages required for economic growth and employment creation.
(2)Financial Stability Oversight Council (Council). The Wall Street Act establishes an “inter-agency oversight council that will identify financial companies that are so large, interconnected, or risky that their collapse would put the entire economy at risk.” Systemic risk is a concept in search of a definition for rigorous measurement. As Professor Hal C. Scott states, Congress should appoint “a new expert commission designed to fully investigate the extent and consequences of interconnectedness before any new regulation of systemically important institutions is actually adopted” http://www.capmktsreg.org/pdfs/09-Dec-11_Do_We_Really_Need_a_Systemic_Regulator_by_Hal_S_Scott(WSJ).pdf
(3)Large, Interconnected Financial Firms. The Council will apply stricter standards and regulation to financial companies posing threats to financial stability, imposing higher capital requirements and limits on leverage and concentration of risk exposures. The twelve members of the Council and limited staff will determine the size, structure and risk decisions of 11 banking organizations that in 2006 had $4.6 trillion of assets equivalent to 44 percent of total US banking assets of $10.5 trillion and 96 percent of US foreign banking assets of close to $1 trillion (Pelaez and Pelaez, Globalization and the State Vol. II, 147). The Council of the Wall Street Act will undermine the competitiveness of American banks to finance American companies of optimum size and technology in world markets. Decisions on reducing the size of financial companies may have similar consequences on financial instability as the alarmist announcement of TARP in September 2008: anticipation of problems in a company will drive the stock price toward zero, causing its disorganized illiquidity and bankruptcy as it happened with Bear Stearns, Lehman Bros, Fannie and Freddie. The Wall Street Act is predicated on the assumption that the Council of 12 agencies is superior in financial management to the entire financial market. The consequences of regulatory failures that may occur will be magnified by these exceptional powers without definition and rigorous measurement of the elusive concept of “interconnectedness. “
(4)Role of the Fed. The Council is a far more politicized agency than the Federal Reserve System (FRS), which is the evident loser in legislation perhaps because of its tradition of independence. The FRS will be the “agent of the Council” in regulating systemic risk consolidated across banks and wherever found individually. The Government Accountability Office (GAO) would examine the FRS to increase transparency of the FRS and its actions. There is significant risk of political decisions on economic events at the wrong time. Surveillance of the actions of the Federal Open Market Committee (FOMC) could frustrate monetary policy as financial markets and the public anticipate reversals because of political pressure of what could be correct policy that still has not had time to be processed. The relation of the Council and the Fed resembles several individuals simultaneously handling the steering wheel and stepping on accelerators and breaks of a vehicle. The best informed driver, the Fed, would not have control of the vehicle as it moves into frontal collision.
(5)Dissolution Authority. The Wall Street Act declares the end of the doctrine of “too big to fail.” Regulators will dissolve large, very complex financial institutions in an “orderly and controlled manner.” These are the same regulators that managed the resolution of Bear Stearns, Lehman Bros, AIG, CountryWide, Washington Mutual, Fannie, Freddie and over 100 banks now armed with the elusive definition and measurement of interconnectedness. The main objective of the new authority is that shareholders and unsecured creditors instead of taxpayers bear the burden of dissolution. The new process will be different from bankruptcy because it will prevent “contagion and disruption to the entire system and the overall economy.” There is no new knowledge on defining, measuring and preventing systemic risk. There is no such thing as orderly resolution of a financial crisis. The Wall Street Act creates a Systemic Dissolution Fund with assessments on financial companies for a total of $150 billion. This Fund would be insufficient to deal with Fannie and Freddie whose fate and pivotal role in the financial crisis are not even mentioned in the Wall Street Act.
(6) Consumer Financial Protection Agency (CFPA). The CFPA is designed to protect the public from unfair and deceptive financial products and services in avoiding another financial crisis. The actual deception of the public was in encouraging excessive risk and debt by the promise of nearly zero interest rates during an indefinite period and the housing subsidy that could make true the dream of owning a house bought at peak real estate prices with guaranteed mortgages and the interest rates near historical lows. The CFPA will restrict the volume of consumer loans and increase interest rates in consumer credit much the same as the credit card bill because of the lack of investors and lenders providing funds under regulation that prevents sound assessment of lending risk.
The major weakness of the Wall Street Act is its sole reliance on OPSR. Constructive regulation should be based on Functional Structural Finance (FSAF) by which the government would induce the spirals of innovation that have contributed to past prosperity with balanced regulation. The uses and limitations of regulations are not properly blended in the Wall Street Act, which can frustrate financial functions for growth of output and employment creation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)