What financial reform means to you
It's not easy to boil down 2,300 pages of new legislation into 1,000 words, but here's the down and dirty of what you need to know.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (.pdf file), otherwise known as financial regulatory reform, will soon be signed into law by President Barack Obama now that Congress has passed it. There's no single article that can fully explain every way in which this sweeping legislation -- all 2,319 pages of it -- will ultimately impact your life. But it's important to understand at least the basics.
Let's have a look inside this new reform measure.
First watch the following 90-second video that reveals the broad strokes. Then we'll go into more detail.
Now, a deeper look at exactly how this reform bill will impact your life in coming months and years:
- In the case of a failing financial institution, the Federal Deposit Insurance Corp. will borrow from the Treasury to pay for the cost of liquidation, then get its money back by selling off the institution's assets. If asset sales aren't enough to repay Treasury, the FDIC could charge a fee to other banks.
- Payments to creditors of a failing institution designed to prevent a crisis from spreading will be limited to payments a creditor would receive in bankruptcy. In other words, money owed by failing financial firms to other companies might not be entirely repaid. This would prevent a repeat of the $180 billion taxpayer bailout of American International Group.
- If a bank fails, the FDIC will have the ability to take back compensation paid to its current or former senior executives in the two years preceding its failure. In addition, the government can ban senior executives found responsible for a bank's failure from future work in the financial services industry.
- Interchange fees, also known as "swipe fees," are charges merchants are required to pay Visa and MasterCard for processing debit and credit card transactions. The fees for debit cards average 1.6%; credit card swipe fees average more than 2%. Under the new law, the Federal Reserve can cap the fees on debit cards (but not credit cards) to what is "reasonable and proportional to the actual cost incurred."
It will take months for the Federal Reserve to decide what's reasonable, but in Europe, Visa and MasterCard interchange fees are as low as 0.2%. In Australia, they're capped at 0.5%. Odds are that caps in teh U.S. will be higher than those on other continents, but lower than they are here today. In lobbying for this change, retailers assured Congress that they would pass along their savings to consumers. Many consumer advocates, however -- including me -- are skeptical.
- Merchants will be allowed to offer a discount to customers who pay with credit or debit cards that carry lower transaction fees. That hasn't been allowed in the past. They'll also be allowed to set both minimums and maximums for card transactions.
- The days of the "liar loan" are now officially over. Lenders will be required to fully document a borrower's income before agreeing to provide a mortgage loan. They will also be required to determine that the borrower can otherwise repay the loan.
- The bill also prohibits lenders from offering incentives (called yield spread premiums) to mortgage brokers in exchange for originating loans with terms unfavorable to borrowers, such as higher interest rates.
- Prepayment penalties for most mortgage loans will no longer be allowed.
The downside of these consumer protections? By making mortgages less profitable for lenders, loans could become tougher for borrowers to get. We're already seeing stricter lending standards with higher required down payments.
Preventing another oil bubble
The ability of big Wall Street banks to trade huge, unregulated derivatives contracts hasn't been eliminated by the new law, but it has been curtailed. Many of the trades that in the past have been hidden from regulatory scrutiny will now be forced onto exchanges, where transactions will be more transparent. The reform bill also directs the Commodity Futures Trading Commission to craft new rules designed to limit speculation.
While this provision of the bill may seem the least relevant and most obscure to many on Main Street, this change could theoretically provide the biggest change to the lives of many Americans, with the prices of everything from food to oil affected.
To understand why, think back to July 2008, the days of $145-a-barrel oil and $4-a-gallon gasoline. While at the time the American public was assured that these prices were nothing more than the result of normal free market supply and demand, some believe that the oil market was being artificially inflated by hedge funds and other big investors buying billions of dollars worth of oil futures contracts for no other reason than speculation. Prices on Wall Street -- and at the pump -- weren't a reflection of the balance between suppliers and consumers. Instead, speculative demand created by unregulated trading pushed prices up.
According to CNNMoney.com, in a note to employees on April 23, Delta Air Lines CEO Richard Anderson wrote: "Prices are artificially inflated and volatility is created as a consequence of excessive speculation and trading by parties with no tangible need for the commodities."
The new rules requiring greater transparency in the trading of derivatives contracts like commodities will make it less likely that undisclosed speculators will be able to manipulate markets.
There is a counterargument from commodities speculators: They increase market liquidity, which in turn allows end-users like Delta to use commodities markets to hedge their fuel prices in the first place. Some in the securities industry say that limiting speculation will create more price volatility, not less.
In coming months and years, we'll find out if regulatory reform causes commodities and other derivatives markets to lose liquidity or gain stability along with accountability.
To get a greater understanding of derivatives, see our story "What the heck are derivatives?" Here's an article from The Wall Street Journal (subscription required) that further explains how the new rules could affect the price of agricultural commodities.
In the final version, the bill allows only consumers who are denied a loan or suffer some other sort of "adverse action" to get a free look at their credit score. Adverse actions include an increase in the cost of insurance, being charged more for or being denied a car lease, or if the interest rate offered on a credit card or loan is higher than one being offered to those with excellent credit.
The obvious question: If investment advisers at Wall Street firms like Merrill Lynch aren't required to do the right thing for their clients, what have retail investors been paying them for over the last century?
As it turns out, the little guys on Main Street have been paying for a lesser standard, known in the industry as "suitability." Investment recommendations made by retail stock brokers -- often working on commission -- needed to be merely suitable for their clients, not necessarily in their best interests.
Example: Your broker calls and recommends you buy a particular mutual fund. The mutual fund would generally fit your investment profile -- it's suitable for someone with your risk tolerance, tax bracket and investment objectives.
What you don't know, however, is they're recommending that fund because it pays them more commission and thus costs you more in fees than other similar funds. Under the old rules of suitability, that was OK, because the fund recommended was suitable. But it's not OK under the rules of a fiduciary, because they know there are better choices, and thus aren't acting in your best interests.
The fact that people paid to provide you with objective advice haven't been required to do so up to now is amazing. What's more amazing is that Congress didn't include this provision in the final bill. The new law instead directs the problem to be studied by the Securities and Exchange Commission for six months, then gives it the authority to change the standard as it sees fit.
But there is one large group of lenders that escaped oversight by the new agency: car dealers.
According to Edmunds.com, of the 11 million cars expected to be sold this year, about 70% will be financed or leased through a car dealership. But despite opposition from both consumer advocates and the White House, Senate Republicans successfully excluded car dealers from regulatory overview by the new bureau.
The argument from car dealers and their lobbyists? They're already regulated by plenty of state and federal consumer protection rules that are designed to prevent practices such as bait-and-switch lending and loans packed with undisclosed extras such as extended warranties.
In addition, dealers argued, if another layer of regulations were imposed on them, lending and leasing could become so unprofitable that many dealers would simply stop offering financing, ultimately hurting consumers.
- Financial literacy. The legislation requires the SEC to conduct a financial literacy study. It also creates an Office of Financial Literacy that will be tasked with developing programs to teach Americans about savings, loans, liens and fees. The agency would establish standards for financial advice programs and help keep Americans, particularly seniors, from becoming victims of scams.
- Investor Advocate. The bill creates an Investor Advocate within the SEC to represent the interests of retail investors.
- Greater disclosure to retail investors. The legislation requires that adequate disclosures be made to retail investors before they invest in financial products.
- More protection for underserved investors. Another goal is to allow greater access to mainstream financial institutions for those who don't use or underuse banks.
Where you can learn more about the legislation:
- The White House
- House Financial Services Committee
- Senate Banking, Housing and Urban Affairs Committee
- The Financial Services Roundtable
- Consumer Federation of America
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