News Journal: Kaufman: Financial regulations finally getting teeth

Any occasional reader of these columns knows I haven’t been happy about what has been done to avoid another financial crisis like the one that caused the Great Recession. Well, better late than never. It has taken five years, but a number of regulatory agencies are finally putting in place new rules and policies that will reduce the chances of that kind of meltdown happening again.
Back in 2008, derivatives were exactly what Warren Buffet called them then – financial weapons of mass destruction. In June of this year, the SEC finally adopted a new rule that in some ways effectively regulated trading in derivatives. But like so many regulations called for by the Dodd-Frank Wall Street Reform Act, it included a gigantic loophole that allowed banks to trade derivatives through foreign subsidiaries without SEC oversight.
The good news is that the European Union’s Financial Stability Board has forced Goldman Sachs and 17 other American banks to agree to forego the right to abandon derivatives contracts during a financial crisis. The abandonment of derivatives’ contracts is generally acknowledged to be one of the major reasons for the failure of Lehman Brothers. You can bet that the affected banks are going to reduce the risks they take when trading derivatives.
Another cause of the financial crisis was the complete securitization of home mortgages by Wall Street banks. Banks made mortgage loans knowing that they could package them and sell those packages to others. The banks received a fee and were off the hook if, as was the case, many of the mortgages turned out to be fraudulent or worthless. New regulations require the mortgage banks to keep five percent of the credit risk in all the mortgages they sell for securitization. There will actually be an incentive for banks to make sure the mortgage loans they make are sound.
One of the Federal Reserve’s major actions was to require banks with total assets of over $50 billion to conduct in-house stress tests. These tests analyze how a bank would fare under various economic conditions. The banks submitted their stress tests a few weeks ago and the Fed immediately unloaded on them, calling the tests “weak or poorly specified” and criticizing their documentation and support.
The big banks are going to have to institute realistic stress tests or face the consequences. The Fed specifically said that that if a bank made too many risky loans it would be considered in their “comprehensive capital analysis review.” The Fed considers loans risky if they are more than six times the borrowing company’s yearly earnings. The Fed’s new requirements should have a real effect on Wall Street banks behavior because when a bank fails a stress test, its ability to issue dividends is restricted.
The Fed also dismissed the attempts by eleven megabanks to write “living wills” as required by Dodd-Frank. The living wills are supposed to make sure the banks have a plan to deal with any major financial reversal so they do not have to be bailed out by the government. The Fed demanded the banks come back with more realistic plans to avoid a bailout.
There is also good news about policing high frequency traders. For the first time the SEC fined an HFT trader, finding that Athena Capital Research was “using high-powered computers, complex algorithms and rapid-fire trades” to manipulate the “closing prices of tens of thousands of stocks during the final seconds of almost every trading day.” SEC Chair Mary Jo White said, “When high-frequency traders cross the line and engage in fraud, we will pursue them as we do anyone who manipulates the markets.”
In addition, the U.S Attorney in Chicago has brought the first criminal charge against an HFT trader for using illegal methods to fraudulently take advantage of investors. The charge is that the trader engaged in a technique called “spoofing,” which consists of tricking others by entering and canceling orders to get a price advantage. Spoofing was outlawed in Dodd-Frank.
There’s a lot more that should be done, and I hope it won’t be affected by some in the new Congress who are talking about repealing much of Dodd-Frank. That would be a terrible step backward, just as U.S. and European regulators are beginning to put in place regulations with real teeth in them.
Ted Kaufman is a former U.S. Senator from Delaware.