On March 31, 2008, Treasury Secretary Henry Paulson announced the Bush Administration's proposal for significant new regulation of the financial markets in the United States. As recently as the turn of the New Year, this proposal might have been an unimaginable response from the Administration to the current crises in the financial marketplace. Perhaps not as difficult to predict is that the Democratic Congress appears poised to seek even wider new regulations under the banner of protecting consumers and modernizing outmoded regulatory structures.
This alert from Blank Rome Government Relations will discuss in broad terms recent proposals from both the Administration and from Congress for addressing the perceived weaknesses in U.S. financial markets and the outlook in 2008 and 2009 for changes in the existing regulatory structure. We, together with our colleagues at the law firm of Blank Rome LLP, are analyzing developments in the markets and in domestic and international government agencies on a regular basis.
This alert is the first of a series that is intended to keep our colleagues, clients, and friends up to date on pending proposals and their prospects for success.
Background
While there are a variety of views in Washington on how best to change the regulatory framework in which the financial industry operates, there is a growing consensus on the nature of the problem that would have been hard to predict a few short months ago. That emerging consensus view holds that innovation in the financial sector has outpaced the ability of regulatory agencies—some of which were created seventy or more years ago— to ensure the markets function in an environment of trust. Since the third quarter of 2007, we witnessed significant failures in the marketplace for mortgage backed securities, certain collateralized debt obligations, and certain types of municipal bonds, such as auction rate securities. At the same time, a wave of mortgage foreclosures has swept unevenly across the country but in significant enough measure to warrant a national response. The near failure of Bear Stearns, the dramatic action of the Federal Reserve to rescue it, and the domino effect it was predicted to cause are also viewed as indicators of a weakness in certain markets and the failure of their regulators to see trouble coming before it occurs.
The failures of the marketplace and its regulators call into question the risk profile of very substantial financial houses; the underwriting process of mortgage brokers and banks; the rigor of the credit rating agencies; the structure of debt insurance companies; and the role of the alphabet-soup of federal and state regulators who oversee the process.
Those who believe remedial action by government is needed to shore up the weaknesses in these financial markets can take heart that official Washington appears to be in agreement. Those who believe these markets can selfcorrect have reason to be concerned but can take some solace in the fact that little is expected to be accomplished before the November election and the swearing-in of a new President and Congress in January 2009.
The Administration Plan
Even in announcing the Administration's plan to modernize, streamline, and increase regulation of certain sectors of the financial markets and to provide some assistance to homeowners at risk of foreclosure, Secretary Paulson indicated he did not expect Congress to act on major parts of the proposal before the Administration leaves office. One can therefore surmise that one major purpose of announcing the proposal was to put Congress on notice of the limits of the Administration's willingness to sign on to significant new regulation or to government financed assistance to those who suffered losses as a result of recent events. In broad summary, the Paulson plan calls for:
- increasing the regulatory authority of the Federal Reserve to enhance market stability and broaden its powers to include oversight and regulation of hedge funds and private equity funds;
- streamlining securities oversight by merging the Commodities Future Trading Commission into the Securities and Exchange Commission and allowing certain current functions of the SEC to be performed by industry groups;
- simplifying bank regulation by abolishing the Office of Thrift Supervision while vesting most of its powers in the Office of the Comptroller of the Currency;
- creating new agencies such as one to oversee agencies with an explicit government guarantee and another agency to create and oversee standards for mortgage origination;
- providing insurance companies the option of a federal charter as an alternative to state regulation; and
- expanding the authority of the Federal Housing Administration to back existing and future home mortgages.
Congressional Response
On Capitol Hill, key Democratic leaders such as Senate Majority Leader Harry Reid (D-NV), Senate Banking Committee Chair Chris Dodd (D-CT) and House Financial Services Committee Chair Barney Frank (D-M) all declared, in their own words, that the Paulson plan was insufficient to address the current issues in these markets. Dodd, the most critical of Paulson's plan, used the opportunity to lay out what he sees as the guiding principles of market reform, "First, where we can simplify and rationalize regulation, we should. More effective and efficient regulation will help keep our financial sector competitive in the global economy. Second, we must restore the trust and confidence of investors and consumers. That trust has been shattered-not because regulators did too much, but because they did too little."
Frank, while disagreeing with many of the specifics in the blueprint, applauded Paulson's efforts to move the debate forward, saying, "by rejecting the argument for the status quo; by making it clear that new regulation done properly enhances the function of the market rather than detracts from it; and by explicitly including consumer protection among the core functions of the system he proposes, he has narrowed, albeit by no means removed, the differences between his position and that of many Democrats." Both Dodd and Frank suggested a stronger regulatory hand at the federal level over the securities and investment banking industries. They also questioned whether the role proposed for the Federal Reserve is appropriate for a body that has the ability to commit taxpayer dollars, as it did in the Bear Stearns rescue, but is not directly accountable to either the Administration or to Congress. Among the proposals gaining momentum on Capitol Hill are those that would:
- require investment banks to meet federally mandated capital reserve levels;
- limit the availability of, and create standards for, certain "high risk" products like collateralized debt obligations, credit swaps, and mortgage backed securities through a new regulatory agency;
- base regulations on the functions a firm performs (e.g. creating credit)—not the ownership form of the firm;
- spend tens of billions of federal dollars to assist homeowners in restructuring the principal and interest of their mortgages; and
- amend bankruptcy laws to allow judges to restructure the principal and interest of home mortgages. While the Administration and Congress float a variety of proposals, the three leading Presidential candidates are also speaking out on certain parts of this agenda. Senators Clinton and Obama each proposed multi-billion dollar plans to address the foreclosure crisis and discussed the need for stricter regulation to protect consumers. Senator McCain, on the other hand, urged a "go slow" approach and indicated it is not necessarily government's role to intervene in the marketplace to address issues beyond the impacts of the foreclosure crisis on those who live in the properties subject to foreclosure.
Conclusions
Given concerns about the effects of market turbulence on the American, if not the world, economy and the emerging consensus that some federal government action is needed to respond to the needs of a more complex and sophisticated array of financial institutions and products, we believe Congress and the Administration could well come together to take some initial steps in 2008. Senate Majority Leader Reid and Minority Leader McConnell already signaled their willingness to work together on these issues. Legislation to address what many perceive to be the mortgage foreclosure crisis has the best chance of success this year. Some combination of federal expenditures to expand the ability of the FHA to insure restructured existing and new loans and relaxed reserve standards for government sponsored enterprises such as Fannie Mae and Freddie Mac will receive strong consideration.
The Senate has already advanced bipartisan legislation on foreclosure assistance Their bill would provide funds to expand mortgage counseling and for the purchase by municipalities of foreclosed properties. It also includes tax credits to encourage the purchase of foreclosed properties and a permanent increase in the maximum amount of a mortgage that can be insured by the FHA. The House is expected to move swiftly on similar, if not identical, legislation.
While enactment of legislation this year may be limited to the foreclosure issue, serious work will be done by leaders of the House and Senate to develop concepts that will find their way into more formal legislative proposals later this year. This will set the table for action by the next Congress and for debate in the upcoming Presidential and congressional elections. Understanding the importance of this early legislative work, Blank Rome will be monitoring it closely and urges its clients and colleagues to do likewise.
Sweeping changes may be in the offing in the financial marketplace. We are here to help our clients understand the proposals under consideration, assess potential impacts on their businesses, affect the outcome of the policy process, and prepare for new regulatory regimes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.