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The Impact of Changing Rules for Wall Street

Capitol at Sunset One of the key messages resonating in the aftermath of the 2008 financial crisis was that it should not have happened, and new regulations were necessary to prevent that kind of crisis from happening again. It is taking awhile, but lawmakers have passed regulations broadly dubbed financial reform.

When people talk about financial reform in the aftermath of the financial crisis, they are almost always talking about the Dodd-Frank Wall Street Reform and Consumer Protection Act, most commonly referred to as Dodd-Frank. The law, which is more than two thousand pages long, is exceedingly complex.

While passed by Congress and signed by the president, the Dodd-Frank has yet to be fully implemented. In other words, the details are still being worked out, so we will only review the bill’s broad strokes.

1.      Greater transparency will help you make better investment decisions ─ provided you take the time to sit down and really dig into the information. The provisions of Dodd-Frank, designed to give greater transparency to financial products, would have “given investors insight into the quality of the sub-prime loans underlying the securities they purchased, giving them the opportunity to discover just how much risk they were assuming and would have required some risk retention, “according to Mary Schapiro, then-Chairman of the U.S. Securities and Exchange Commission (SEC).

Dodd-Frank mandates greater transparency in three ways:

  • It establishes the Office of Financial Research to, in part, collect and analyze data to “identify and monitor emerging risks to the economy” and make that information available in public reports and Congressional testimony.
  • It gives the SEC authority to impose a fiduciary duty on brokers who give investment advice; in other words, brokers will be required to provide only advice that is in the client’s best interest.
  • It requires issuers of asset-backed securities to analyze the quality of the assets underlying those securities and to disclose that information.

But this greater transparency is only meaningful if you take the time to do your due diligence ─ to read the reports from the Office of Financial Research, to read the disclosures provided by issuers, and really understand the underlying assets.

2.      New rules governing rating agencies will help ensure that ratings are a reliable source of information. Investors should be able to rely on credit rating agencies (like Standard & Poor’s, Moody’s, and Fitch) to help them discern the riskiness of securities. Securities given the highest rating, AAA, should present the least risk to investors. But the Senate Investigations Subcommittee found that over 90% of the AAA ratings given to subprime mortgage-backed securities originated in 2006 and 2007 were later downgraded by the credit rating agencies to junk status.

  • Mandates more disclosure from Nationally Recognized Statistical Ratings Organizations (NRSROs) ─ like Standard & Poor’s, Moody’s, and Fitch, for example. It requires those NRSROs to disclose their methodologies, use of third parties for due diligence efforts, and ratings track record.
  • Subjects NRSROs to expert liability, meaning investors can bring private rights of action against ratings agencies for a “knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source.”
  • Ends shopping for ratings. Issuers of asset-backed securities will no longer be allowed to select the rating agency they think will give the highest rating.

3.      As a shareholder, you’ll have more control over executive compensation and corporate governance. Many experts believe that the risk-taking that precipitated the financial crisis was driven by a focus in corporations on achieving ever-higher, short-term gains. So the provisions of Dodd-Frank that affect executive compensation and other aspects of corporate governance, giving the shareholders more say are designed to mitigate that kind of short-term focus.

To accomplish that goal, Dodd-Frank gives shareholders a say on pay and corporate affairs with a nonbinding vote on executive compensation and golden parachutes, which are lucrative severance pack-ages for executives.

4.      You’ll have a voice in SEC rules and regulations. Dodd-Frank also provides investors a chance to regulate the regulators. The Investment Advisory Committee, established by Dodd-Frank, is a committee of investors designed to advise the SEC on its regulatory priorities and practices. Dodd-Frank also creates the Office of Investor Advocate within the SEC to “identify areas where investors have significant problems dealing with the SEC and provide them assistance” and an ombudsman to handle complaints.

5.      The SEC will have more access to your information, which is a good thing. While most Americans bristle at the thought of the government having access to their private, personal financial information, the provisions of Dodd-Frank that give the SEC some access to certain investor information is designed to ensure that investors’ money is where their hedge fund manager says it is ─ to protect investors from another Bernie Madoff. Dodd-Frank accomplishes this by requiring hedge funds and private equity advisors to register with the SEC as investment advisors and provide information about their trades and portfolios.

6.      You may have reduced access to certain types of investments. Probably one of the most well-known aspects of Dodd-Frank is the Volcker Rule, which is broadly designed to prevent the kind of intermingling of risk that hit the financial system in 2008. Specifically, the Volcker Rule prohibits banks, their affiliates, and holding companies, as well as nonbank financial institutions supervised by the Fed, from engaging in proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and limits relationships with hedge funds, and limits relationships with hedge funds and private equity funds.

The Volcker Rule may mean restricted access to the kinds of investment opportunities that banks used to make available to their high-net-worth clients. Before the financial crisis, many banks invested their own money in hedge funds and private equity funds and also opened those individual funds to their wealthiest clients. Under the Volcker Rule, such funds will largely disappear.

In addition, Dodd-Frank raises the bar for investors to meet the legal definition of accredited investor. Previously, a net worth of $1 million, or a $200,000 salary for three consecutive years, qualified an investor as accredited, which meant that the investor could access certain types of investments ─ such as limited partnerships and hedge funds─ not available to other investors. Under Dodd-Frank, an investor’s primary home is not included in the $1 million calculation, which will considerably shrink the pool of investors who qualify for those limited access opportunities.

Dodd-Frank is an absolutely massive piece of legislation that touches every corner of the U.S. financial system. Its rules were undoubtedly meant to protect investors and to prevent another 2008-like financial crisis. How Dodd-Frank impacts the financial system once all of its rules have been implemented remains to be seen.

Copyright © Integrated Concepts 2012. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.

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